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What is Option Arbitrage?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 29 September 2016
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The underlying concept of option arbitrage has to do with a systemic and simultaneous buying and selling of stock when certain market conditions are in effect. Here are some facts about how this process is conducted and what types of market conditions usually exist that warrant the implementation of it.

Option arbitrage often occurs when the main goal is to create a modest profit that involves little or no risk to the shareholder. To this end, there are several different forms that this activity can take. One of the more common models is referred to as a strike option arbitrage. With this model, there is a simultaneous buying and selling of the same options, with all activity carrying the same type, either put or call. In order for the strategy to work, the strike difference has to be less than the premium difference. This type is almost completely risk free and has the potential to yield a small profit.

A calendar option arbitrage is very similar to the strike method, in that the investor is once again dealing with the same options and type. With this approach, however, the strike must also match and the options will not carry the same months. The nearer months will be sold for a higher price than the amount that is paid for the further months. This strategy also allows the value of the shares in hand to increase slightly.

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Intra-market option arbitrage also involves the buying and selling of shares with the same options, strike, month, and type. But here the difference is that more than one exchange is used in the transaction. Thus options that carry the same point spread, but on two different exchanges, may be bought and sold, with the idea being to buy at a lower price and sell at a higher price.

While still relatively common, the practice of option arbitrage has decreased since the advent of automated trading strategies, in that the newer approaches can often produce the same results, but without as many steps involved. Understanding that option arbitrage is a good idea when stock options are relatively overpriced can also help the investor to explore his or her options, and possibly realize a higher return on the investment. With this concept in mind, it is doubtful that the use of option arbitrage will ever fully disappear from the business of buying and selling stocks.

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SkyWhisperer
Post 4

@everetra - I was going to get into options trading some time ago. The allure of buying something at a future date with a set price, rather than simply owning it outright from the start, seemed to be promising.

Then I checked with my financial advisor and he said that about 80% of options traders lose money. Options are basically bets, and the house is stacked against you. You have to be right about both timing and stock price movements, almost to a fault, to make any real money.

If you want to get into something comparable to options, I would just get into day trading. There you can own the stock momentarily, and make incremental gains (or losses) in a short amount of time.

The idea of owning an option, which is not the actual asset itself but a contract on it, just doesn’t make sense to me.

everetra
Post 3

My broker told me about this kind of trade but he said that it’s not that common anymore, nor is it as easy to make a profit, even a modest one, as it used to be.

This trade basically executes overpriced options and underpriced options at the same time, in hopes of making a small profit. The problem, as my broker explained to me, is that there is a small window of opportunity where you have to execute both of these trades.

During that window other traders usually execute the options too and eventually restore the price points to normal, or a state of equilibrium. In other words, if you don’t move fast enough you won’t make any profit, period.

With the advent of automated trading, moving fast becomes even harder. In short, there is no free lunch in the option trades market.

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