Arbitrage in Options Trading: Meaning, Types & Benefits
Arbitraging is a strategy that includes taking advantage of the price differences of an asset trading on different exchanges and reaping gains. It is generally applicable for equity, currency or commodity investments, but traders of derivatives can also make use of this method.
So, if you are an investor who is looking to arbitrage using options contracts, keep reading this blog. You will find applicable options arbitrage strategies that you can implement in this regard.
What is Arbitrage in Options Contracts?
Arbitrage in options contracts is a trading strategy in which you buy and sell derivatives agreements having the same underlying asset and expiration date but at two different exchanges. It is a low risk tactic which allows you to earn profits on the price discrepancies of a derivatives contract .
Types of Options Arbitrage Strategies
Here are some of the commonly used types of options arbitrage strategies:
- Call-Put Parity
According to the Black-Scholes model, the call and put options of a derivatives contract need to be around the underlying asset’s intrinsic value. This factor is known as call-put parity.
However, there can be situations in which the price of either option – i.e., call or put, is far away from the underlying security’s intrinsic value. This gives rise to a price disparity and creates a chance for call-put parity arbitrage.
For instance, the call option of a certain contract can be undervalued in comparison to the put based on the same underlying asset. Inversely, a call option can have a higher value compared to another call option having a different expiry and strike price on the same underlying.
- Strike Arbitrage
Strike arbitrage is a situation when there is a disparity in strike values of two options contracts, both having the same underlying asset.
For example, you have two options contracts for Reliance shares, both having different strike prices. Under such circumstances, you can consider selling the overvalued Out-of-The-Money (OTM) option and purchasing the undervalued one. This way, if the underlying stock value remains more or less the same upon expiration, the difference between the strike shall be your profit.
- Box Spread
Box spread or long box spread is an arbitrage options trading strategy which involves initiating a Bull Call Spread as well as a Bear Put Spread. For constructing the former, you need to purchase 1 Out-of-The-Money (OTM) and 1 In-The-Money (ITM) call option. Whereas for the latter, you need to buy 1 Out-of-The-Money (OTM) and 1 In-The-Money (ITM) put option. A thing to note is that all options must have the same strike price and date of expiry.
This strategy has very little profit margins and is recommended for use when markets are relatively stable.
- Reversal Arbitrage
Reversal arbitrage is also a viable strategy when it comes to taking advantage of varying options prices with the same underlying asset. To implement this method, you need to buy synthetic calls and put options to match the former underlying security’s position.
Now, if your synthetic options deviate from their prices, there is a chance of arbitrage which you can utilise for securing gains.
Benefits of Options Arbitrage Trading
These are some of the benefits of trading options via arbitrage:
- Very Low Risks
A significant benefit of arbitraging options contracts is that this strategy comes with very low risks. This is because the underlying asset that you need for conducting arbitrage will be the same on different platforms.
For example, if you are planning to conduct options arbitrage by keeping Infosys stock as the underlying asset, they will be the same on both the NSE and the BSE. Only, there may be a difference in options prices which can help you earn a profit.
- Prevents Stark Price Variations
Arbitraging effectively reduces the price discrepancies that may be present among similar assets across various trading platforms. This negates the chances of stark asset price variations across exchanges, enabling you to purchase or sell securities at justified values.
- Improves Market Efficiency
Conducting options arbitrage also improves overall market efficiency. This is because, if arbitrage activities did not occur, securities would have traded at various price levels, making it difficult for a majority of the traders to speculate the market. Thus, there would be a concentration of power in the hands of big investors, giving rise to unfair trading practices.
Despite the low risks of arbitrage trading, there are some things which you must keep in mind. The profit potential in this form of investing is low and in some situations, may not be enough to cover the brokerage fees and taxes. To counter this problem, you can consider opting for a brokerage firm with lower service charges.
Frequently Asked Questions
What are the conditions for conducting arbitrage trading?
In order to conduct arbitrage trades, there are two essential factors that you need to keep in mind. First, there must be a price discrepancy in the asset values in different exchanges. Second, the transactions need to be simultaneous as the window to gain profits via arbitraging is very small.
What are the best arbitrage strategies for international trading?
For arbitraging in the international markets there are several available strategies. Some of the best which you can follow are covered interest arbitrage, two-point arbitrage and triangular arbitrage.
Is arbitrage trading legal in India?
Yes, arbitrage trading is legal in India, but SEBI does not allow same day buying or selling of securities on different exchanges. Thus, you can sell the assets that you already have in your Demat account from one exchange and buy them for a lower price on another exchange.
Who is suitable for arbitrage trading?
Arbitrage trading is suitable for those investors who want to trade with the lowest possible risks. Moreover, they must be active individuals who can spot split second price changes and take advantage of them.