OPTIONS
Intriguing, Elusive, Useful
Option Arbitrage
by Jesse Chen
What is arbitrage and is it really for you?
OF all the option analysis strategies,
arbitrage trades seem to be one of the most intriguing and elusive strategies.
Arbitrage is defined as the buying and selling of a financial instrument
in order to profit from the price differential. This traditionally occurs
between two different exchanges, possibly between a domestic and foreign
exchange where one exchange has not adjusted for the constantly changing
currency rates. Arbitrage was made famous in the movie Rogue Trader,
in which Nick Leason supposedly made millions arbitraging the Nikkei index
between the Singapore and UK exchanges.
Option arbitrage involves the simultaneous buying and selling of options
either between exchanges or the same exchange. We will cover six different
types of option strategies: strike, calendar, intramarket, and conversions,
boxes, and straddles. When trading arbs, take into account that there can
be early assignment of any in-the-money options for all American-style
exercise options (exercise before expiration). In addition, possible dividend
liability exists on any exercised short puts during dividend dates.
CALENDAR OPTION ARBITRAGE
A calendar arbitrage involves the buying and selling of options with
the same underlying options, strike, and type (call or put), but different
months where the nearer month is sold for more than the farther month is
bought (Figure 1). Calendar arbitrages may require longer periods in order
to realize the small profit.
STRIKE ARBITRAGE
A strike arbitrage involves buying and selling the same underlying options,
month, and type (call or put) but different strikes where the strike difference
is less than the premium difference (Figure 2). When this occurs, a riskless
trade can be formed.
FIGURE 1: CALENDAR ARBITRAGE. You buy and sell options
with the same underlying options, strike, and type (call or put), but different
months where the nearer month is sold for more than the farther month is
bought.
...Continued in the May issue of Technical Analysis of STOCKS &
COMMODITIES
Excerpted from an article originally published in the May 2007 issue
of Technical Analysis of
STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2007, Technical Analysis, Inc.
Return to May 2007 Contents
