Options Arbitrage

Options Arbitrage refers to strategies that exploit price inefficiencies in options markets to generate risk-free or low-risk profits. These strategies involve taking offsetting positions in options and/or the underlying asset. Below are common types of options arbitrage strategies:

1. Conversion and Reverse Conversion Arbitrage

  • Concept: Exploits mispricing between call and put options of the same strike price and expiration.
  • Execution:
    • Conversion Arbitrage: Buy the underlying, buy a put, and sell a call.
    • Reverse Conversion: Short the underlying, sell a put, and buy a call.
  • Goal: Lock in a risk-free profit from discrepancies in put-call parity.

2. Calendar Arbitrage

  • Concept: Takes advantage of mispricing between options with the same strike price but different expiration dates.
  • Execution:
    • Buy an option with a longer expiration (cheaper time decay).
    • Sell an option with a shorter expiration (faster time decay).
  • Goal: Benefit from time decay differentials (Theta).

3. Volatility Arbitrage

  • Concept: Profits from differences between implied volatility and actual (realized) volatility.
  • Execution:
    • Go long (buy options) when implied volatility is low compared to historical or forecasted volatility.
    • Go short (sell options) when implied volatility is high.
  • Goal: Capture the mispricing between expected and realized price movements.

4. Dispersion Arbitrage

  • Concept: Exploits the difference in volatility between an index and its constituent stocks.
  • Execution:
    • Short index options (lower implied volatility).
    • Long options on the individual stocks (higher implied volatility).
  • Goal: Profit from the difference in volatility pricing.

5. Box Spread Arbitrage

  • Concept: A risk-free arbitrage strategy created by combining a bull call spread with a bear put spread.
  • Execution:
    • Buy a call and sell a call at a higher strike (bull spread).
    • Sell a put and buy a put at the same strike prices (bear spread).
  • Goal: Earn the difference between the net premium and the discounted value of the strikes.

6. Statistical Arbitrage

  • Concept: Uses quantitative models to find short-term mispricings in options markets.
  • Execution:
    • Combine options and the underlying asset based on historical price relationships.
    • Utilize algorithms to manage trades dynamically.
  • Goal: Achieve consistent, low-risk returns by exploiting statistical patterns.

Key Considerations

  1. Transaction Costs: High costs can erode arbitrage profits.
  2. Liquidity: Illiquid options may hinder execution.
  3. Execution Risk: Rapid price changes can disrupt arbitrage setups.
  4. Model Risk: Incorrect assumptions can lead to losses in volatility or statistical arbitrage.