Arbitrage trading is an advanced strategy that experienced traders often attempt in unequal or imbalanced markets. While beginners aim to study price directions and profit from trends or trend reversals, skilled market participants look for discrepancies in the pricing of market instruments and try to use this gap to their advantage. However, arbitrage opportunities can be rare, and to make the most of them in dynamic markets, you need advanced trading features and analytical tools like those offered in the Samco trading app.

With live updates from the options market, a whole range of technical indicators at your fingertips and various advanced features like TradingView charts and Options B.R.O, Samco Securities makes options trading easier and better for traders at all skill levels.

However, if you want to make the most of Samco’s trading tools for arbitrage trading, you must first understand what arbitrage trading is, how options arbitrage works and what the key strategies in this segment are.

A Closer Look at Arbitrage Trading

Arbitrage is the practice of exploiting the price difference of an asset in two different markets. This is the simplest form of the trading technique we are discussing. For instance, if a stock is trading at Rs. 100.70 on the NSE and at Rs. 101.20 on the BSE, you can buy that stock on the NSE and sell it on the BSE to profit from the price difference of Rs. 0.50 per share.

However, arbitrage trading can also be done in other ways. For instance, spot-to-futures arbitrage is a common practice that aims to take advantage of the discrepancies between the spot market and the futures market for the same asset. Here, you simultaneously buy (or sell) the asset in the spot market and sell (or buy) the asset in the futures market. By taking such opposing positions in the cash and futures market, you can potentially lock in a risk-free profit if the price difference is greater than the cost of the trade.

Arbitrage in the Options Market

Beyond arbitrage in the stock market, traders can also look for mispricings in other segments like the options market. Options arbitrage can be slightly more complicated, but with the right options arbitrage strategies, you can adopt different ways to make the most of price discrepancies in these derivative contracts.

If you want to initiate arbitrage trades in the options market, you can do it in one of two ways. The first is to leverage the price mismatch between two options, and the second is to take an arbitrage position using an options contract and its underlying asset.

Since options trading involves various price metrics like the price of the underlying asset, the call option’s premium and the put option’s premium, it takes more skill and experience to get better at options arbitrage.

Decoding Common Options Arbitrage Strategies

Options arbitrage strategies can help you capitalise on price discrepancies or mismatches in the options market. The most common options arbitrage strategies include the following trading methods:

• Put-Call Parity

Put-call parity is a fundamental principle in options pricing that helps you establish a relationship between the prices of European calls and puts and their underlying assets. As per the principle of put-call parity, a portfolio with a long call and a short put should have the same value as a long position in the underlying asset’s spot market.

This principle can be summed up using the following formula:

C + PV = P + S

Here, C is the call option premium, PV is the present value of the strike price (discounted at the risk-free rate), P is the put option premium and S is the current price of the underlying asset in the spot market. Options arbitrage using this principle involves identifying options that do not validate the above equation — indicating a price mismatch between the calls and puts — and trading such price discrepancies.

Let us discuss an example to understand this options arbitrage strategy better. Say a stock is trading at Rs. 1,000. Its call and put options, each with a strike price of Rs. 1,050 and expiring in 3 months, are priced at Rs. 50 and Rs. 90 respectively. The risk-free interest rate is 5% per annum.

The present value of the strike price can be calculated as follows:

PV = 1,050 ÷ [(1 + 0.05)3/12] = 1,037.27

Substituting these values in the put-call parity equation, we have:

50 + 1,037.27 ≠ 90 + 1,000

1,087.27 ≠ 1,090

So, the call is overpriced relative to the put option. You can use this lack of parity to implement an options arbitrage strategy as outlined below:

• Sell the overpriced put at Rs. 90
• Buy the underpriced call at Rs. 50
• Short the stock at Rs. 1,000
• Strike Price Arbitrage

Strike price arbitrage involves exploiting price inconsistencies between options with the same expiry date but different strike prices. This strategy is based on the principle that the prices of options should maintain a consistent relationship across different strike prices.

For example, consider a stock trading at Rs. 500 with the following call options expiring in 1 month:

• Strike price Rs. 480 at a premium of Rs. 30
• Strike price Rs. 500 at a premium of Rs. 20
• Strike price Rs. 520 at a premium of Rs. 12

In a perfectly priced market, the difference in premiums between strike prices should be consistent. However, in this case:

Difference between 480 and 500 strikes: Rs. (30–20) = Rs. 10

Difference between 500 and 520 strikes: Rs. (20–12) = Rs. 8

This inconsistency suggests a potential arbitrage opportunity. To implement an options arbitrage strategy, you can:

• Buy 1 call option at 500 strike for Rs. 20
• Buy 1 call option at 520 strike for Rs. 12
• Sell 2 call options at 480 strike for Rs. 60 (2 x 30)

The net credit from this position is Rs. 28 [i.e. Rs. 60 minus Rs. (20 + 12)]. This position has limited risk and potential for profit, depending on where the stock price ends up at expiration.

• Reversal Arbitrage

This is an options arbitrage strategy that exploits violations of put-call parity. It involves simultaneously buying a put option, selling a call option, and buying the underlying asset. This creates a synthetic short position in the underlying asset.

You can implement this strategy when you identify that the relationship between put and call prices does not align with the underlying asset’s price according to put-call parity theory. The goal is to profit from the price discrepancy without taking on any directional risk. However, keep in mind that reversal arbitrage requires precise timing and execution because these opportunities often disappear quickly in efficient markets.

• Box Spreads

A box spread is an options arbitrage strategy that combines a bear put spread with a bull call spread using options with the same expiration date but different strike prices. It creates a position with a known payoff at expiration, regardless of the underlying asset’s price movement.

Theoretically, in a perfectly efficient market, the cost of establishing a box spread should be equal to the present value of the difference between the two strike prices. This means you must look for situations where the market price of the box spread deviates from this theoretical value. By buying underpriced box spreads or selling overpriced ones, you can lock in risk-free profits. However, the transaction costs and margin requirements can impact the overall viability of this options arbitrage strategy.

Conclusion

Arbitrage trading involves a great deal of analysis and skill. In addition to this, with markets being highly dynamic and efficient in the current trading environment, it is extremely challenging to identify and leverage arbitrage scenarios — primarily because the window of opportunity that is available is often short and quickly gone.

That said, options arbitrage is only one of the many ways in which you can trade in the options market. With Options B.R.O. from Samco, you can also find the ideal strategy for various markets — like bullish, bearish, neutral or volatile.