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Which Option Trading Arbitrage Strategy Is The Best?

Posted by Pete Stolcers on November 24, 2007

Option Trading Question

Among the strategies discussed on your site I was looking for arbitrage strategies (no chance of loss), such as this: you buy a $50 put for $1.00 and you sell three $47 puts for $.38. The total net credit on the transaction is $.14. Even if the index slips quickly the $47 you will have enough money to buy back the sold puts with the money you make on the $50 puts. If the index closes $47-$50 you will make money. If the index closes above $50 you will make enough to cover your commissions. If there is a rapid decline to $47.50 I could sell a $47 put and buy a $46 put for overnight protection.

Option Trading Answer

Thank you for the question.  There are a few different topics that I would like to address in my response.

First let’s start with your strategy.  This is not an arbitrage play.  You may feel like you can adjust your risk at a moment’s notice, but catastrophic overnight events can create enormous gaps in the market. 9/11 is a great example.  The market did not open for days and there was no way to hedge your risk (the futures market could have been used to lock in your loss, but they instantly priced in an enormous drop).

In the trade above, your breakeven point is just below $46.  If the index moves below that level, you will start to lose money.  This strategy is called a ratio spread because you are selling more options than you are buying.  You are naked two of the $47 puts and you will need to put up naked margin for that position. When the index falls to $47.50, you are not reducing your risk, you are adding to it by selling another put credit spread ($47-$46). I am wondering if you meant to say that you are buying in a $47 put and selling a $46 put. In that case, you are reducing risk, but not much.

Let me first start I saying that I don’t like these strategies.  They are consistent and you can make small amounts of money over extended periods of time.  However, one big event will wipe out years of profits and then some.  After 20 years, I have seen it many times.

As for arbitrage strategies, they are truly riskless.  For example, you would buy a $50 put and sell a $49 put for a credit of $.02. Assuming that $.02 covers your commissions, there is no way you can lose money on this trade.

No one in their right mind would sell you the spread because they are guaranteed a loss.  The only way you can establish this trade is to leg in. That is what Market Makers do.

Market Maker firms have the deepest pockets on Wall Street.  They pay membership fees to the exchanges for the right to make markets in a particular equity or index.  The exchange protects these members by making it difficult for a retail customer to post a bid and an ask. Brokerage firms are allotted a certain order cancellation percentage.  When the brokerage firm’s cancel to fill ratio goes above a certain point, the exchange charges the brokerage firm for each cancel.  The brokerage firms identify the source of the cancels and then they start charging the customer. This means that on a retail basis you can’t post and cancel bids and offers in an effort to buy bids and asks.

Even if you could do this without the cancellation fees, you would be competing with some of the most sophisticated computer systems in the world.  They auto quote the option markets based on the underlying stock, the other stocks in the group or the sector, option pricing models, the other bids and asks in other option serie… Large financial firms hire the best programmers.  When the firm does get filled on an order, the system recalculates the risk in if needed; it instantly hedges the position using the underlying stock.

Large institutions have lower transaction costs, better research, lower carrying costs, and lower margin requirements. They have reduced the profit margins on these trades to the point where only the most efficient systems can compete.

If you think about it, everyone would love to make money on a riskless trade.  That type of opportunity attracts stiff competition.

If I can nail home one point in this response it would be - forget about arbitrage strategies.

Option Trading Comments

  • On 07/25, Debashis Nandi said:

    Dear Sir,
    Suppose I Buy futures of XYZ, sell a deep ITM call and buy an ATM put.  What may be the outcome through expiration.

  • On 08/04, Pete Stolcers said:

    That is an arbitrage trade. Let’s say the futures contract is at 1010 and you sell the 1000 call and buy the 1000 put. That trade will always be worth $1000. If you bought it for less than $1000, the difference will be your profit. This is the type of strategy used by Market Makers as they leg into trades. If you bought the futures for $1010, sold the call for $12 and bought the put for $2, it will be a breakeven trade.

  • On 12/13, Larry said:

    Hello Sir,
    I am exploring different option arbitrage strategies. I have been seeing quite a few “reversal” opportunities available lately.
    For example:
    Sell short 100 shares of SPY for $89.00
    Sell 1 Dec $89.00 PUT for $2.75
    Buy 1 DEC $89.00 CALL for $2.35
    At expiration, if SPY is at $95.00, the PUT’s would be worthless; the short stock position would be -$600.00 and the Call position would be +$600.00, which would leave the $40.00 credit from the opening trade. My question is, at expiration Friday, at what point/time do you sell the calls to then buy back the short stock position to get an equal price? Or is it done automatically by your broker thus avoiding additional commissions?

  • On 12/15, Pete Stolcers said:

    If you were lucky enough to get an arb off, you would just let auto-exercise/assignment kick in after expiration.

    After being in the business for 20 years and working in the OEX pit in its hay-day, I can say with confidence, you are not going to get this trade off. Sophisticated (multi-million dollar) auto-quote systems developed by the richest proprietary trading firms make arbitrage extremely rare. If you did find an arb, your gain would be much less than $.40.

    Don’t look for arbitrage, it is not there. Focus on research.

  • On 12/15, Larry said:

    Thank you for replying. I appreciate your taking the time to answer my question and providing your insight.
    I asked because the last several weekends I have seen the same thing occurring like clockwork. I imagine because of the increased volatility lately.

    Thanks again.

  • On 12/15, Pete Stolcers said:

    You can’t look at last prices or weekend prices. You have to look at real-time bids and asks. As people learn of arb strategies, they think they have found a risk-free way of making money. It’s not there!

  • On 05/12, David said:

    I will often times see bid and ask with maybe a couple hundred on either side for an option contract that surround intrinsic value almost exactly, however no contracts show in volume during the day.  Why are these not being executed?  I have been to the floor of the CBOE and know that floor brokers and traders go back and forth until equilibrium is found.  My concern is ensuring that my order is executed and at an appropriate price for options deep in the money that do have some open interest.  Should I place a limit order that is a couple cents over intrinsic value?  Would that ensure that my order is executed in a timely fashion?  Thank You, David

  • On 05/13, Pete Stolcers said:

    The quotes you see, are auto-quote. Market Maker firms have very complex algorithms that calculate where and option should be priced relative to the stock. They even account for changes in the stock bid/ask size, the last trade and size in the stock, the other option bid/asks…

    I have traded against auto-quote off floor for years, trust me, they are complex programs. There are not many Market Makers left on the floor, technology is much more efficient.

    To exit an option trade at a fair price when it is trading at parity, use my search feature to find an article. “The Expiration Rip-off”.

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