What is Options Arbitrage?

Options arbitrage is a financial term used to describe a certain type of low-risk transaction. Arbitrage is any type of deal through which a profit can be made almost automatically. If the same commodity costs less in one place than in another, arbitrage is the practice of buying it cheaply and immediately selling it at a profit. Options are a financial tool guaranteeing their owner the right to buy or sell an underlying asset at a certain price — the "strike price" — by a certain time. Options arbitrage therefore describes any transaction in which options can be bought and sold for an automatic profit.

Exploiting arbitrage opportunities for options can be highly lucrative. The market for options is necessarily more complicated than the market for underlying assets since each asset can spawn many different types of options. At any given moment, there is more or less one price at which an asset, such as a single company's stock, is sold. Many options, with different strike prices and expiration dates, can be sold for that same stock. The price differences between options for the same stock will usually depend logically on these variables.

For example, if the only difference between two options is the expiration date, a later expiration date should always be worth more. Consider two different options for a similar asset. These options might provide their owner with the right to buy 500 shares of stock in Company X at $10 US Dollars (USD) per share. Regardless of the current price of the stock, these options have the possibility of providing immediate value if Company X's stock ever exceeds their strike price. That is, any time the price of the stock goes above $10 USD, the options can be exercised to buy the stock and immediately sell it at a profit.

If option A provides the right to buy 500 shares in company X at $10 USD at any point in the next year, and option B provides the same option at any point in the next five years, option B is typically better. The only difference between the two options is that in a year, A becomes worthless, whereas B will be remain valid for four more years. It is impossible for A to create a profit that would not have been available with B, just as B may create many opportunities that would not have been possible for the owner of A. Option B should thus always be more lucrative than option A. In practice this does not always happen. Options arbitrage is the process of noticing this type of discrepancy and taking advantage of it; in this case, by selling option A and buying option B. This particular type of options arbitrage is called calendar arbitrage.

A few successful arbitrage trades ultimately correct the discrepancy in the market. The trades alter supply and demand for the options in question until they reach prices no longer exploitable by arbitrage. The increased use of computers for analysis and trading means that opportunities for arbitrage usually disappear fairly quickly.

Other types of options arbitrage include taking advantage of different strike prices or differences in prices of the same options between different markets. The trading can get complicated. A more complicated type of options arbitrage involves buying different types of options at different strike prices after realizing that a profit can be made regardless of which way and how much the price of the underlying asset changes.