Arbitrage – Strategy, Process And Trading Software For Arbitrage Trades

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    The Best Binary Options Broker 2020!
    Perfect For Beginners!
    Free Demo Account!
    Free Trading Education!

  • Binomo
    Binomo

    Good choice for experienced traders!

Arbitrage – Strategy, Process And Trading Software For Arbitrage Trades

As you know, we have a product line for VIP customers. This is actually a professional and more sophisticated versions of Arbitrage Software provided by BJF Trading Group.

What’s new?

Signing Code

We signed code for all our VIP products with digital code signing certificate. Code signing is the process of digitally signing executable files to confirm the software author (2202934 Ontario Inc.) and guarantee that the code has not been altered or corrupted since it was signed. Read more on Wikipedia https://en.wikipedia.org/wiki/Code_signing Code signing establishes reputation in Windows 8.0 and later, and for all antiviruses.
besides this, improvements have been made for every VIP Product.

Namely

VIP Latency Arbitrage for MT4

3 strategies (modes) was added
1 –-Normal ( standard latency arbitrage), 2 –Hedge, 3- Martingale, 4 – Averaging

In Hedge mode and Averaging mode the first order on instrument is opened in the direction of arbitrage. In Martingale mode, order is opened in reverse direction.
For all 3 modes trailing is not performed. After the S/L is hit, in Hedge mode the system opens new order in the reverse direction of the last order on instrument, and in Martingale mode and Averaging mode it opens new order in the direction of the last order (i.e. the first order in chain direction). The size of this new order is calculated by formula: last order in chain lot x Lot multiplier (1). Then the system applies stoploss to this new order according to the instrument settings, and we repeat the step 2) until total number of orders opened on the instrument is less than “Trade deep” parameter. No new orders are opened by arbitrage until the orders chain is not closed.
The orders chain can be closed in 2 cases: In loss – by pair equity stop parameters; in profit – if the cumulative profit of all orders in the chain (doesn’t matter if there is only one, two, three etc. order(s), i.e. not the maximum – “trade deep”) is more than “Min Profit” value for the instrument and the all orders are opened for more than ”Order lifetime” seconds. Please pay attention that for these 2 strategies Min profit parameter is not in points, but in currency units (controlling the “chain” total profit).

Example of system behavior (Trade deep = 4, S/L=50, Lot multiplier 2, Lot = 0.01)

Hedge strategy action

Martingale strategy action

Buy arbitrage situation()

VIP Lock Arbitrage for MT4

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    The Best Binary Options Broker 2020!
    Perfect For Beginners!
    Free Demo Account!
    Free Trading Education!

  • Binomo
    Binomo

    Good choice for experienced traders!

Strategies

To make it easy for traders to add non-toxic orders to their overall trading volume, we have developed a system that can be included with the VIP lock arbitrage product.

This system lets the trader create trading volume aimed at small profits or breakeven results, which in turn helps the broker earn more in commission fees, makes your trading very attractive to the broker, and helps camouflage your arbitrage strategy. We advise our clients to use this system in conjunction with the lock arbitrage software. This should help the trader use an arbitrage trading strategy with the same broker successfully for long periods of time.

This strategy is improved combination of 2 algorithms: Pairs trade and Triangular arbitrage algorithm.

The pairs trade or pair trading is a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. This strategy is categorized as a statistical arbitrage and convergence trading strategy. The pair trading was pioneered by Gerry Bamberger and later led by Nunzio Tartaglia’s quantitative group at Morgan Stanley in the 1980s. Read more on Wikipedia®

Triangular arbitrage (also referred to as cross currency arbitrage or three-point arbitrage) is the act of exploiting an arbitrage opportunity resulting from a pricing discrepancy among three different currencies in the foreign exchange market. A triangular arbitrage strategy involves three trades, exchanging the initial currency for a second, the second currency for a third, and the third currency for the initial. During the second trade, the arbitrageur locks in a zero-risk profit from the discrepancy that exists when the market cross exchange rate is not aligned with the implicit cross exchange rate. Read more on Wikipedia®

If these add-on is interesting for you, feel free to contact us via email.

Lock closure automatization and Lock reopen automatization

This options allows software to close locks in fully automated mode in preset day(s) and time and then reopen. It can be helpful, for example, to close locks before swap will be added and reopen after.

VIP Lock Arbitrage for FIX API

We added new FIX API connectors: Price Markets, XENFIN, Spotex
Also Strategies was added.

VIP Multileg Arbitrage

We added telegram alerts – you an find more information about telegram alerts , please read our article
FIX API connectors: Price Markets, XENFIN, Spotex was added as well.

What is a Forex arbitrage strategy?

There are many ways to profit on the Forex market. Anticipating the future price movements of currency pairs is one of them, and arguably the most widespread among retail Forex traders. Carry trades and accumulating rollover profits is also a popular trading approach, which is based on buying a higher-yielding currency and simultaneously selling a lower-yielding currency, making a profit on the interest rate differential. However, did you know that traders can also make profits with very low risk through Forex arbitrage? If you don’t know what Forex arbitrage is, then you’re in the right place. In this article, we’ll cover everything you need to know about the Forex arbitrage strategy and give examples on how it works.

What is arbitrage in Forex?

Arbitrage is a well-known practice in financial markets that aims to take advantage of price discrepancies on the same asset, traded on different markets. An arbitrageur would simultaneously buy and sell the same asset or two similar assets which show a price imbalance on different markets, making a profit from the price difference. To make this concept crystal clear, let’s cover it with a hypothetical example. For instance, if the same car costs $30,000 in your country, but $35,000 in a neighbouring country, you could theoretically buy the car in your country and sell it in the other country, making a profit of $5,000. Of course, we didn’t take into account any import tariffs or gasoline costs to transport the car to the other country, as this is a simple example of an arbitrage opportunity.

Similar to our car example, arbitrage opportunities also exist on financial markets. Traders could buy commodities, currencies, or even stocks on one market, and sell them seconds later on another market on which the security trades at a higher price. Arbitrage is an important concept of today’s financial markets, as it helps to balance prices across different markets.

For example, a company could list its stocks on more than one stock exchange. If the price of the same stock differs on the New York Stock Exchange and the London Stock Exchange, one could buy the lower-priced stock on one exchange and simultaneously sell it at a higher price on the other exchange, making a profit from the price differential. Arbitrage on the Forex market is quite similar to that of the stock market, only the assets involved are not stocks, but currencies.

Triangular Forex arbitrage

Since arbitrage is a fairly low-risk strategy, arbitrage opportunities don’t last long on the market. The buying pressure on the lower-priced asset and the selling pressure on the higher-priced asset on different exchanges causes the prices to converge eventually. The advancement in technology and software helped large investors to continuously search for price discrepancies of the same assets traded on different markets, causing the arbitrage opportunity to disappear in a matter of seconds by increasing the demand for the lower-priced asset and increasing the supply for the higher-priced asset. Still, arbitrage opportunities arise from time to time and traders could make a profit with the help of certain arbitrage strategies, such as the triangular Forex arbitrage strategy.

The Forex market is an over-the-counter market without a centralised exchange. This means that currencies trade at the same prices most of the time. While a swap arbitrage Forex strategy looks for discrepancies in currency swaps, the triangular currency arbitrage on the spot market aims to exploit exchange rate anomalies between different currency pairs.

Let’s say that EUR/USD is trading at 1.1450, USD/CAD at 1.3110, and EUR/CAD at 1.5005. When buying a currency pair, you’re basically buying the base currency and selling the same amount of the counter currency at the current market rate. For example, if you buy one standard lot of EUR/USD, you’re buying 100,000 euros and selling US dollar in the amount of 100,000 euros, i.e., 114.500 USD.

Buying one lot of USD/CAD follows the same principle. You’re buying 100,000 US dollars, and selling 131,000 Canadian dollars at the same time, at the current market rate.

Since currency pairs are basically fractions with numerators and denominators, we’re able to calculate the intrinsic exchange rate of EUR/CAD by using the exchange rates of EUR/USD and USD/CAD. Simply multiply these two exchange rates to get the EUR/CAD exchange rate.

EUR/USD at 1.1450 x USD/CAD at 1.3110 = EUR/CAD at 1.5010

If you have 100,000 euros at your disposal, you could theoretically buy 114,500 USD, exchange it for CAD at 1.3110, which is equal to CAD 150,100, and exchange the Canadian dollar to euros again at the current market rate of 1.5005 to receive 100,033 euros. Starting with 100,000 euros, you now have 100,033 euros simply by exchanging them first to US dollars, then to Canadian dollars, and then to euros again, making a risk-free profit of 33 euros.

An example of another triangular Forex trade, which includes EUR/GBP, GBP/USD, and EUR/USD, is shown in the following graph.

Since the Forex market is a fairly efficient market, the difference in exchange rates between various currency pairs is usually very small or doesn’t exist at all. That’s why you need a larger position size to make a sizeable profit from the exchange rate discrepancies. In our example above, we were dealing with a position size of one standard lot to make a profit of 33 euros. If we increased that position size to 10 standard lots (1,000,000 euros), the potential profit would increase to 330 euros.

Statistical arbitrage on Forex

Another interesting Forex arbitrage trading system is statistical arbitrage. This strategy is based on shorting a basket of over-performing and buying a basket of under-performing currencies, with the idea that the over-performing currencies will eventually decrease in value, while under-performing currencies will increase in value. Most assets eventually revert to their mean value, and mean-reverting strategies aim to exploit this phenomenon.

Of course, tight historical correlation between the two baskets would be an advantage in this basket trading Forex strategy, in order to create a market-neutral portfolio.

Correlation is a statistical method that measures the interrelationship and interdependence between two (or more) variables. If one of the variables changes, correlation measures how the other variables will react to that change.

The most popular Forex correlation type is between currency pairs, which is often represented in the form of Forex correlation tables. These tables show the current correlation coefficient between various pairs, which can take a value of between -1 and +1. In general, a correlation coefficient of -1 reflects a perfectly negative correlation, i.e., if a currency pair goes up by 1 pip, the other pair goes down by 1 pip. Similarly, a correlation coefficient of +1 reflects perfectly positive correlation, i.e., if a currency pair goes up by 1 pip, the other pair will also gain 1 pip. A correlation coefficient of 0 shows that no significant relationship between the two currency pairs exists.

The following table shows a Forex correlation table, taking into account currency moves from November 2020 to September 2020.

As the table shows, the EUR/USD pair is highly correlated with the AUD/USD pair, with a high positive correlation of 0.9116. In other words, these two pairs will move in the same direction most of the time. On the other side, EUR/GBP exhibits a strong negative correlation with GBP/JPY, i.e., these two pairs will move in the opposite direction most of the time. The GBP/JPY pair has an almost non-existent correlation with the EUR/CHF pair, which is no wonder given that these pairs don’t include the same currencies.

If the euro is an over-performing currency, and the Australian dollar an under-performing currency, you could look to sell EUR/USD and buy AUD/USD to create a market-neutral arbitration portfolio.

Risks of arbitrage strategies

Now that you know what arbitrage trading is in Forex, let’s take a look at the risks involved.

While arbitrage usually carries very low risks and is often described as a risk-less way to make a profit, this is not always the case. Since the Forex market is a highly liquid and efficient financial market, arbitrage opportunities are rare, and even when they occur, the difference in the exchange rates tends to be very small. This is why we need significantly large position sizes to make a notable profit with arbitrage.

Slippage and transaction costs are also important points to consider given the small difference in exchange rates. Slippage can easily eat into the profits of an arbitrage opportunity, and transaction costs need to be taken into account when calculating the potential profit. Also, not all Forex brokers allow arbitrage trades. You need to open an account with arbitrage brokers Forex in order to trade on these strategies. Forex brokers that allow arbitrage usually state this feature on their website.

Finally, in the case of a triangular Forex arbitrage system, all trades should be executed almost instantly in order for the exchange rate to remain at the same levels. Remember, many traders are looking for arbitrage opportunities, which is why these setups quickly disappear from the market.

Conclusion

Arbitrage is a well-known technique that aims to exploit price differences of the same asset on different markets. Arbitrage opportunities can occur in all types of markets, even in your supermarket. While arbitrage is often considered risk-free, it’s important to calculate transaction costs and slippage into the equation since these costs can easily make an arbitrage opportunity worthless. In addition, since the differences in exchange rates on the Forex market are usually very small or don’t exist at all, position sizes need to be relatively large to make a notable profit from the arbitrage opportunity. When arbitrage trading Forex on leverage, pay attention to the required margin needed to open the positions in order to avoid a margin call.

How to Arbitrage the Forex Market – Four Real Examples

What Is Arbitrage?

Arbitrage is a trading strategy that has made billions of dollars as well as being responsible for some of the biggest financial collapses of all time. What is this important technique and how does it work? That is what I will attempt to explain in this piece.

An Excel calculator is provided below so that you can try out the examples in this article.

Arbitrage and Value Trading Are Not the Same

Arbitrage is the technique of exploiting inefficiencies in asset pricing. When one market is undervalued and one overvalued, the arbitrageur creates a system of trades that will force a profit out of the anomaly.

In understanding this strategy, it is essential to differentiate between arbitrage and trading on valuation.

You will often hear people say that when a security is undervalued or overvalued an “arbitrageur” can buy it or sell it and hence hope to profit when the price comes back to fair value.

The keyword here is hope. This is not true arbitrage. Buying an undervalued asset or selling an overvalued one is value trading.

The true arbitrage trader does not take any market risk. He structures a set of trades that will guarantee a riskless profit, whatever the market does afterwards.

Arbitrage Example

Take this simple example. Suppose an identical security trades in two different places, London and Tokyo. For simplicity, let’s say it’s a stock, but it doesn’t really matter.

The table below shows a snapshot of the price quotes from the two sources. At each tick, we see a price quoted from each one.

Time London Price Tokyo Price Difference London Desk Tokyo Desk
08:05:00 54.32 54.32 0.00
08:05:01 54.31 54.31 0.00
08:05:02 55.20 55.10 0.10 Sell 10 @ 55.20 Buy 10 @ 55.10
08:05:03 55.80 55.70 0.10
08:05:04 55.85 55.75 0.10
08:05:05 54.32 54.32 0.00 Buy 10 @ 54.32 Sell 10 @ 54.32
08:05:06 54.33 54.33 0.00
08:05:07 53.76 53.76 0.00
08:05:08 53.89 53.89 0.00
08:05:09 53.56 53.56 0.00
08:05:10 53.00 53.00 0.00
Lock in 8.80 -7.80
Net risk free profit 1.00

At 8:05:02 the arbitrageur sees that there is a divergence between the two quotes. London is quoting a higher price, and Tokyo the lower price. The difference is 10 cents. At that time, the trader enters two orders, one to buy and one to sell. He sells the high quote and buys the low quote.

Because the arbitrageur has bought and sold the same amount of the same security, theoretically he does not have any market risk. He has locked-in a price discrepancy, which he hopes to unwind to realize a riskless profit.

Now he will wait for the prices to come back into sync and close the two trades. This happens at 8:05:05. He reverses out of the two positions and the final profit is $1 less his trading fees.

Not a huge profit, but it took just three seconds and did not involve any price risk.

Arbitrage is a bit like “picking pennies”. The opportunities are very small. This is why you have either to do it big or do it often.

Before the days of computerized markets and quoting, these kinds of arbitrage opportunities were very common. Most banks would have a few “arb traders” doing just this kind of thing.

Cross-broker Arbitrage

Arbitrage between broker-dealers is probably the easiest and most accessible form of arbitrage to retail FX traders.

To use this technique you need at least two separate broker accounts, and ideally, some software to monitor the quotes and alert you when there is a discrepancy between your price feeds. You can also use software to back-test your feeds for arbitrageable opportunities.

Ebook Pack

eBook value set for the classic trading strategies: Grid trading, scalping and carry trading. All ebooks contain worked examples with clear explanations. Learn to avoid the pitfalls that most new traders fall into.

A mainstream broker-dealer will always want to quote in step with the FX interbank market. In practice, this is not always going to happen.

Variances can come about for a few reasons: Timing differences, software, positioning, as well as different quotes between price makers.

Remember, foreign exchange is a diverse, non-centralized market. There are always going to be differences between quotes depending on who is making that market.

Delayed quotes: When a broker’s quotes momentarily diverge from the broader market, a trader can arbitrage these events. This will allow a risk free profit. In truth, there are challenges. More on that later.

Let’s look at an example. The table below shows two broker feeds for EUR/USD.

Time Broker A Trade Broker B Trade
01:00:00 1.3035 / 037 1.3035 / 037
01:00:01 1.3036 / 038 Buy 1lot @ 1.3038 1.3048 / 052 Sell 1 lot @ 1.3048
01:00:02 1.3049 / 053 Sell 1 lot @ 1.3049 1.3049 / 053 Buy 1 lot @ 1.3053
01:00:03 Profit 11 pips -5 pips

Having both quotes available, the arbitrager sees at 01:00:01 that there is a discrepancy. He immediately buys the lower quote and sells the higher quote, in doing so locking in a profit.

When the quotes re-sync one second later, he closes out his trades, making a net profit of six pips after spreads.

Spreads

When arbitraging, it is critical to account for the spread or other trading costs. That is, you need to be able to buy high and sell low. In the example above, if Broker A had quoted 1.3038/1.3048, widening the spread to 10 pips, this would have made the arbitrage unprofitable.

The outcome would have been:

Entry trade: Buy 1 lot from A @ 1.3048 / Sell 1 lot to B @ 1.3048
Exit trade: Sell 1 lot to A @ 1.3049 / Buy 1 lot from B @ 1.3053

In fact, this is what many brokers do. In fast moving markets, when quotes are not in perfect sync, spreads will blow wide open. Some brokers will even freeze trading, or trades will have to go through multiple requotes before execution takes place. By which time the market has moved the other way.

Sometimes these are deliberate procedures to thwart arbitrage when quotes are off. The reason is simple. Brokers can run up massive losses if they are arbitraged in volume.

Arbitraging Currency Futures

Anywhere you have a financial asset derived from something else, you have the possibility of pricing discrepancies. This would allow arbitrage. The FX futures market is one such example.

Suppose we have the following quotes:

  • GBP/USD spot rate =1.45
  • 12-month GBP/USD futures contract trades at 1.44
  • 12-month interest on USD is 1.5%
  • 12-month interest on GBP is 3%

A financial future is a contract to convert an amount of currency at a time in the future, at an agreed rate. Suppose the contract size is 1,000 units. If you buy one GBP/USD contract today, in 12-months time, you will receive £1,000 and give $1,440 in return.

The arbitrageur thinks the price of the futures contract is too high. If he sells one contract, he will have to deliver GBP 1,000 in 12-months time, and in return will receive USD 1,440.

He does the following calculations:

To deliver £1,000, the arbitrageur needs to deposit £970.45 now for 12-months @ 3%.

He can borrow in US dollars the amount, $1407.15 at 1.5% interest.
He can convert this to £970.45 at the spot rate.
The cost of the deal is $1407.15 + $21.27, 12-months interest @ 1.5% ($1,428.41).

The above deal would create a synthetic futures contract that would convert £1,000 to $1428.41 in 12-months time. The cost today is USD 1,428.41.

From this, he knows that the 12-month futures price should really be 1.4284. The market quote is too high. He does the following trade:

Sell one futures contract @ 1.44.
Create the synthetic futures deal as above

At the end of 12-months, under the contract he delivers the £1,000 and receives $1,440. Using the money, he pays back his loan of $1407.15, plus $21.27 interest. He makes a riskless profit of:

USD 1,440 – USD 1,428.41 = USD 11.59

Notice that the arbitrageur did not take any market risk at all. There was no exchange rate risk, and there was no interest rate risk. The deal was independent of both and the trader knew the profit from the outset. This is known as covered interest arbitrage. The cashflows are shown in the diagram below (Figure 3).

Value Trade Alternatives

Seeing the futures contract was overvalued, a value trader could simply have sold a contract hoping for it to converge to fair value. However, this would not be an arbitrage. Without hedging, the trader has exchange rate risk. And given the mispricing was tiny compared to the 12-month exchange rate volatility, the chance of being able to profit from it would be small.

As a hedge, the value trader could have bought one contract in the spot market. But this would be risky too because he would then be exposed to changes in interest rates because spot contracts are rolled-over nightly at the prevailing interest rates. So the likelihood of the non-arb trader being able to profit from this discrepancy would have been down to luck rather than anything else, whereas the arbitrageur was able to lock-in a guaranteed profit on opening the deal.

Cross-currency arbitrage

Trading text books always talk about cross-currency arbitrage, also called triangular arbitrage. Yet the chances of this type of opportunity coming up, much less being able to profit from it are remote.

With triangular arbitrage, the aim is to exploit discrepancies in the cross rates of different currency pairs.

For example, suppose we have:

Broker A
EUR/USD = 1.3000
GBP/USD = 1.6000

This means we should have the cross rate:
GBP/EUR = 1.6000 / 1.3000 = 1.2308

Suppose Broker B quotes GBP/EUR at 1.2288. From the above the arbitrageur does the following trade:

Buy 1.2288 EUR @ 1.300×1.2288 USD from Broker A
Buy 1 GBP @ 1.2288 EUR from Broker B
Sell 1 GBP @ 1.6 USD to Broker A
His profit is 1.6 USD – 1.3 x 1.2288 USD = .00256 USD

Of course, in reality the arbitrageur could have increased his deal sizes. If he trades standard lots, his profit would have been 100,000 x .00256 or $256.

The cashflows are shown in Figure 4.

In practice, most broker spreads would totally absorb any tiny anomalies in quotes. Secondly, the speed of execution on most platforms is too slow.

Electronic Markets Reduce Price Anomalies

Arbitrage plays a crucial role in the efficiency of markets. The trades in themselves have the effect of converging prices. This makes “gaps” disappear so removing the opportunities of risk free profits.

Over the years, financial markets have becoming increasingly efficient because of computerization and connectivity. As a result, arbitrage opportunities have become fewer and harder to exploit.

At many banks, arbitrage trading is now entirely computer run. The software scours the markets continuously looking for pricing inefficiencies on which to trade. For the “ordinary trader”, this makes finding exploitable arbitrage even harder.

Nowadays, when they arise, arbitrage profit margins tend to be wafer thin. You need to use high volumes or lots of leverage, both of which increase the risk of something getting out of control. The collapse of hedge fund, LTCM is a classic example of where arbitrage and leverage can go horribly wrong.

Beware Brokers Who Ban Arbitraging

Some brokers forbid clients from arbitraging altogether, especially if it is against them. Always check their terms and conditions. Beware because some brokers will even back test your trades, to check if your profits have coincided with anomalies in their quotes.

Forbidding arbitraging is shortsighted in my opinion. Seeing a “no arbitrage” clause should raise red flags about the broker concerned. Arbitrage is one of the linchpins of a fair and open financial system.

Without the threat of arbitraging, broker-dealers have no reason to keep quotes fair. Arbitrageurs are the players who push markets to be more efficient. Without them, clients can become captive within a market rigged against them.

The following Excel workbook contains an arbitrage calculator for the examples above.

Challenges to the Arbitrage Trader

Arbitraging can be a profitable low risk strategy when correctly used. Before you rush out and start looking for arbitrage opportunities, there are a few important points to bear in mind.

  • Liquidity discount/premiums – When checking an arbitrage trade, make sure the price anomaly is not down to vastly different liquidity levels. Prices may discount in less liquid markets, but this is for a reason. You may not be able to unwind your trade at your desired exit point. In this case, the price difference is a liquidity discount, not an anomaly.
  • Execution speed challenge – arbitrage opportunities often require rapid execution. If your platform is slow or if you are slow entering the trades, it may hamper your strategy. Successful arb traders use software because there are a lot of repetitive checks and calculations.
  • Lending/borrowing costs – Advanced arbitrage strategies often require lending or borrowing at near risk free rates. Traders outside of banks cannot lend or borrow at anywhere near risk free rates unless they can access secured borrowing – for example with repos or collateralized loans. This prohibits many arbitrage opportunities for the smaller trader.
  • Spreads and trade costs – Always factor in all trading costs from the start inlcuding margin costs.

Options Arbitrage Strategies

In investment terms, arbitrage describes a scenario where it’s possible to simultaneously make multiple trades on one asset for a profit with no risk involved due to price inequalities.

A very simple example would be if an asset was trading in a market at a certain price and also trading in another market at a higher price at the same point in time. If you bought the asset at the lower price, you could then immediately sell it at the higher price to make a profit without having taken any risk.

In reality, arbitrage opportunities are somewhat more complicated than this, but the example serves to highlight the basic principle. In options trading, these opportunities can appear when options are mispriced or put call parity isn’t correctly preserved.

While the idea of arbitrage sounds great, unfortunately such opportunities are very few and far between. When they do occur, the large financial institutions with powerful computers and sophisticated software tend to spot them long before any other trader has a chance to make a profit.

Therefore, we wouldn’t advise you to spend too much time worrying about it, because you are unlikely to ever make serious profits from it. If you do want to know more about the subject, below you will find further details on put call parity and how it can lead to arbitrage opportunities. We have also included some details on trading strategies that can be used to profit from arbitrage should you ever find a suitable opportunity.

  • Put Call Parity & Arbitrage Opportunities
  • Strike Arbitrage
  • Conversion & Reversal Arbitrage
  • Box Spread
  • Summary

Put Call Parity & Arbitrage Opportunities

In order for arbitrage to actually work, there basically has to be some disparity in the price of a security, such as in the simple example mentioned above of a security being underpriced in a market. In options trading, the term underpriced can be applied to options in a number of scenarios.

For example, a call may be underpriced in relation to a put based on the same underlying security, or it could be underpriced when compared to another call with a different strike or a different expiration date. In theory, such underpricing should not occur, due to a concept known as put call parity.

The principle of put call parity was first identified by Hans Stoll in a paper written in 1969, “The Relation Between Put and Call Prices”. The concept of put call parity is basically that options based on the same underlying security should have a static price relationship, taking into account the price of the underlying security, the strike of the contracts, and the expiration date of the contracts.

When put call parity is correctly in place, then arbitrage would not be possible. It’s largely the responsibility of market makers,who influence the price of options contracts in the exchanges, to ensure that this parity is maintained. When it’s violated, this is when opportunities for arbitrage potentially exist. In such circumstances, there are certain strategies that traders can use to generate risk free returns. We have provided details on some of these below.

Strike Arbitrage

Strike arbitrage is a strategy used to make a guaranteed profit when there’s a price discrepancy between two options contracts that are based on the same underlying security and have the same expiration date, but have different strikes. The basic scenario where this strategy could be used is when the difference between the strikes of two options is less than the difference between their extrinsic values.

For example, let’s assume that Company X stock is trading at $20 and there’s a call with a strike of $20 priced at $1 and another call (with the same expiration date) with a strike of $19 priced at $3.50. The first call is at the money, so the extrinsic value is the whole of the price, $1. The second one is in the money by $1, so the extrinsic value is $2.50 ($3.50 price minus the $1 intrinsic value).

The difference between the extrinsic values of the two options is therefore $1.50 while the difference between the strikes is $1, which means an opportunity for strike arbitrage exists. In this instance, it would be taken advantage of by buying the first calls, for $1, and writing the same amount of the second calls for $3.50.

This would give a net credit of $2.50 for each contract bought and written and would guarantee a profit. If the price of Company X stock dropped below $19, then all the contracts would expire worthless, meaning the net credit would be the profit. If the price of Company X stock stayed the same ($20), then the options bought would expire worthless and the ones written would carry a liability of $1 per contract, which would still result in a profit.

If the price of Company X stock went up above $20, then any additional liabilities of the options written would be offset by profits made from the ones written.

So as you can see, the strategy would return a profit regardless of what happened to the price of the underlying security. Strike arbitrage can occur in a variety of different ways, essentially any time that there’s a price discrepancy between options of the same type that have different strikes.

The actual strategy used can vary too, because it depends on exactly how the discrepancy manifests itself. If you do find a discrepancy, it should be obvious what you need to do to take advantage of it. Remember, though, that such opportunities are incredibly rare and will probably only offer very small margins for profit so it’s unlikely to be worth spending too much time look for them.

Conversion & Reversal Arbitrage

To understand conversion and reversal arbitrage, you should have a decent understanding of synthetic positions and synthetic options trading strategies, because these are a key aspect. The basic principle of synthetic positions in options trading is that you can use a combination of options and stocks to precisely recreate the characteristics of another position. Conversion and reversal arbitrage are strategies that use synthetic positions to take advantage of inconsistencies in put call parity to make profits without taking any risk.

As stated, synthetic positions emulate other positions in terms of the cost to create them and their payoff characteristics. It’s possible that, if the put call parity isn’t as it should be, that price discrepancies between a position and the corresponding synthetic position may exist. When this is the case, it’s theoretically possible to buy the cheaper position and sell the more expensive one for a guaranteed and risk free return.

For example a synthetic long call is created by buying stock and buying put options based on that stock. If there was a situation where it was possible to create a synthetic long call cheaper than buying the call options, then you could buy the synthetic long call and sell the actual call options. The same is true for any synthetic position.

When buying stock is involved in any part of the strategy, it’s known as a conversion. When short selling stock is involved in any part of the strategy, it’s known as a reversal. Opportunities to use conversion or reversal arbitrage are very limited, so again you shouldn’t commit too much time or resource to looking for them.

If you do have a good understanding of synthetic positions, though, and happen to discover a situation where there is a discrepancy between the price of creating a position and the price of creating its corresponding synthetic position, then conversion and reversal arbitrage strategies do have their obvious advantages.

Box Spread

This box spread is a more complicated strategy that involves four separate transactions. Once again, situations where you will be able to exercise a box spread profitably will be very few and far between. The box spread is also commonly referred to as the alligator spread, because even if the opportunity to use one does arise, the chances are that the commissions involved in making the necessary transactions will eat up any of the theoretical profits that can be made.

For these reasons, we would advise that looking for opportunities to use the box spread isn’t something you should spend much time on. They tend to be the reserve of professional traders working for large organizations, and they require a reasonably significant violation of put call parity.

A box spread is essentially a combination of a conversion strategy and a reversal strategy but without the need for the long stock positions and the short stock positions as these obviously cancel each other out. Therefore, a box spread is in fact basically a combination of a bull call spread and a bear put spread.

The biggest difficulty in using a box spread is that you have to first find the opportunity to use it and then calculate which strikes you need to use to actually create an arbitrage situation. What you are looking for is a scenario where the minimum pay out of the box spread at the time of expiration is greater than the cost of creating it.

It’s also worth noting that you can create a short box spread (which is effectively a combination of a bull put spread and a bear call spread) where you are looking for the reverse to be true: the maximum pay out of the box spread at the time of expiration is less than the credit received for shorting the box spread.

The calculations required to determine whether or not a suitable scenario to use the box spread exists are fairly complex, and in reality spotting such a scenario requires sophisticated software that your average trader is unlikely to have access to. The chances of an individual options trader identifying a prospective opportunity to use the box spread are really quite low.

Summary

As we have stressed throughout this article, we are of the opinion that looking for arbitrage opportunities isn’t something that we would generally advise spending time on. Such opportunities are just too infrequent and the profit margins invariably too small to warrant any serious effort.

Even when opportunities do arise, they are usually snapped by those financial institutions that are in a much better position to take advantage of them. With that being said, it can’t hurt to have a basic understanding of the subject, just in case you do happen to spot a chance to make risk free profits.

However, while the attraction of making risk free profits is obvious, we believe that your time is better spent identifying other ways to make profits using the more standard options trading strategies.

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    The Best Binary Options Broker 2020!
    Perfect For Beginners!
    Free Demo Account!
    Free Trading Education!

  • Binomo
    Binomo

    Good choice for experienced traders!

Like this post? Please share to your friends:
How To Make Money on Binary Options Trading
Leave a Reply

;-) :| :x :twisted: :smile: :shock: :sad: :roll: :razz: :oops: :o :mrgreen: :lol: :idea: :grin: :evil: :cry: :cool: :arrow: :???: :?: :!: