In the world of trading, one of the most coveted concepts is assignment arbitrage—the practice of exploiting price differences for the same asset across different markets or forms. This blog will explore arbitrage and how it applies to different trading strategies.
What Is Assignment Arbitrage?
At its core, arbitrage involves exploiting price differences for the same asset in different markets or forms. For arbitrage to work, there must be an inequality in the price of the same security.
When a security is underpriced in another market, you buy the underpriced security in that market and then sell it at the market price in this market simultaneously to reap a risk-free profit.
When combined, arbitrage can be a powerful tool for traders, allowing them to capitalize on market inefficiencies. It’s particularly true when certain market conditions make it profitable to exercise an option early or when price discrepancies exist.
In simpler terms, arbitrage is about finding opportunities to make risk-free profits from these pricing gaps. For the savvy trader, understanding how to identify these opportunities and how to act quickly can significantly improve overall trading performance.
How Does Arbitrage Work With Options?
Let’s examine it further. Assignment arbitrage is typically used with options in more structured scenarios, often around the expiration of an option contract.
For example, suppose you have a scenario where a call option (which gives you the right to buy an asset) and a put option (which gives you the right to sell the same asset) have different prices.
When these prices deviate significantly, you can use arbitrage to execute a series of trades that will allow you to capture the difference in value between these two options.
How Is Underpriced Defined in Arbitrage?
The concept of underpriced in options arbitrage is similar to day trading, with the only distinction being how “underpriced” is defined. In options trading, “underpriced” can mean a far broader range of things:
- Consider an underpriced call option compared to another one for the same underlying stock.
- It is underpriced when compared to a put option.
- Options with one expiration can be underpriced relative to options with a different expiration.
The principle of Put Call Parity governs all of this. When Put Call Parity isn’t upheld, there are opportunities for options arbitrage.
Options arbitrage relies on differences in the relative value of one option compared to another, also known as “relative value arbitrage.”
Unlike stock arbitrage, which usually involves buying and selling securities simultaneously to achieve an arbitrage trade, options arbitrage utilizes intricate spread strategies to “secure” the arbitrage value and generally waits for the spread to close by expiration to realize the entire profit.
5 Ways to Apply Arbitrage in Options Trading
In case you didn’t know, there are five primary methods for options arbitrage:
- Strike Options Arbitrage (also known as Strike Arbitrage)
- Calendar Options Arbitrage (or Calendar Arbitrage)
- Intra-market Options Arbitrage (or Intra-market Arbitrage)
- Conversion/Reversal
- Box Spread
5-Minute Takeaway
- Arbitrage involves exploiting price discrepancies between related assets to make risk-free profits.
- It relies on stock market inefficiencies that traders can use to gain risk-free profits.
- The strategy works well in day, swing, and options trading.
- Market competitors often use similar arbitrage techniques to maximize returns, so timing and market understanding are key.
How to Apply Arbitrage in Day and Swing Trading
Arbitrage can be used in various trading strategies but is most commonly applied in day and swing trading.
Day Trading
In day trading, where positions open and close within the same day, traders constantly look for opportunities to capitalize on short-term market inefficiencies. Arbitrage allows day traders to take advantage of pricing discrepancies between options and the underlying assets they’re tied to.
For example, if a stock is trading at $60 on the NYSE and $61 on the LSE, a trader can buy shares on the NYSE and sell them on the LSE.
Swing Trading
In swing trading, where traders hold positions for a few days or weeks to capture price swings, arbitrage can help capitalize on larger price inefficiencies that develop over time.
As the underlying asset price fluctuates, traders look for scenarios in which the strike price of an option and the asset’s market price are out of sync. As a result, they can make money by exercising the option early or holding it until the arbitrage opportunity reaches its peak.
Be Careful With Assignment Arbitrage
The primary appeal of arbitrage lies in its potential for risk-free profits. By leveraging stock market inefficiencies, traders can generate returns without taking on significant risks.
However, the strategy requires sharp market insight and quick decision-making. Timing is everything—making the wrong move can quickly turn a seemingly risk-free trade into a costly mistake.
Additionally, traders must be aware of their competitors—other traders and institutions who may also be looking for these arbitrage opportunities.
As stock market technology advances, more and more trading platforms use sophisticated algorithms to identify arbitrage opportunities in real-time, so you must be quick on your feet.
A Real-Life Example of Arbitrage
High-frequency trading is a relentless search for arbitrage opportunities – trying to identify minute changes in the market. Stock ABC trades for $40 on the NYSE (New York Stock Exchange).
At the same time, it sold for $40.05 in London on the LSE (London Stock Exchange). You want to capitalize on this 5-cent share difference, so you buy ABC on the NYSE and immediately sell it on the LSE.
If all goes smoothly, you profit 5 cents a share, a little less once you subtract broker fees. You can continue to do this until the shares run out or the share price is adjusted.
Pros Of Assignment Arbitrage
Now that we’ve explored the competitors let’s examine the pros of Assignment Arbitrage and why it can be a valuable strategy for traders.
- Risk-Free Profits: Arbitrage’s main advantage is the potential for risk-free profits. By taking advantage of market inefficiencies, traders can lock in guaranteed profits if they execute their trades at the right time.
- Leverage: This strategy allows traders to leverage the pricing discrepancies between different contracts, maximizing potential returns from small price changes.
- Flexibility: Apply arbitrage in day trading or swing trading in various market conditions.
What Are The Cons of Arbitrage?
While there are clear advantages, it’s also important to understand the potential drawbacks. Assignment arbitrage isn’t ever completely riskless.
Even though it’s a very low risk, it can have tremendous downside risk if the underlying assumptions don’t hold.
One expression is that it’s “picking up nickels in front of a steamroller” – you don’t make a lot on any trade, but there are a lot of trades, and if you stumble, you are dead. Hence, there will always be SOME risk, but it may not be price risk. Let’s now examine the cons of arbitrage.
- Execution Risk: To profit from arbitrage, you must execute trades quickly and at the right time. You must also be able to lock in the price difference. Connection delays, errors in trade execution, and even settlement risk can destroy your profits.
- Market Volatility: Sharp market movements or changes in asset volatility can impact this strategy’s effectiveness. Traders must prepare for unexpected market shifts.
- Transaction Costs: Frequent trades can lead to significant transaction costs. These fees can eat into potential profits, so it’s important to account for them.
Types of Assignment Arbitrage in the Market
Currency Arbitrage
Traders leverage variations in exchange rates among various currency pairs. For example, if the exchange rate for USD to EUR is 1.10 in one market and 1.12 in another, a trader could purchase EUR in the market with the lower rate and sell it at the higher rate, gaining profit from the difference.
Commodity Arbitrage
Let’s say gold sells for $1,800 per ounce in New York and $1,820 in London. As a trader, you can buy gold in New York and sell it in London to take advantage of the price difference.
Merger Arbitrage
In this approach, investors purchase shares of the company being bought and short-sell shares of the company making the acquisition. If the purchase price exceeds the existing stock price, the investor stands to gain once the deal is finalized.
Final Thoughts: Assignment Arbitrage
Assignment arbitrage can be a highly effective and great way for traders to make money from inefficiencies in the market. Arbitrage is an option whether you’re a day trader, swing trader, or someone who holds long-term positions. However, ensure you understand the risks before going down the arbitrage road.
Frequently Asked Questions
How Does Arbitrage Work in Options Trading?
Options assignment arbitrage provides more opportunities than stock arbitrage because it allows traders to take advantage of price differences between exchanges and inconsistencies in Put Call Parity involving stock options. Unique strategies have been created to benefit from these specific options arbitrage opportunities.
Can Arbitrage Be Applied to Day Trading?
Arbitrage can be used in day trading by taking advantage of intraday price discrepancies. However, it would be best if you acted fast to capitalize on the short-term price movements to profit from this strategy.
What Are the Risks of Arbitrage?
The main risks of arbitrage include missed opportunities, market volatility, and transaction costs. Traders must act swiftly and factor in the costs of executing multiple trades.
Is Arbitrage a Safe Strategy?
While arbitrage can be highly profitable when executed correctly, it is not without risk. Traders must be able to quickly identify pricing inefficiencies and execute trades promptly to lock in profits.
