Arbitrage Strategies and Price Relationships
Jim Graham

Arbitrage Strategies and Price Relationships

When looking at an option chain, you see all the data for an underlying asset and its related options.  Between the various sections – the underlying, the call and put options, and the different expiration months – there are fundamental relationships that underlie their pricing.

When these relationships get out of line, an arbitrage opportunity exists—buying an option(s) and selling the related option(s) for a (near) risk-free profit.  To illustrate these relationships we will use arbitrage strategies, and we will begin by discussing synthetics, which form the basis for all the different arbitrage strategies.

Synthetic Relationships

There can be up to three different parts to any potential option strategy: The underlying asset; the Call options; and the Put options.  Most arbitrage strategies use the concept of synthetics, and they are a large part of the strategies we use here.  A synthetic strategy is one where you combine any two parts (calls, puts and/or the underlying) to create a position that looks like the third one.

For example, if you buy both the stock and a put option, you will make money if the market goes up, but your loss is limited if the market falls.  That's exactly the same risk/reward you would get if you bought a call option – you make money if the market goes up but your loss is limited to the premium paid if the market falls.  Buying the stock and buying a put is therefore called a synthetic call.  In terms of risk and reward, it is exactly the same thing!

The various synthetic relationships may seem a little confusing, but with a little practice you will see how easy it is to understand.  An important rule to keep in mind is that the strikes and months of the calls and puts must be identical.  For synthetics that involve both the stock and options, the number of shares represented by the options must be equal to the number of shares of stock.  The table below lists the basic synthetic positions:

Synthetic Relationships
Synthetic short stock=Long put + short call*
Synthetic long stock=Long call + short put*
Synthetic long call option=Long underlying + long put
Synthetic short call option=Short underlying + short put
Synthetic long put option=Short underlying + long call
Synthetic short put option=Long underlying + short call
* Using the same strike price and expiration date

These are not new strategies.  We have discussed them before, and you will see them covered in many intermediate or advanced option trading books.  The point here is not to suggest new trades you should consider doing, but rather to use them to put things in perspective and show how the underlying, options, and their prices are related.

Synthetics are used in arbitrage because all basic option strategies have a synthetic equivalent.  And if the risks and rewards are the same (across the same strike prices) then a synthetic position should be priced the same as the actual position.  That is, at the same strike prices, a synthetic call should cost the same as an actual call.  If this condition is violated, an opportunity for arbitrage exists.  The arbitrage strategies we will be using in this article are:

Conversions
Reversals