2007issue C051-3
Option arbitrage as a six-layout construction problem
Option arbitrage is constructed as simultaneous buying and selling of options, on one exchange or across exchanges. Six constructions are classified by a five-attribute matrix of underlying, month, strike, option type, and exchange.
- Option arbitrage is simultaneous buying and selling of options, either across exchanges or on the same exchange.
- Strike, calendar, intramarket, conversion, box, and straddle constructions are classified by which of underlying, month, strike, option type, and exchange stay fixed.
- A calendar construction sells the nearer month for more than the farther month costs; a strike construction can be treated as riskless when the strike gap is smaller than the premium gap.
- American-style in-the-money shorts can be assigned early, and exercised short puts can create dividend liability around dividend dates.
Six constructions from one checklist
Option arbitrage is constructed as simultaneous buying and selling of options, either across exchanges or on the same exchange. Arbitrage trading is that simultaneous long-short procedure.
Six constructions are specified: strike, calendar, intramarket, conversion, box, and straddle. They are classified by an arbitrage matrix, a five-attribute checklist of underlying, month, strike, option type, and exchange.
Calendar and strike spreads
A calendar construction holds the same underlying, strike, and option type while changing expiration, selling the nearer month for more than the farther month costs. Calendar arbitrage is that same-strike, same-type long-short across different expirations. It may need a longer holding period to realize a small residual.
A strike construction holds the same underlying, month, and option type while changing strikes. Strike arbitrage is that same-month, same-type long-short across different strikes when the strike gap is smaller than the premium gap, and can be treated as riskless under that condition.
Editorial: calendar and strike are the option spread cases in this matrix, because option type stays fixed while expiration or strike changes.
Intramarket, conversion, and box packages
An intramarket construction holds the same underlying, month, strike, and option type while changing exchange. Intramarket arbitrage is that same-contract long-short across different exchanges. Listed venues include CBOE, Philadelphia, Pacific, and American.
A conversion is a same-strike, same-month put-call pair plus a long underlying, held as a locked package. A short conversion reverses the option legs and shorts the underlying.
A box is two conversions without the underlying: long call and short put at one strike, plus long put and short call at a second strike. That box conversion uses two strikes and omits the underlying.
A straddle at one strike
A straddle-style construction uses different option types at the same underlying, month, strike, and exchange, including a negative-time-value long-call plus long-put layout. That options straddle is straddle arbitrage: a same-strike, same-month long-short of different option types.
Early assignment and dividend liability
American-style in-the-money shorts can be assigned early. Early assignment is exercise risk on those short options before expiration.
Exercised short puts can create dividend liability around dividend dates. Dividend liability is cash-flow risk on those exercised short puts.
All readings on this track · 5 readings
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- 2004Constructing the cash open from futures fair value
- 2007Option arbitrage as a six-layout construction problem
- 2008Opening auction, market making, and arbitrage as a capital business
- 2012Forex arbitrage is usually correlation, not riskless profit