Are there derivative arbitrage opportunities still out there?

We all wish we were born in the 1960’s to see the beginning of the first derivative products, armed with the combined knowledge of theoretical pricing models and the common derivative pitfalls. We all know of the stories in the early days of options, where smart traders earnt huge sums from large price discrepancies and the slow movement of knowledge.

Nowadays, with the introduction of advanced derivative pricing models, supercomputers, and ultra-fast technology, some assume that the marketplace is barren of all these “money-free” opportunities. Yet, while doing some light-hearted investigation, it was found there may still be some gold for those willing to dig.

Using a synthetic derivatives strategies (conversion and reversal strategies), we found volatile stocks within the ASX marketplace present an opportunity for risk-free seekers. Conversion involves the buying of an underlying stock, selling a call and buying a put (at the same strike and expiry). It is best to visualise this strategy using a profit and loss diagram.

When option prices remain at the levels of $0.20 for a call and $0.70 for a put, no arbitrage can be made. Yet, if the put sells for $0.65, an opportunity presents to capture a profit of $0.05.

Example: Reversal

A reversal synthetic option is a mirror image of the conversion strategy. It involves shorting the stock, buying a call and selling a put (same exercise and expiry). If either the put or call premiums are disjointed, an arbitrator has the possibility of making a profit.

Are opportunities actually out there?

Using live market data, we found volatile stocks such as FMG and RIO, present these opportunities especially with the reversal strategy. See the below example of FMG with real-life market prices.

Potential Risks:

It goes without saying there is no such thing as a free lunch. Even these arbitrage strategies could be risky. Below outlines some potential pitfalls an investor may incur.

• Can these be done in a net order and can brokerage firms facilitate these orders simultaneously?

• Will market makers react by using high frequency trading to conversely pull out of orders once a trader establishes a position?

• Can the stock in question be shorted with high degree of safety?

• Does the limit on the number of contracts offered enough to make a profit? How much would need to be invested?

• Does the exiting the position rely on stock trading at parity towards the end of the options life. If not, exiting the position can be done through exercising the options and either selling or buying the stock on the market. Again, with such large volumes, market makers may be reluctant to offer prices at parity.

• Are the commission costs eating away at the profits too much? This is includes the commissions on entering or exiting the options or underlying stock.

Conclusion:

Whilst theoretically the opportunities are there, more research needs to be done to determine the practical capabilities of investors to be able to profit reasonably from these opportunities. However, this article demonstrates that option market makers are not necessarily making the options market “efficient”, yet still providing vital liquidity to the marketplace for investors. Opportunities may still be there for investors who can capitalise on these strategies.