In this chapter, we will learn ‘Options Arbitrage’. But what exactly is arbitrage?
Arbitrage is the opportunity to make risk-free profit by simultaneously buying an underpriced asset and selling it at market price.
Options arbitrage is the use of options to reap marginal risk-free profit by locking value created through violation of Put-Call Parity.
The only drawback of options arbitrage is that profitable opportunities are hard to come by and gets filled out extremely fast by computers and system trading used by financial institutions which monitor for such opportunities all the time.
An inequality in price of the security must exist for arbitrage to work. When a security is underpriced in another market, you simply 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. A call option can be underpriced compared to other options of the same expiry or same options with different expiry. All these are governed by the principle of Put Call Parity. When this principle of Put Call Parity is violated, opportunities of options arbitrage comes into the picture.