Arbitrage options trading strategy with Examples from Fish Market to Share Market

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The Fish market Arbitrage

I’ll assume you understand the concept of Arbitrage. In short, it means buying an item at a lower price in one market and then selling the same product at a higher price in another. With some planning, these trades can be virtually risk-free. To illustrate this point further, let me give you an example.

Living by a coastal city with an abundance of fresh sea fish, the rate for its purchase is low, say Rs.100 per Kg. The neighbouring city 125 km away has a huge demand for the same type of fish, which sells at Rs.150 per Kg.

If you buy fish from your city for Rs.100, and are able to resell it in the neighbouring city for Rs.150, you’d make a neat profit – subtracting transportation and other logistics will still leave you with Rs.30 per kg! All in all, this is an attractive deal, showing the potential of arbitrage in the fish market.

It appears a foolproof plan – if you purchase fish from your city at Rs.100 each day and resell in the next town for Rs.150, after accounting for Rs.20 on expenses, you can make an assured profit of Rs.30 per KG with no risk involved.

This is risk-free, as long as nothing shifts. Nevertheless, if conditions do alter, your potential for earning will be affected too. Here are some examples of circumstances that could change:

  1. Going to the market with the intent of buying fish at Rs.100, you soon find out that there isn’t any available. Consequently, you miss out on the chance to make a profit of Rs.30/-.
  2. No buyers (liquidity risk) – You purchase the fish for Rs.100 and travel to the nearby town to try to sell it at Rs.150, but you find out that there are no potential buyers. You end up with a bunch of dead fish which have little or no value!
  3. Bad bargaining (execution risk) – The potential of arbitrage relies on the fact that you can purchase at Rs.100 and sell at Rs.150. Nevertheless, if you experience a bad day and buy at 110 and then sell at 140, transport expenses of 20 Rupees will be incurred, resulting in a profit margin of only 10 Rupees as opposed to the typical 30 Rupees. If this pattern continues, it is likely that the arbitrage opportunity will no longer be attractive enough to pursue.
  4. Transport becomes expensive (cost of transaction) – The transport costs play a pivotal role in arbitrage trade profitability. If, for instance, the cost of transportation rises from Rs.20 to Rs.30, the attractiveness of this trading opportunity quickly fades away as execution costs get higher and higher. The cost of transaction is a decisive element in arbitrage prospects.
  5. Competition kicks in (who can drop lower?) – The world is naturally competitive, and you may find someone else looking to take advantage of the risk-free Rs.30. Picture this:
    1. So far you are the only one doing this trade i.e buy fish at Rs.100 and sell at Rs.150
    2. Your friend has spotted that you are taking a risk-free profit and would like to emulate you. Unfortunately, this is a free market so there is nothing you can do to stop him.
    3. Both of you purchase the item for Rs.100, transport it to the neighboring town for Rs.20 and try to sell it there.
    4. A potential buyer enters the shop and finds a new seller offering the same quality of fish. Who between you two is likely to secure the sale?
    5. It’s obvious that if the quality of the fish is comparable, the buyer will go for the seller who offers it at a lower rate. To gain the customer’s favor, it makes sense to decrease the price to Rs.145/-.
    6. The following day, your friend drives the price even lower and offers to sell fish at Rs.140 per KG, spurring a price war. Subsequently, the cost consistently decreases until all arbitrage opportunities completely vanish.
    7. What is the lowest price one can pay for this fish? Rs. 120, which covers both the cost of buying the fish and transport – any less would not be economically feasible.
    8. Ultimately in a perfectly competitive world, competition begins, and arbitrage chances are eliminated. Consequently, the cost of fish in neighbouring towns would go down to Rs. 120 or a value near that sum.

The above conversation hopefully gave an insight into arbitrage. We can express any such opportunity mathematically, like in the case of fish – here is the equation.

[Cost of selling fish in town B – Cost of buying fish in town A] = 20

If there is an imbalance in the equation, then we find ourselves with a potential arbitrage opportunity. All types of markets, whether fish market, agri market, currency market or stock exchange are ruled by simple maths.

– The Options arbitrage

Arbitrage opportunities can be found in nearly all markets, requiring a sharp eye to spot them and gain from them. In the stock market, these trades give you the chance to lock in a small but secure profit and maintain your advantage no matter how the market swings. Such reliability makes arbitrage trades particularly attractive for those who don’t like taking risks.

I’d like to talk about a simple arbitrage scenario, which has its origins in ‘Put Call Parity’. Instead of describing the theory, I will demonstrate one of its applications.

 

So based on Put Call Parity, here is an arbitrage equation –

Long Synthetic long + Short Futures = 0

You can elaborate this to –

Long ATM Call + Short ATM Put + Short Futures = 0

This equation implies that upon expiration, the P&L from holding a synthetic long and short future should be nothing. Put-call parity explains why this specific position results in no gain or loss.

However, if the P&L is a non zero value, then we have an arbitrage opportunity.

On 21st Jan, Nifty spot was at 7304, and the Nifty Futures was trading at 7316.

 

The 7300 CE and PE (ATM options) were trading at 79.5 and 73.85 respectively. Do note, all the contracts belong to the January 2016 series.

Going by the arbitrage equation stated above, if one were to execute the trade, the positions would be –

  1. Long 7300 CE @ 79.5
  2. Short 7300 PE @ 73.85
  3. Short Nifty futures @ 7316

Take note that together these initial two positions create a long synthetic. In order for the arbitrage equation to be valid at expiry, the positions should yield no P&L. Let’s assess if this is correct.

Scenario 1 – Expiry at 7200

  • The 7300 CE would expire worthless; hence we lose the premium paid i.e 79.5
  • The 7300 PE would have an intrinsic value of 100, but since we are short at 73.85, the net payoff would be 73.85 – 100 = -26.15
  • We are short on futures at 7316, which would result in a profit of 116 points (7316 – 7200)
  • Net payoff would be -79.5 – 26.15 + 116 = +10.35

Clearly, instead of a 0 payoff, we are experiencing a positive non zero P&L.

Scenario 2 – Expiry at 7300

  • The 7300 CE would expire worthless; hence we lose the premium paid i.e 79.5
  • The 7300 PE would expire worthless; hence we get to retain 73.85
  • We are short on futures at 7316, which would result in a profit of 16 points (7316 – 7300)
  • Net payoff would be -79.5 +73.85+16 = +10.35

Scenario 3 – Expiry at 7400

  • The 7300 CE would have an intrinsic value of 100, and therefore the payoff would be 100 – 79.5 = 20.5
  • The 7300 PE would expire worthless; hence we get to retain 73.85
  • We are short on futures at 7316, which would result in loss of 84 points (7316 – 7400)
  • Net payoff would be 20.5 + 73.85 – 84 = +10.35

You can test this arbitrage strategy in any market and it’s likely you will earn 10.35 points when the expiry time comes. To emphasize: this method allows you to gain 10.35 at expiry.

When deciding whether to go ahead with this trade, one must consider the cost of execution and ascertain whether it is viable.

  • Brokerage – Trading with a traditional broker can really eat away your profits, as you may end up paying 8-10 points on top of your 10 point return. Conversely, trading as a discount broker offers an advantage: the breakeven point is only 4-5 points, giving you more incentive to open an account.
  • STT – Do bear in mind that your Profit and Loss will only be realised upon expiry. If you have an ITM option (which is likely), it is important to remember that you will have to pay a considerable STT amount upon expiry, which will decrease your profits. Please take the time to read more about this.
  • Other applicable taxes – You must also consider service tax and stamp duty when creating your budget.

Considering the costs, it might not be sensible to pursue an arbitrage trade if the payoff is only 10 points. Yet, a more significant reward of 15 or 20 points could make it worthwhile. Furthermore, it may even be possible to stay clear of STT charges by exiting positions right before maturity – although a few points could still be lost.

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