SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Option Arbitrage Risks


Options traders dealing in arbitrage might not appreciate the forms of risk they face. The typical arbitrage position is found in synthetic long or short stock. In these positions, the combined options act exactly like the underlying. This creates the arbitrage.  

 

For example, opening a long call and a short put at the same strike ands expiration is likely to create a zero net cash position, or close to it. For this reason, the synthetic is ideal because there are two benefits. For the long call, any appreciate is entirely a net profit because no cash had to be paid up front. For the short put, time decay is entirely advantageous because if the underlying declines by expiration, the put is profitable; and if it does not move at all, the put’s lost time value also generates a profit. This synthetic long stock position is only one form of arbitrage.
 

A synthetic short stock is the opposite, combining a short call and a long put. The same arguments apply regarding profits and potential advantages based on underlying movement in either direction.


A naïve point of view would be that synthetic positions are entirely without risk, because you profit regardless of how the underlying behaves. This ignores the reality that risk is not limited to the profit or loss in the position. There are other risks to be considered, and there is no such thing as a position without any risks.


The interest rate risk must be analyzed before entering a synthetic position to exploit the arbitrage involved. It is easy to ignore this risk, but cash flow is always a part of trade considerations. For example, the trade’s value relies on interest that could be earned on a credit balance used to carry the debit between entry and expiration or close. Because market rates change, risks can change as well. For ex ample, if your profit relies on earning a 7% return on your credit balance, what happens if interest rates fall to 4%? This change in market rates reduces the true net profit when cash flow is considered. If you are holding a debit balance with an assumed interest of 5%, what happens if the market rates rises to 7%? This represents a 2% reduction in profit or realization of a loss.


Another form of risk to be aware of is pin risk. This is the risk that the closing price of the underlying will be exactly at the money for the synthetic position. This is the result of price pinning to the closest rounded price, or execution price of the option.
 

When the price at expiration is above or below the strike, you will realize a profit from one side or the other. But when the price is exactly at the strike, there is a dilemma. If a short call can be exercised based on last-minute price changes, it creates a problem. If a short put is going to be exercised, you end up with shares you didn’t want. The net outcome could represent a small profit if the synthetic set up a net credit, or a sham loss resulting from a net debit. However, the realized net profit changes significantly due to transaction costs if the shares acquired are to be sold. There will be transaction fees on the way in as well as on the way out.


The execution risk should not be ignored. In studying synthetic positions, the outcome may appear foolproof with underlying movement in either direction. However, if the short side is exercised, you either must pay for stock or acquire stock, and it is likely that neither outcome is desirable. In trying to avoid this, traders tend to roll ITM sides of synthetic positions forward. But rolling to avoid exercise has consequences. These often consist of collateral requirements higher than expected for uncovered short positions. The original arbitrage, then long forgotten, could be replaced with growing collateral and paper loss possibilities.


The execution risk is not limited to the most apparent form, that a short position will be exercised. It also includes the possibility of increasing net paper losses that may have to be realized at some point; and the increasingly expensive collateral required to carry a rolled position in the hopes of avoiding exercise.


Traders also need to be aware of dividend risk in a synthetic position. The holder of stock expects to receive a dividend based on value before ex-dividend, but dividends can be reduced or skipped. This affects much of the expected profit. Entering a synthetic position when 100 shares of stock are held appears at first to be a good way to remove exercise risk for synthetic short stock trades. Exercise would not be a net loss because the trader owns shares (assuming the purchase price was lower than the strike). If not exercised, the short call expires worthless. It appears a perfect solution, but any changes in dividend lead to possible loss of profits.


Another dividend-related risk arises due to dividend capture. If your short call is in the money immediately prior to ex-dividend, the owner of a long call may transact early exercise, acquiring stock and then earning the dividend with as little as a one-day holding period. This may also destroy a synthetic strategy based on reduced risk plus earned dividends.


Anyone opening synthetic positions in the futures market also faces settlement risk. The short side of a synthetic futures option trade is at risk of exercise. While this is easily avoided by rolling or closing, it represents a loss, and this could be a substantial loss. Many traders who understand stock forms of options may be out of their element when it comes to the futures market. It is by no means the same type of market, and settlement risks can grow suddenly and, of course, unexpectedly.


The point to keep in mind about the “perfect” synthetic trade is that arbitrage always appears to solve all the problems of price movement. Realistically, however, the different forms of risk cannot be ignored. Far too many options traders realize net losses because they did not think it was possible to lose money on a “sure thing.”

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Publishing as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.
 

 

 

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Things To Think About Before Getting Involved In Investing

    There are various benefits associated with investing. It can be a great way to boost your income, providing you with financial security during a troubling time. Smart investing also comes with the possibility of long-term returns, meaning it can be better to invest your money than leave it in your regular bank account (even if you are earning interest). 

    By Kim,

    • 0 comments
    • 189 views
  • Micron Technology (MU) Earnings Report June 30, 2022

    Welcome to the ORATS earnings report where we scan for companies with upcoming earnings announcements, check out historical earnings information, and find a potential options trade. Read on or watch the video overview here: https://youtu.be/IDgR3FzONnI.

    By ORATS_Matt,

    • 0 comments
    • 224 views
  • Does “Managing Winners” Add Value to Short Strangles?

    Some option educators suggest short strangles have historically benefited from actively managed exit strategies. A widely popularized approach is to enter S&P 500 strangles at 45 DTE and exit at 50% of the credit received or a 21 DTE time stop, whichever occurs first.

    By Jesse,

    • 2 comments
    • 4,702 views
  • NKE Earnings Report June 27, 2022

    Welcome to the ORATS earnings report where we scan for companies with upcoming earnings announcements, check out historical earnings information, and find a potential options trade. Read on or watch the video overview here: https://youtu.be/2mtx2ja-VwQ.

    By ORATS_Matt,

    • 0 comments
    • 233 views
  • KBH Earnings Report June 22, 2022

    Welcome to the ORATS earnings report where we scan for companies with upcoming earnings announcements, check out historical earnings information, and find a potential options trade.

    Read on or watch here:

    By ORATS_Matt,

    • 0 comments
    • 298 views
  • Know How To Trade Before Making An Investment

    Everyone is searching for a way to improve their living quality. Plenty of scopes are coming to the forefront and people are grabbing the opportunities with the hope of receiving the best revenue against their investment. A share market is a place that can return the high revenue of your investment.

    By Kim,

    • 0 comments
    • 319 views
  • Implied Volatility and Standard Deviation

    1. Isn't holding a naked long call (as a result of locking in a profit or plain buying outright call) in general a bad idea? Reason I think so is because of the nature of IV: it mostly falls when the underlying is rising. So you have short theta and a big long vega moving against you.

    By Mark Wolfinger,

    • 0 comments
    • 299 views
  • Introducing a "Risk Free" Trade

    A few weeks ago, I got the following email from one of our former members: "I would like to share with you an article about "projected no risk trades" or "no risk trades". Of course I was skeptical. But when he shared the setup with me, I became intrigued. How does the following risk profile look to you?

    By Kim,

    • 6 comments
    • 1,392 views
  • What You Trade Matters

    Traders love to tell people that they can trade anything. That if you have the skills to be a trader, the specific item traded is unimportant. That may be true for some professional traders who are skilled technicians. However, it’s very different for gullible amateurs.

    By Mark Wolfinger,

    • 0 comments
    • 633 views
  • The Big Loss

    At his blog, Joey offers his perspective on the top reason that so many trader wannabes are not, and will not, become profitable traders. His post is titled: Learn to Lose Money to Make Money. Here are the Excerpts from the blog.

    By Mark Wolfinger,

    • 0 comments
    • 822 views

  Report Article

We want to hear from you!


There are no comments to display.



Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs Expertido