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


  • Put/Call Parity: Two Definitions

    Traders hear the term put/call parity a lot, but what does it mean? There are two definitions and they are vastly different from one another. The first definition involves the net credit/debit for any combination trade, with trading costs are considered. The second definition takes assumed interest rates and present value into mind.

    By Michael C. Thomsett,

  • Do Options Affect Stock Prices?

    It is widely acknowledged that the price of the underlying directly impacts the premium of the option. Therefore, options are termed derivatives. Their current value is directly derived from movement of the underlying price. Is the opposite also true? Does movement of the option value affect the underlying price?

    By Michael C. Thomsett,

  • Portfolio Withdrawal Strategies

    This article will discuss three ways to take systematic withdrawals from your investment portfolio that would be expected to last 30 years, which is a typical time period a 65-year couple might need to plan for in retirement.

    By Jesse,

  • Pricing Models and Volatility Problems

    Most traders are aware of the volatility-related problem with the best-known option pricing model, Black-Scholes. The assumption under this model is that volatility remains constant over the entire remaining life of the option.

    By Michael C. Thomsett,

  • 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.  

    By Michael C. Thomsett,

  • Why Haven't You Started Investing Yet?

    You are probably aware that investment opportunities are great for building wealth. Whether you opt for stocks and shares, precious metals, forex trading, or something else besides, you could afford yourself financial freedom. But if you haven't dipped your toes into the world of investing yet, we have to ask ourselves why.

    By Kim,

  • Historical Drawdowns for Global Equity Portfolios

    Globally diversified equity portfolios typically hold thousands of stocks across dozens of countries. This degree of diversification minimizes the risk of a single company, country, or sector. Because of this diversification, investors should be cautious about confusing temporary declines with permanent loss of capital like with single stocks.

    By Jesse,

  • Types of Volatility

    Are most options traders aware of five different types of volatility? Probably not. Most only deal with two types, historical and implied. All five types (historical, implied, future, forecast and seasonal), deserve some explanation and study.

    By Michael C. Thomsett,

  • The Performance Gap Between Large Growth and Small Value Stocks

    Academic research suggests there are differences in expected returns among stocks over the long-term.  Small companies with low fundamental valuations (Small Cap Value) have higher expected returns than big companies with high valuations (Large Cap Growth).

    By Jesse,

  • How New Traders Can Use Trade Psychology To Succeed

    People have been trying to figure out just what makes humans tick for hundreds of years.  In some respects, we’ve come a long way, in others, we’ve barely scratched the surface. Like it or not, many industries take advantage of this knowledge to influence our behaviour and buying patterns.

    By Kim,


  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