Arbitrage Opportunities for Day Traders in the Options Market
Options form the basis of many arbitrage strategies, especially for those day traders who work the stock market. First, many different types of options are available, even on the same security. The two main categories are puts, which bet on the underlying security price falling, and calls, which bet on the underlying security price rising.
Puts and calls on the same security come in many different strike prices, depending on where you want to bet the price goes.
Some options, known as American options, can be cashed in at any time between the date of issue and the expiration date, and you can exercise others, known as European options, only at the expiration date. (To complicate matters, American and European options can be issued anywhere.) With all those choices, the alert arbitrageur is bound to notice a few price discrepancies.
Maybe a day trader notices that on a day when a company has a big announcement, the options exchanges seem to be assuming a slightly higher price for the stock than where the stock is actually trading.
He decides to buy the underlying stock as well as a put; he also sells a call with the same strike price and expiration date as the put. This strategy creates a synthetic security that has the same payoff as shorting the security, meaning that the trader has pulled off a riskless arbitrage transaction.
He effectively bought the security cheap in the stock market and sold it at a higher price in the options market.