with a long term view of the business, some exchanges engage in dubious behavior for the sake of attractin…

In answer to your question What are some arbitrage opportunities you have found in real life?let me set the answer in context with how Im defining the term arbitrage because strictly speaking the word implies a riskless set of transactions, where profits were left behind by people who didnt notice the difference.

Arbitrage isnt ever completely riskless. Theres always going to be SOME risk, but it may not be price risk.

Even old-tyme arbitrage trades like buying IBM in the UK and selling the stock in the US simultaneously had settlement risk and currency risk (GBPUSD fluctuation between the time of purchase and the time of sale. At a minimum, the bid-ask spread).

Any arbitrage which requires holding the position for a period of time typically has some risk between the two assets diverging – the market has become overly confident in their statistical models and often fails to properly measure this risk.

When options began trading puts on the US exchanges, I worked for a small proprietary firm. I spelled arbitrage correctly and was promoted to option trader, trading conversions and reversals.

WHEN WAS THIS ARBITRAGE TRADED AND FOR HOW LONG?

If you ask any options trader in the US over the age of 50, theyll tell you these trades existed for a long enough period that many firms had their own Conversion & Reversal trading desks. So, it was a separate profit center that could stand on its own. The purpose of this disclaimer will make sense when you see the transaction.

Heres an example of a CONVERSION (A.K.A. FORWARD CONVERSION)

Focusing on the options trades: the short 65 call and long 65 put, both expiring in 60 days is a SYNTHETIC SHORT POSITION in the common stock.

If the stock is above 65 on expiration day, the calls will be exercised and the puts will expire worthless. If the stock is below 65 on expiration day, the puts will be exercised and the calls will expire worthless.

In 60 days, if the stock closes above or below $65 the stock will be sold at $66.20

The long stock will be delivered upon exercise/expiration of the synthetic short

The cost of the stock + cost to carry the position for days

The stock was purchased at $65 and financed at 3.50% for 60 days

The cost of actual long = Amount financed * interest rate /365 * days to expiry

The cost of actual long = $65 * .035 / 365 * 60 = .37 (rounded)

On expiration day, the closing price of the stock will determine whether the calls are assigned (stock above $65), or the puts are exercised (stock below $65).

The short position (at $66.20) will be covered by delivering the long stock (at $65.37).

The net profit is .83 cents in profit on 10,000 shares or $8,300.

The above-described conversion would have been traded in large size. Further, we scanned all liquid equity options to find conversions & reversals. So the result was both conversions and reversals. Long story short, it was a real business. The Risk-Adjusted return was lower than 7.76%. Lets take a look.

There is one risk in a conversion or reversal. If the stock expires AT the strike price on expiration, you dont know whether to exercise your puts. Because you dont know if the calls will be assigned. ACK!!

The risk management techniques of the late 70s early 80s were limited by computer power. But the same process would be used today.If the stock looks like the stock is going to be PINNED to the strike price, exit the trade on or just prior to expiration day.

The risk-adjusted return will depend on how much it costs to unwind the position on or just prior to expiration day.

When the edge narrows to pennies, the risk of the bulldozer is greater than the pennies. Its time to move onto a new trade.

And thats arbitrage – If the trade works others will join in and tighten the spread.

Arbitrageurs always have an eye out for the next trade.

WAS THERE A LARGER MARKET BENEFIT FROM THIS ARBITRAGE?

Yes! The first benefit of this arbitrage activity was greater liquidity which brought tighter bid-ask spreads, which resulted in other participants entering the market.

Asset Managers & other investors could use options in the quantity they needed.

Short term speculators could use options because they were liquid enough to reverse their position in the same trading day.

The second benefit of this arbitrage activity was aligning option prices. The No-Arbitrage Derivatives Pricing Theory says

Lets take a look at the spreadsheet below. Take note of the implied volatilities of the options on the left versus the implied volatilities of the options on the right.

On the left, the implied volatility of the 65 calls is 39%, but the implied volatility of the 65 puts is 31%. Lets move down the snapshot.

Take a look at the SYNTHETIC FORWARD versus the ACTUAL FORWARD. The SYNTHETIC FORWARD is much higher than the ACTUAL FORWARD.

The dis-alignment is because the calls were trading at $4.25 (39% implied). But as more and more arbitrageurs sell those calls the price trades down. Eventually, the call will trade in line with the put.

Now take a look at the options on the right side of the snapshot. Note the implied volatilities for both calls and puts are 31%. This is called Put-Call Parity.

Further down shows the SYNTHETIC FORWARD and ACTUAL FORWARD are both $65.37. From a No-Arbitrage Pricing standpoint, the options are now back in line.

There are people who view the contribution arbitrageurs made to the growth of exchange-traded options differently. But derivative products develop into liquid, viable markets by attracting multiple types of users, who enter the market for different reasons and for different time frames.

The reason for sharing this last point is because there new derivative products are introduced. Some of them have enough similarity with the underlying asset that the same type of arbitrage transaction (as the conversion/reversal) will exist until the market becomes liquid.

I can say with confidence, today, CONVERSIONS & REVERSALS are rarely executed in the liquid US options markets. But that doesnt mean there wont be possible arbitrage opportunities in emerging capital markets, as newer derivative products are introduced.

I kind of short-changed your question by pointing one of the arbitrage opportunities Ive traded. But I went for quality, instead of quantity with an arbitrage which had limited price risk.

Thanks for the A2A. I hope this answers your question and provides some framework around that period of time (early 1980s). I hope it gives you insights for the future and you enjoy the rest of your day.

This information is not an offer to buy nor a solicitation to …

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