Understanding stock and option pricing requires an awareness of arbitrage and market efficiency. Although most retail investors do not have the tools to take advantage of arbitrage opportunities, a comprehensive understanding of how it works adds to our financial literacy and so I am sharing this 2-part series with our readers.
What is arbitrage?
Arbitrage is the simultaneous purchase and sale of an asset to profit from a difference in the price. It is a trade that profits by exploiting the price differences of identical or similar financial instruments in different markets or in different forms. Arbitrage exists because of market inefficiencies.
Arbitrage is a necessary force in the financial marketplace
Arbitrage provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time. With advancements in technology, it has become nearly impossible to profit from pricing errors in the market. Sophisticated traders have computerized software programs used to monitor fluctuations in similar financial instruments Any inefficient pricing combinations are acted upon quickly, and the opportunity is often eliminated in a matter of seconds. Arbitrage is a necessary force in the financial marketplace.
An arbitrage example
- Stock BCI is trading at $30.00 on exchange ABC
- Stock BCI is trading at $30.05 on exchange XYZ
- Buy the stock on ABC and immediately sell the same shares on XYZ earning a no-risk profit of 5 cents per share
- A trader can continue to exploit this arbitrage until the specialists on ABC run out of inventory of BCI stock, or until the specialists on ABC or XYX adjust their prices to eliminate the opportunity
Arbitrage for the call buyer
An arbitrage opportunity exists when in-the-money options (ITM) are trading less than parity (below intrinsic value). Here we exercise the call (buy the shares) and short the stock:
- XYX is trading at $50.00
- $40.00 call (ITM)is trading at $9.75 (below parity of $10.00)
- Exercise the call 9that cost $9.75) and buy shares at $40.00
- Short the stock (sell) at $50.00
- Arbitrage profit = (+ $10.00 – $9.75) = $0.25
Arbitrage for the put buyer
An arbitrage opportunity exists when in-the-money options are trading less than parity (below intrinsic value). Here we buy the stock and exercise the put (sell stock):
XYZ is trading at $30.00
$40.00 put (ITM) is trading at $9.75 (below parity of $10.00)
Buy stock at $30.00
Exercise put and sell stock at $40.00
Arbitrage profit = (+ $10.00 – $9.75) = + $0.25
In this day and age of computerized trading and efficient markets, arbitrage opportunities are few and far between and generally not available to retail investors. When these opportunities do appear, they are quickly erased by institutional investors with sophisticated software programs that find and eliminate these inefficiencies. From our perspective, it is instructive to understand the operation of the markets we invest in. In Part II of this series, we will add dividends into these arbitrage equations.
Related article: Put-Call Parity
HOLIDAY DISCOUNT COUPON: PROMO CODE “HOLIDAY10”: Holiday gifts at a discount
The BCI team is thanking our members with a 10% discount off all items in the Blue Collar store for all orders placed from now through December 24th. Use promo code holiday10 to receive the 10% discount at checkout. Premium members, enter the store from the premium site to receive your additional member discount.
1- BCI Video membership (premium members do not need this subscription as you are already receiving these benefits)
- Over 140 Ask Alan videos + 1 new video added each month
- Blue Hour webinars + 4-6 new webinars added per calendar year
- Beginners Corner for Covered Call Writing added to this site
- Beginners Corner for Selling Cash-Secured Puts added to this site
- 5% discount on all items in BCI store
- Bonus streaming DVDs
- $20-per-month or $200 for 12 months (2 months free)
2- New book, Covered Call Writing Alternative Strategies (coming early 2018)
- Portfolio Overwriting
- The Collar Strategy
- The Poor Man’s Covered Call
3- Three new calculators for strategies detailed in the new book
Upcoming speaking event
Orlando Money Show
February 8th – 11th, 2018
I will also be part of the event opening All Stars of Options Presentations.
This week’s economic news of importance:
- Producer price index for November: 0.4% (expected)
- Consumer price index for Nov3ember: 0.4% (expected)
- Core CPI: 0.1% (0.2% expected)
- FOMC announcement: 1.25 – 1.50% (expected)
- Weekly jobless claims: 225,000 (235,000 expected)
- Retail sales: 0.8% (0.4% expected)
- Manufacturing PMI: 55.0 (expansion)
- Services PMI: 52.4 (expansion)
- Industrial production: 0.2% (0.4% expected)
THE WEEK AHEAD
Mon Dec 18th
- NAHB home builders index for Nov.
Tue Dec 19th
- Housing starts for Nov
- Building permits Nov
Wed Dec 20th
- Existing home sales Nov
Thu Dec 21st
- Weekly jobless claims
- GDP revision
- Leading indicators
Fri Dec 22nd
- Durable goods orders
- Personal income
- Consumer spending
- Core inflation
- New home sales
- Consumer sentiment
For the week, the S&P 500 rose by 0.91% for a year-to-date return of 19.52%
IBD: Market in confirmed uptrend
GMI: 5/6- Buy signal since market close of August 31, 2017
BCI: My portfolio makeup remains in a neutral bias, selling an equal number of out-of-the-money and in-the-money calls. Let’s see the final tax bill.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a slightly bullish outlook. In the past six months, the S&P 500 was up 10% while the VIX (9.42) moved down by 14%.
Much success to all,
Alan and the BCI team