Option Arbitrage in the Forex Market
What is arbitrage? Arbitrage is the simultaneous buying and
selling of identical financial instruments taking advantage of
price discrepancies between different brokers, exchanges,
clearing firms, etc. and thus locking in a profit. On paper,
arbitrage is a risk-less trading strategy. In the real world
however, risks abound.
So why trade arbitrage? Well, if the risks can be managed,
arbitrage can be extremely profitable if you can find the
opportunities and take advantage of the opportunities before they
disappear. After all, the arbitrage opportunity is present
because one side is slow to react to market news, momentum, etc.
When it corrects the opportunity is gone.
Why arbitrage forex options? Well, because the opportunity
exists if you look far it. The forex market is a cash inter-bank
/ inter-dealer market. In simplest terms, this means the foreign
currencies traded in the forex market are traded directly between
banks, foreign currency dealers and forex investors wishing
either to diversify, speculate or to hedge foreign currency risk.
The forex market is not a "market" in the traditional sense due
to the fact that there is no centralized location for forex
trading activity and, therefore, trades placed in the forex
market are considered over-the-counter (OTC). Forex trading
between parties occurs through computer terminals, exchanges and
over telephones at thousands of locations worldwide.
Therefore the forex market is not as efficient as the NYSE for
example. Price discrepancies exist between trading platforms,
clearing firms, banks, etc if only for a small period of time.
Options pricing is also affected for the same reasons but since
there are other components involved in pricing an option than
just the price of underlying currency, they tend to exist for
longer periods of time.
One of the most common causes of option pricing differences is
the calculation of volatility. Volatility is generally the
standard deviation measured over a period of time. Sounds simple
enough right? Well, if compare the volatility measure across
different forex option providers, you'll likely find differences
as large as 2%. When you find this you have also probably found
an arbitrage opportunity.
Now that you've found an arbitrage opportunity, how do you
trade it? Well, that's a bit trickier and this article cannot
possibly cover all the risks associated with pulling off the
trade but I will list some issues you should consider.
First of all, are the options really the same? Are the
contract sizes, expiration dates and times the same? American or
You also need to consider execution risk. Will there be
slippage. Will there be a time delay in getting filled. Is the
market moving too fast?
Exit strategy, how are you going to exit the trade and still
capture the profit? What happens if the options expire in-the
money? Out-of-the-money? What if you get assigned a position on
one option but not the other?
These are just a few of the issues one must consider when
trying to profit from option arbitrage. The key to option
arbitrage is not unlike any other trade -- planning and risk
management. Plan the trade, manage the risks, and execute the
plan and you will be successful.
Senior Account Executive,
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