Options arbitrage compares positions intended to produce matching cashflows. A trader buys a relatively underpriced position and sells its more expensive equivalent. Matching must include contract terms, dividends and financing; a displayed price difference does not guarantee an executable profit.
If puts are overpriced relative to calls, the arbitrager would sell a naked put and offset it by buying a synthetic put. Similarly, when calls are overpriced in relation to puts, one would sell a naked call and buy a synthetic call. The use of synthetic positions are common in options arbitrage strategies.
Pricing discrepancies can be brief and may disappear after fees, bid–ask spreads, funding and stock-borrow costs. Trading in synthetic positions, conversions and reversals helps constrain relative prices. The theoretical relationship is explained by put–call parity, subject to its assumptions.
Conversion and Reversal
Floor traders perform conversions when options are overpriced relative to the underlying asset. When the options are relatively underpriced, traders will do reverse conversions, otherwise known as reversals.
Box Spread
A Box Spread combines matched vertical spreads to produce a fixed expiration cashflow under idealized contract assumptions. Its price reflects financing as well as costs. American-style early exercise and assignment can disrupt a simple fixed-cashflow interpretation.
Dividend Arbitrage
The dividend-arbitrage example compares stock, put and dividend cashflows. Dividend timing, option exercise eligibility, financing and costs matter; receiving a dividend is not by itself a risk-free gain.
