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 European style?
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.
John Nobile,
Senior Account Executive,
CFOS/FX,
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