tell me why this isn't easy arbitrage...

Discussion in 'Options' started by huge, Aug 20, 2011.

  1. huge


    Let me start by saying that I *DONT* think Ive found a magical risk-free money-making strategy. Ive found something that looks like an arbitrage opportunity to my non-expert eye, and Im posting here for more experienced folk to tell me why it wont work.

    Theres a stock Ive been watching/trading, sometimes just buying & selling the stock, sometimes writing covered calls near expiration.

    I considered buying the stock Thursday, but was nervous about the market overall and did not pull the trigger. That was fortunate for me because the stock declined further on Friday.

    Near the close on Friday with the stock down substantially, I considered going long again, and decided to look at the stocks option chain. I noticed that the price of put options a few months out seemed very expensive to me, and decided that instead of buying the stock outright, I would sell-to-open near-the-money puts with the hope of either pocketing the premium or picking up the stock at a substantial discount to the already depressed price. I executed the trade - I simply hit the bid price because I didnt want to mess around trying to get filled in between the spread, and the price seemed like such a good deal to me that I just wanted to make sure I got filled.

    OK, nothing unusual so far - Ive done this before when I was bullish on a stock but wasnt really hoping for a quick upward swing.

    Then I looked at the call prices and I became very surprised. It looked like the call prices were very cheap compared to the puts - so much so that I could establish a synthetic long position at a significant discount to the stock price, even if I just ate the cost of the bid/ask spread on both legs.

    By the time I figured this out it was after the close, and at any rate I wasnt confident of what I was seeing. Anyway I was happy with the position I had established and decided to just do some research and determine whether what I was seeing was real or a dangerous mirage.

    I found a helpful article:

    containing this excerpt:
    In this day and age the expression “There’s no free lunch on Wall Street” is more omnipresent than ever. With the sophistication of the market as it is, you’re unlikely to see this sort of arbitrage gem without a prevalent fishy aroma in the air.

    When would you come across this type of “look, but don’t touch” situation? This kind of pricing is most evident when a trader has inadvertently come across an underlying market which is hard-to-borrow [HTB] for shorting shares or maybe just a very thinly and loosely traded product. Either way, it’s best to be highly skeptical first before you consider placing your order.

    In a situation where shares are “HTB” or impossible to short; calls can trade at a theoretical discount to puts. The reason is the natural hedge to reduce delta or directional risk with short stock is either very tricky business or altogether, not a viable option, pardon the pun. This means the yummy looking value meal isn’t the same opportunity offered as part of a regular conversion / reversal market.

    So that makes sense to me, and had occurred to me already: that if the stock is very hard to short, then I cant easily establish a true arbitrage trade by selling the stock and buying calls. But it still seems bizarre and surprising to me that I seem to be able to exploit the put pricing to take on a simulated long position at a very significant discount to the current stock price (significant enough to vastly outweigh commission costs).

    Ive looked at other option chains and its a little hard to evaluate them because the market is closed so Im not sure Im seeing option prices that are actually parallel to the stock price, but it looks like there are some disparities around - not quite as big as what I found but big enough that if you wanted to buy the stock anyway (or wanted to liquidate a short position) you would be much better off going the synthetic route.

    What am I missing? What should I be wary of?

    Thanks for any insight or warnings you can provide...
  2. donnap


    Possibly HTB or the stock has a greater dividend yield than today's near zero rates.

    If it's the div., then the synthetic is discounted because it does not receive it. With the reversal arb the short stock side pays the div.
  3. FSU


    Often for a hard to borrow stock this is a much better way for someone to "buy" the stock. You sell the put (as you did) and if you want to exactly replicate being long the stock, you buy the call of the same strike. The "hard to borrow" value is written into the options that you can take advantage of. If you simply bought the stock, the brokerage house would be taking advantage of this value by loaning your stock out at a price.
  4. spindr0


    It's very are to find a magical risk-free money-making position. In a fast market you might see a price out of kilter but by the time you assess it, its usually gone. Even if you could react that fast, you wouldn't get much size and more likely, you end up with some legs but not all.

    More realistically, if you see what looks like a free lunch, understand there are none. But let's pretend that one appears. First, check the dividend. If ex-div is before expiration, it's priced into the options.

    For the reversal, first thing to do is to determine borrowability. Quickest way for me is to place a short shares order at a much higher price, one that will not get filled. If not borrowable the order is flagged by a specific color. If shortable, then check the indicative borrow rate and determine if that's the cause of the put-call price discrepancy.

    If all of these have checked out, pffffft! It;'s probably gone by now :)
  5. kxvid


    Are your sure this is not stock-specific due to accounting irregularities or securities fraud class action, etc? If not, this suggests that market is under strain resulting in a breakdown of the typical black-scholes pricing model. Option market-makers simply do not want to be short puts, and are demanding an additional premium.

    Under normal conditions, puts and calls should be priced similarly due to the "random" nature of the market. In theory, stocks are just as likely to go up as down, at least over the short term. What may be causing this is heavy demand for protection "puts". If you believe that the market really is a random walk, this would be an opportunity to sell to open puts and buy to open calls. There would be serious problems using such a tactic if the market crashed, which is being somewhat priced into those options prices.
  6. huge


    I'll write a longer, gratitude-spilling reply soon, but first a quick note: sorry I forgot to mention in my original post that the underlying stock does not pay a dividend.
  7. huge


    Thanks to all of you for the helpful, smart, quick replies. I've obviously found exactly the right place to ask this question. (By contrast, and for your amusement only, I submit to you a link to the other place I posed the question and the first reply I received there).

    Joking aside, on to a couple of specific replies:

    I'm guessing when you say "flagged by a specific color", you're talking about some specific brokerage's software or online interface. I placed the trade with TD Ameritrade (hopefully that won't get me sneered at too badly), but also have accounts with Fidelity and Merrill (where my sister is a broker) - hopefully between those three resources I'll be able to figure out pretty quickly whether the stock is shortable or not.

    I'm not aware of any allegations of fraud or accounting problems. Certainly the stock is beaten-down and certainly there is heavy short interest - I'm guessing that would qualify as meeting your description of "under strain". I guess I don't quite understand why, under any of those circumstances, the market makers would not also boost the premiums on call options to maintain something close to parity.

    This may be going too far into conspiracy theory, but I guess you could speculate that the option pricing is really the "smart money", indicating that the stock is overpriced and headed lower (and specifically that the risk of the stock heading drastically lower is much higher than the reverse, or than is priced into the stock). Obviously I hope that's not true because it would be bad for my position, but if it is true then maybe the options I've sold were just fairly priced, and I'm getting a merely fair shake.

    I'd be interested to know what people think about that conspiracy paranoia - the idea that the fact that market makers are pricing in a premium to their put prices is really a strong bearish indicator for the stock (as opposed to just reacting to supply and demand, as they might do if lots of people are trying to buy puts because they are unable to short the stock directly).

    For now, I'm happy with the position I've established, but obviously if I can establish a full position with true arbitrage value I'll be even happier. I'll certainly post what happens...

    Thanks again for the thoughtful and helpful replies.
  8. m22au


    It's probably a hard-to-borrow stock with a high interest rate (such as LNKD) where it makes sense to sell the put and buy the call, rather than buy the stock outright.

    If this is the situation, then arbitrage is not possible because the cost to borrow the stock (to short) is the same as the net premium received on the two option trades.
  9. My money is on M22's suggestion that it's LNKD. OP, this isn't news. IB was charging 80% to hold the short, and there is no guarantee that you'll get to maintain that short position.

    Funny how he asks for help but doesn't reveal the ticker. A real stand-up guy.
  10. GordonTheGekko

    GordonTheGekko Guest

    Maybe you should replace him since you're obviously well qualified and smarter, given the words in your post.
    #10     Aug 21, 2011