When looking at an option chain, you see all the data for an underlying asset and its related options. Between the various sections – the underlying, the call and put options, and the different expiration months – there are fundamental relationships that underlie their pricing.
When these
relationships get out of line, an arbitrage opportunity exists—buying an
option(s) and selling the related option(s) for a (near) risk-free
profit. To illustrate these relationships we will use arbitrage
strategies, and we will begin by discussing synthetics, which form the basis
for all the different arbitrage strategies.
Synthetic
Relationships
There can be up
to three different parts to any potential option strategy: The underlying
asset; the Call options; and the Put options. Most arbitrage strategies
use the concept of synthetics, and they are a large part of the strategies we
use here. A synthetic strategy is one where you combine any two parts
(calls, puts and/or the underlying) to create a position that looks like the
third one.
For example, if
you buy both the stock and a put option, you will make money if the market goes
up, but your loss is limited if the market falls. That's exactly the same
risk/reward you would get if you bought a call option – you make money if the
market goes up but your loss is limited to the premium paid if the market
falls. Buying the stock and buying a put is therefore called a synthetic
call. In terms of risk and reward, it is exactly the same thing!
The various
synthetic relationships may seem a little confusing, but with a little practice
you will see how easy it is to understand. An important rule to keep in
mind is that the strikes and months of the calls and puts must be identical.
For synthetics that involve both the stock and options, the number of shares
represented by the options must be equal to the number of shares of
stock. The table below lists the basic synthetic positions:
