Synthetic Option Arbitrage is a strategy that exploits price discrepancies between synthetic options and the actual market prices of options. This approach uses combinations of options, such as calls, puts, and futures, to construct synthetic positions that mimic the behavior of a single option or spread. By identifying when these synthetic options are mispriced relative to actual options, traders can take advantage of arbitrage opportunities.

The key to this strategy is constructing synthetic options using other financial instruments and comparing them with the real market prices. A mispricing or discrepancy between the synthetic and actual option prices creates an arbitrage opportunity, allowing traders to profit by entering offsetting positions in the market.

What is Synthetic Option Arbitrage?

Synthetic Option Arbitrage involves creating synthetic options using a combination of other options and instruments (such as futures contracts or stocks) to mimic the payoff of a single option. Traders can then identify price discrepancies between the synthetic options and the actual market prices, and profit by executing trades to exploit the mispricing.

• Synthetic Option: A synthetic option position is created by using a combination of other financial instruments (such as stock and options) to replicate the price movement of a specific option. For example, a synthetic call option can be created by buying stock and simultaneously selling a put option.
• Real Option: A real option is a standard option contract that provides the holder with the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specified price (strike price) before a certain expiration date.

The strategy works by constructing synthetic options and comparing their prices to actual options prices. If the synthetic option is mispriced, an arbitrage opportunity arises, and traders can execute trades to profit from the discrepancy.

How Does Synthetic Option Arbitrage Work?

Synthetic Option Arbitrage works by constructing synthetic options using various combinations of instruments and comparing their prices to the actual market prices of standard options. The strategy typically follows these steps:

1. Construct Synthetic Options:

The first step is to construct a synthetic option using a combination of financial instruments. The synthetic option aims to replicate the price movement of a real option. Here are a few common synthetic options:

• Synthetic Call Option: A synthetic call option can be created by buying the underlying asset (e.g., stock) and selling a put option on that asset. This position mimics the payoff of a traditional call option.
• Synthetic Put Option: A synthetic put option can be created by selling the underlying asset and buying a call option on that asset. This position mimics the payoff of a traditional put option.

These synthetic options replicate the risk and reward characteristics of the real options.

2. Identify the Real Option Price:

Once the synthetic option is constructed, the next step is to identify the real option price. This is the market price of the standard option (either a call or put) that is being replicated by the synthetic option. The real option price is determined by factors like the underlying asset’s price, time to expiration, strike price, and implied volatility.

3. Compare Synthetic and Real Option Prices:

The next step is to compare the price of the synthetic option with the real option price. If there is a significant price discrepancy between the two, it suggests that an arbitrage opportunity may exist. The goal is to identify when the synthetic option is either underpriced or overpriced relative to the real option.

• Overpriced Synthetic Option: If the synthetic option is overpriced relative to the real option, traders can sell the synthetic option and buy the real option to profit from the price convergence.
• Underpriced Synthetic Option: If the synthetic option is underpriced relative to the real option, traders can buy the synthetic option and sell the real option to profit from the price convergence.

4. Enter the Arbitrage Trade:

Once a pricing discrepancy is identified, traders can enter into an arbitrage trade by taking opposing positions in the synthetic option and the real option. This creates a risk-free trade where the trader can lock in a profit once the price discrepancy between the two options converges.

For example:

• If the synthetic call is overpriced, traders can sell the synthetic call (long on stock, short on put) and buy the real call to profit when the prices converge.
• If the synthetic call is underpriced, traders can buy the synthetic call and sell the real call to capture the arbitrage profit.

5. Exit the Trade:

The trade is exited when the price discrepancy between the synthetic option and the real option has narrowed or disappeared. This usually happens when the market corrects the mispricing. The trader can then close both positions to lock in profits.

Advantages of Synthetic Option Arbitrage

1. Exploiting Mispricing: The strategy enables traders to profit from inefficiencies or price misalignments between synthetic options and real options.
2. Capital Efficiency: By using synthetic positions, traders can leverage derivatives and replicate options without having to trade the actual options, which may require higher capital.
3. Arbitrage Profits: The strategy can offer risk-free profits when executed correctly, as the price discrepancy between the synthetic and real options is expected to converge.
4. Flexibility: Synthetic options can be constructed for a variety of underlying assets, making this strategy adaptable to different market conditions and asset classes.

Key Considerations for Synthetic Option Arbitrage

1. Transaction Costs: The strategy involves multiple trades and potentially high transaction costs, which could erode the profits from the arbitrage opportunity.
2. Liquidity Issues: If the synthetic options or real options lack sufficient liquidity, it may be difficult to enter or exit positions at the desired price, leading to slippage or missed opportunities.
3. Time Sensitivity: Synthetic option arbitrage requires quick execution, as price discrepancies can be corrected rapidly. Traders need to monitor the market closely to capture the arbitrage opportunity.
4. Market Efficiency: The more efficient the market, the less likely there will be significant mispricing. The strategy works best in markets where inefficiencies or temporary pricing discrepancies exist.

Pros and Cons of Synthetic Option Arbitrage

Pros:

1. Risk-Free Profits: When executed correctly, the strategy can provide risk-free profits by exploiting price inefficiencies.
2. Capital Efficiency: Synthetic options allow traders to replicate real options with less capital, making the strategy capital-efficient.
3. Profit from Mispricings: The strategy focuses on exploiting arbitrage opportunities, which can result in profitable trades when market mispricing occurs.
4. Flexibility Across Markets: Synthetic option arbitrage can be applied to various markets, including equities, commodities, forex, and interest rates, making it versatile.

Cons:

1. Complexity: The strategy requires advanced knowledge of derivatives, options pricing, and the ability to construct synthetic positions, making it complex and suitable for experienced traders.
2. High Transaction Costs: Frequent trading in both synthetic and real options can result in high transaction costs, reducing the overall profitability of the strategy.
3. Liquidity Risk: Lack of liquidity in synthetic or real options can cause slippage or prevent the trader from entering or exiting positions at favorable prices.
4. Market Efficiency: In highly efficient markets, price discrepancies between synthetic and real options may be rare or quickly corrected, reducing the effectiveness of the strategy.

Conclusion

Synthetic Option Arbitrage is an advanced strategy that involves creating synthetic options using derivatives and exploiting pricing discrepancies between synthetic and real options. By identifying mispricings, traders can enter arbitrage positions that lock in risk-free profits as the two prices converge. While it offers significant profit potential, this strategy requires a deep understanding of options, derivatives, and market mechanics.

For traders interested in learning more about Synthetic Option Arbitrage and other advanced strategies, exploring our Trading Courses can provide expert-led insights and in-depth training.