Arbitrage Strategies With Binary Options
Any keen observer of the financial markets might have noticed that, at times, a security could have different prices in different markets. This price difference can be exploited to make a profit in the market. This strategy involved is known as arbitrage. Traders can use various arbitrage strategies to make the most of such price differences. One such is the options arbitrage strategy. In this blog, we will take a close look at arbitrage and how to use binary options to create strategies.
Arbitrage: An Explainer
Arbitrage refers to a trading strategy in which a trader benefits from buying and selling a security in two different markets to benefit from the price differences. Here’s an example to understand the concept better.
Suppose stock ABC is quoted on the BSE at Rs 10 per share and on the NSE at Rs 10.20. A trader notices this difference in prices and aims to capitalise on it. In order to enter into an arbitrage trade, the trader will buy the security on the BSE and sell it on the NSE.
If the trader buys 1,000 shares of ABC at Rs 10 per share on the BSE, he will invest Rs 10,000. If he sells the 1,000 shares on NSE for Rs 10.20 per share, he will pocket a profit of Rs 0.20 per share.
The net profit will be 0.20 x 1,000 shares = Rs 200
Companies | Type | Bidding Dates | |
| SME | Closes Today | ||
| SME | Closes 15 Jan | ||
| Regular | Closes 15 Jan | ||
| SME | Closes 17 Jan | ||
| Regular | - |
Options Arbitrage
Arbitrage trades in stocks require two different markets where a security quotes at different prices. This is where options come into play as they offer significantly more opportunities for arbitrage within the same market. Two assets with a similar payoff can be arbitraged against each other. For example, a trader can create a synthetic call by going long on a put option and a future option. The synthetic call option can then be arbitraged against a regular call option on the same exchange.
Similarly, there are different ways a trader can arbitrage within the same exchange. One can enter into a short position in a stock future and arbitrage it against the long position in the stock.
Binary Options
Binary options are a helpful tool in arbitrage trading. As the name suggests, binary options have two outcomes. If the price is above the strike price of the binary option at the time of expiry, the option will be in profit. If the price is below the strike price, the binary option will be in a loss.
Plain vanilla call and put options have a pay-off that increases linearly. It means that the price of the option increases with a rise in the price of the underlying asset.
On the other hand, the payoff in binary options is fixed. A binary option will remain zero till the price of the asset is below the strike price and will rise only when the price moves above the strike price.
Let’s look at an example:
If an asset is trading at Rs 8,000 and a trader purchases a binary option of the strike price of Rs 8,100 expecting the price to rise. The trader purchases the binary option for Rs 20. If the price of the asset rises to Rs 8,105, the binary option will be worth Rs 100. However, if the asset’s price on expiry is Rs 7,900, the trader will lose the Rs 20 that he paid for the binary option.
Arbitrage Trading Strategies with Binary Options
One of the key challenges of arbitrage trading is to find assets that share a similar profile. Arbitrage trading with binary options can help in this area.
Time-Based Arbitrage
Time-based arbitrage strategies mainly benefit from the limited trading hours of stocks, indices, commodities, and other assets. For example, if a piece of positive news for an asset is released after trading hours, arbitrage traders can benefit from the price fluctuations in the pricing of binary options before the asset opens for trading again. The market for binary options is always open which allows traders to ascertain whether a binary option is overbought or oversold.
Arbitrage in Correlated Assets
Correlated assets are another great avenue for arbitrage trading. A change in the price of certain commodities can have an impact on another commodity or currency. For example, a rise in gold or crude oil prices can lead to the weakening of the US dollar. Arbitrage traders can look at forex binary options to seek arbitrage opportunities.
In the case of rising crude oil prices, an arbitrageur can short the US dollar by selling the USD/JPY pair or purchasing the EUR/USD pair which might see a rise in price. Accordingly, the trader can capture any arbitrage opportunities in the forex binary options market.
Benefits of Arbitrage Trading with Binary Options
Arbitrage trading with binary options can be helpful in the following ways.
- Binary options help generate returns when outcomes are certain.
- Arbitrage trading with binary options can potentially result in higher gains.
- In case the binary option expires worthless, the losses are limited to the premium paid.
Disadvantages of Arbitrage Trading with Binary Options
There are a few limitations to arbitrage trading with binary options.
- Traders might not come across arbitrage opportunities often.
- Since binary options have two possible outcomes, they tend to be volatile in nature.
- Higher brokerage fees may impact profits.
Conclusion
Arbitrage trading can be an alternative and viable way for traders to capitalise on a difference in the price of an asset in two different markets. With the help of binary options, traders can discover arbitrage trading strategies for related commodities or time-based arbitrage strategies.
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Disclaimer: This blog is solely for educational purposes. The securities/investments quoted here are not recommendatory. To read the RA disclaimer, please click here RA Sign - |