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Option Arbitrage in the Forex Market

What is arbitrage? Arbitrage is the simultaneous buying and selling 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,
http://www.cfosfx.com