Futures & Options

At Yahoo: Free Money

I write on arbitrage at Yahoo: Free Money

The story goes: an economist was walking on the road with a friend, who said:

"Look, there's a 100 dollar bill lying on the ground, Professor"

"It can't be. If it was, someone would have taken it already", the economist replied.

While that sounds absurd, there still needs to be someone picking up those bills. In market parlance, the act of buying something and selling it almost immediately at a higher price is arbitrage — what might seem to be "risk-free" money.  Let's just look at the field, from an Indian market context.

Inter-exchange arbitrage

The BSE and NSE are the two most popular exchanges in India, and many stocks trade on both of them . If there is a price difference in a stock's quoted prices in each, you can buy on one exchange and sell on the other. You should theoretically not lose any money regardless of which way the market goes. As more people do this, the prices on the two exchanges should converge.

That's technically true, but there are many reasons why there is a gap in the prices, and no one is picking up the free money. Transaction costs can be too high — apart from brokerage, you have clearing costs, exchange fees, stamp duty and securities transaction tax — sometimes high enough to have a healthy gap. And then you have execution risk — what if you get one trade but not the other because prices moved?

In India, you must square off an inter-exchange arb trade within the day for structural reasons. With a T+2 rolling settlement system in India, you need to deliver stock that you sell on the next day of the trade, but you only receive what you buy two days after — so it's perilous to hold this trade through the end of the day. (If you reverse the trade within the day, it doesn't need to be settled) But then, an intra-day "square-off" means that prices must converge within the day — and if that doesn't happen, you might have to square off at a loss at 3:25 p.m.

STT and Option Prices

Why do in-the-money options seem to have no time value?

Options have a time value component to account for the time remaining to expiry, and an "intrinsic" value - the difference between the stock and the strike price (called the "ITM" or in-the-money amount). On expiry day, with nearly no time remaining, you would expect the option to trade at it's intrinsic value, or whereabouts. Yet, most in-the-money options trade below intrinsic value!

The reality is that a regulatory cost, the Securities Transaction Tax (STT), eats up too much that it leaves options quoting at less than intrinsic value. Deepak Shenoy tells you how.

(6 minutes)

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