How to execute put call parity arbitrage with crypto options

The concept of arbitrage has long intrigued traders, and traders dabbling with crypto options are no exception. From capitalizing on market pricing inefficiencies to exploiting the unique pricing of derivatives like crypto options, arbitrageurs can strategically generate gains by simultaneously buying and selling identical assets thanks to the pricing differences between them. One such opportunity lies in understanding and making use of put call parity.

In this article, we’ll explore how to execute a put call parity arbitrage strategy within the growing crypto options market. This includes uncovering the mechanics of put call parity and recognizing arbitrage opportunities when there are imbalances in put call parity. If you’re already experienced in crypto trading but new to arbitrage strategies, understanding this strategy could open up new avenues for trading while deepening your knowledge of market mechanics.

TL;DR

• Crypto arbitrage involves exploiting pricing inefficiencies across different exchanges to generate gains through well-timed arbitrage trades.

• Put call parity is a key concept in options pricing, maintaining the balance between put and call options relative to the underlying asset.

• Put call parity arbitrage exploits mispricing between call and put options in crypto markets, offering lucrative arbitrage opportunities.

• Executing the strategy requires simultaneously buying and selling options and hedging with the underlying asset to minimize risk.

• Challenges include transaction fees, slippage, timing, and liquidity risks, which can diminish potential gains.

What is crypto arbitrage?

Crypto arbitrage refers to a trading strategy that generates gains by making use of pricing inefficiencies across different crypto exchanges. These inefficiencies tend to rear their heads over time because of issues like differences in trading volume, liquidity, and market sentiment across different exchanges. Although simple in theory, successful crypto arbitrage strategies require solid timing and the ability to identify opportunities in plain sight. That's because mispricings quickly resolve themselves as more traders execute the arbitrage strategy.

Now that you’re familiar with the basics of crypto arbitrage, let’s delve into how crypto options come into play thanks to put call parity imbalances.

What is put call parity?

Put call parity is a fundamental relationship in option pricing theory that highlights how the prices of puts, calls, and the underlying asset must be consistent with one another. This implies that a portfolio consisting of a long call option and a short put option should be equivalent to a forward contract for the same underlying asset, expiration, and strike price.

The put call parity equation explained

At the heart of put call parity is a simple but powerful equation.

C - P = S - K

• C represents the price of a call option

• P represents the price of a put option

• S stands for the current price of the underlying asset like Bitcoin or Ether

• K is the strike price of the option

This equation is rooted in the idea that owning a call option combined with selling a put option at the same strike price should create the same payoff as holding the underlying asset directly. Also known as the synthetic long options strategy, the relationship holds true when markets are efficient. When there’s a deviation from this formula, it creates arbitrage opportunities for traders to capitalize on.

Why put call parity matters for crypto options traders

Understanding the idea of put call parity is essential because it highlights potential mispricings in the market. Crypto markets can often experience discrepancies that don’t exist in traditional markets because of their inherent volatility. Opportunistic crypto traders who can recognize these discrepancies have the chance to exploit them through an arbitrage trade, earning a tidy sum of gains if executed correctly.

As a side note, put call parity also serves as a foundation for more advanced options strategies. It allows traders to assess whether the market is pricing options fairly, making it a valuable tool for evaluating crypto options in terms of risk and reward.

Unveiling the mechanics of a put call parity arbitrage with crypto options

Put call parity arbitrage arises when the prices of the call, put, and the underlying crypto asset deviate from the equation’s balance. When this happens, there’s a window of opportunity for arbitrageurs to earn some gains without taking on significant market risk based on the assumption that a crypto market mispricing will eventually correct itself.

In practice, arbitrage works as follows.

• Identify a discrepancy between the price of a put and a call with the same strike price and expiration date.

• Execute a series of crypto options trades by simultaneously buying and selling the call and put options respectively.

• Take a position in the underlying crypto asset of the previously mentioned option contracts.

• As the market corrects the price imbalance, arbitrage traders stand to earn gains from the pricing correction.

Example of put call parity arbitrage with crypto options

Let’s assume Bitcoin is trading at $61,300. By referencing the BTC options chain, we can see that calls and puts with an expiry date of October 25, 2024 and a strike price of $61,000 cost 0.069 BTC and 0.0635 BTC respectively. Based on the put call parity equation, the prices of these options should align so that the difference between the call price and the put price equals the difference between the asset’s price and the strike price. For reference, the call option is priced at $4,209 and the put option is priced at $3,874

C - P = S - K

4209 - 3874 = 61300 - 61000

335 ≠ 300

Based on the put call parity equation, we can see that there’s an imbalance here that arbitrager traders can take advantage of by following these steps.

• Sell the overpriced call option: In this case, the call option is overpriced. Therefore, an arbitrageur would sell the October 25, 2024 call option with a strike price of $61,000 for 0.069 BTC.

• Buy the underpriced put option: To balance the position, they’d buy the October 25, 2024 put option with the same strike price for 0.0635 BTC. This effectively creates a synthetic short position in Bitcoin

• Hedge with the underlying asset: To complete the arbitrage and minimize risk, the trader would also need to hedge their position by purchasing the underlying asset — Bitcoin — in the spot market. The amount of Bitcoin purchased would equal the amount controlled by the options contracts. Since the options in this example are based on 1 BTC, the arbitrageur would buy 1 BTC at the current market price of $61,300.

At this point, the crypto options trader has sold an overpriced call option, bought an underpriced put option, and acquired 1 BTC in the spot market. This creates a hedged, risk-neutral position that locks in the gains from the put call parity imbalance.

Reaping the Bitcoin options arbitrage gains

Through the example above, the arbitrageur has effectively locked in gains based on the mispricing. Here’s how the math works out.

Call option sale: Writing the call option generates 0.069 BTC, which at the current price of $61,300 equates to $4,209.

Put option purchase: Buying the put option costs 0.0635 BTC, which at the same market price is $3,874.

Gains from the imbalance: The difference between the sale of the call option and the purchase of the put option is $335.

As a result, the trader earns gains of $335 from the arbitrage. This is essentially the difference between the call and put prices, which has been shown to deviate from put call parity.

Closing the position at expiration

As the expiration date of October 25, 2024 approaches, the crypto options trader will have to close the position to realize their gains. Here's what happens in each scenario.

If Bitcoin is trading above $61,000 at expiration: The call option seller will be obligated to deliver 1 BTC at $61,000. Since the trader already owns 1 BTC from the hedge, they can deliver it, effectively neutralizing the obligation. The put option will expire worthless, and the arbitrage gains of $335 will remain intact.

If Bitcoin is trading below $61,000 at expiration: The put option will be exercised, allowing the trader to sell 1 BTC at $61,000, locking in the arbitrage gain. The call option will expire worthless, and the arbitrage gains remain the same.

This example shows how put call parity arbitrage can be a lower-risk strategy when properly executed. The key to success is acting quickly when market inefficiencies arise, as arbitrage opportunities can disappear rapidly in the highly volatile and competitive crypto market. However, crypto options traders must also consider factors like transaction fees, slippage, and liquidity when attempting to execute this strategy to make sure that gains aren’t diminished.

By leveraging the volatility and unique characteristics of the crypto options market, traders can use put call parity arbitrage as a tool for arbitrage gains without taking on directional market risk.

An evaluation of put call parity options arbitrage strategies

Put call parity arbitrage is an appealing strategy in both traditional and crypto options markets due to its potential for gains regardless of market direction. However, like any strategy, it comes with its advantages and disadvantages. Below is a detailed comparison of the pros and cons.

Pros

1. Arbitrage potential

The core benefit of put call parity arbitrage is the opportunity to capture gains by exploiting mispricing between the call and put options. As long as the strategy is executed correctly, market risk is minimal as the arbitrage takes advantage of temporary inefficiencies that correct themselves over time.

2. Market-neutral Strategy

This strategy is market neutral, meaning it doesn’t depend on the direction of the market. Whether the price of the underlying crypto asset rises or falls, the arbitrageur’s gains are locked in based on the mispricing between the options. This is particularly advantageous in volatile crypto markets, where price swings can be significant.

3. Flexibility in crypto options markets

The volatility and liquidity disparities in the crypto options market create more frequent arbitrage opportunities compared to traditional financial markets. Crypto markets can experience greater pricing inefficiencies due to differences in exchange volumes, trading activity, and market maturity.

Cons

1. Transaction fees

One of the primary disadvantages of executing put call parity arbitrage in crypto markets is transaction fees. Some crypto exchanges often charge excessive fees for executing trades on both the options and spot markets. These fees can quickly erode the arbitrage gains, particularly if the arbitrage window is small.

2. Slippage

Slippage refers to the difference between the expected price of a trade and the actual price at which it’s executed. In fast-moving crypto markets, slippage can occur due to market volatility or thin liquidity, particularly on smaller exchanges. This can reduce the expected margins from the arbitrage strategy and lead to losses in some cases if trades aren’t executed at the desired prices.

3. Timing and execution risk

Crypto markets are highly competitive and arbitrage windows often close quickly. If the mispricing is discovered by other traders or if market conditions shift, the arbitrage opportunity may disappear before all trades can be executed. Fast and precise trade execution is crucial, and any delay may result in missing the opportunity.

4. Complex strategy for beginners

While the concept of arbitrage is straightforward, the actual execution of put call parity arbitrage requires a deep understanding of options pricing, market conditions, and trade execution. For traders new to options, navigating the complexities of options contracts, pricing structures, and market mechanics can be overwhelming.

Final words and next steps

Put call parity arbitrage offers the potential for gains, especially in volatile and fragmented crypto markets. However, traders must weigh these opportunities against practical challenges such as transaction fees, slippage, and liquidity constraints. For experienced traders who can navigate these hurdles, put call parity arbitrage remains a viable and lucrative strategy in the crypto space. By carefully considering the risks involved and developing a sound trading plan, traders can potentially capitalize on the arbitrage opportunities presented by the numerous pricing inefficiencies in the crypto market.

Seeking more beginner-friendly crypto options strategies to add to your arsenal? Check out our guides to covered calls and strangles.