Arbitrage is the simultaneous buying and selling of the same security in two different markets to profit from the price difference. Given their unique payoff structure, binary options have become popular among traders. Below, we look at the arbitrage opportunities in binary options trading.

What is Arbitrage?

Suppose a stock is listed on the New York Stock Exchange (NYSE) and the Nasdaq. A trader observes that the stock price on the NYSE is $10.10 and that on the Nasdaq, it is $10.20—an occurrence very unlikely to happen since the advent of electronic trading. The trader buys 10,000 of the lower-priced shares (on the NYSE) for $101,000 and simultaneously sells the same quantity of 10,000 higher-priced shares for $102,000. They pocket the difference (102,000-101,000 = $1000) as profit (assuming no brokerage commissions). Effectively, arbitrage is risk-free profit. At the end of the two transactions (if executed successfully), the trader doesn't hold the stock and its risks and has made a profit.

Options Arbitrage

Options trading involves high price variations, which offer good arbitrage opportunities. While stocks may need two different markets (exchanges) for arbitrage, option combinations allow arbitrage prospects on the same exchange. For example, combining a long put and a long futures position creates a synthetic call, which can be arbitraged against a real call option on the same exchange. Effectively, assets with similar payoffs are arbitraged against each other.

In addition, other variations in arbitrage exist. A long position in a stock can be arbitraged against a short position in stock futures. Arbitrage opportunities can also be explored between correlated commodities and currencies. We provide examples below.

Binary Options

While plain vanilla call-and-put options offer a linear payoff, binary options are a particular category of options that provide “all-or-nothing” or “fixed-price” payoffs.

Here is a graphical representation of the difference in payoffs between the two:

The linear (and varying) payoff from plain vanilla options allows for combinations of different options, futures, and stock positions to be arbitraged against each other (and a trader can benefit from the price differentials). The fixed payoff of binary options limits the combination possibilities.

The critical idea of arbitrage is simultaneously trading assets of a similar profile (synthetic or real) to profit from the price difference. A significant challenge with binary options is that hardly any assets have a similar payoff profile. Trying combinations involving different assets to replicate the binary option payoff is cumbersome. It consists of taking multiple positions, which can make it difficult to execute trades in a timely manner and will incur high brokerage commissions.  

Arbitrage Opportunities in Binary Options Trading

Given the above constraints, arbitrage opportunities in binary options trading are limited. Finding similar assets to arbitrage against simultaneously is difficult. The main ways to make money from this strategy are from timing differences and focusing on correlated assets.

Time-Based Arbitrage

Markets for stocks, indexes, futures, options, or commodities have different (and limited) trading hours. If good or bad news comes out when the market is closed, the price will stay the same until the market reopens, while the price in the binary options market, which is always open, will fluctuate in value depending on the news.

Let's look at an example. A news item that affects the FTSE 100 stock index emerges when the London Stock Exchange (LSE) closes. The FTSE 100 closed at 7000, and the last price for the binary option "FTSE > 7100" was $30. As a result of the developing news, the FTSE is expected to rise once the market opens (say five hours from now), and the binary option value will start to rise (and fluctuate) from $30 to $50, $60, $70, and so on.

Since the exact FTSE 100 value when it opens for trading is uncertain, binary option prices fluctuate. Experienced traders can bet on FTSE binary options for time-based arbitrage during this time.  Once the market opens, the actual change in the FTSE 100's value and FTSE futures prices will be visible. That will lead to FTSE 100 binary options prices moving toward accurately reflecting FTSE 100 values. By then, experienced traders could have spotted overbought and oversold conditions in the binary options market and have made profits (perhaps a few times).

Correlated Assets

Other binary option arbitrage opportunities come from correlated assets, such as the impact of commodity price changes that lead to currency price changes. Usually, gold and oil are inversely correlated with the U.S. dollar (i.e., if gold or oil prices rise, the USD currency weakens and vice versa). Experienced traders can look for arbitrage prospects in forex binary options when this happens.

For example, a trader observes that gold prices are rising. They can short sell the U.S. dollar by selling the USD/JPY pair or by buying the EUR/USD pair. Similarly, an increase in oil prices can lead to an expected increase in the price of EUR/USD. A binary options trader can take appropriate positions to benefit from these changes in asset prices. Arbitrage in other binary options, such as "nonfarm payroll binary options," is difficult because these underlying assets are not correlated to anything. One can still try time-based arbitrage, but this would be based solely on speculation (e.g., taking a position as the expiry approaches and attempting to benefit from volatility).   

Binary Options: Better for Arbitrage?

High volatility is a friend of arbitrageurs. Binary options offer “all-or-nothing” or “fixed price” profit ($100) and loss ($0). Like plain vanilla options, there is no variability (or linearity) in returns and risks.

Buying a binary option at $40 will result in a $60 profit (final payoff – buy price = $100 - $40 = $60) or a $40 loss. Any impact from news, earnings, and other market developments will lead the price to fluctuate (from $40 to $50, $80, $10, $15, and so on).  Arbitrageurs usually don’t wait for binary options to expire. They book the partial profits or cut their losses before. Since binary options have fixed price flat payoffs, any change in the underlying value can significantly impact returns. For example, suppose the FTSE 100 closed at 7000, and the binary option FTSE>7100 was trading at $30. Then positive news about the FTSE 100 came out, pushing it up to 7095 and leading it to hover around that level in a 10-point range (7095-7105). The binary option price will show huge variations, as just a one-point difference in the FTSE 100 can make or break the win-loss payout for a trader. If the FTSE 100 ends at 7099, the buyer loses the premium they paid ($30). If the FTSE 100 ends at 7100, they receive a profit of ($100-$30 = $70).

This -$30 to +$70 is a considerable variation based on a one-point limit of the underlying asset (7099 to 7100), which leads to very high volatility for binary option values. This creates huge price swings for active binary options traders to capitalize upon.

Advantages and Disadvantages of Arbitrage with Binary Options

Binary options arbitrage trading can be lucrative but isn’t for everyone.

Advantages include the ability to make lots of money in a short period. These trades don’t tend to be open for long, and the returns can be much higher than what your average stock or bond offers. Losses are capped, too. The most you can lose is the price of the contract.

But there are some downsides. Opportunities aren’t always easy to come across. When they do arrive, you need to move very fast. In addition, brokerage fees can eat into profits.

The Bottom Line

Standard arbitrage (simultaneous buying and selling of similar security across two markets) may not be available to binary options traders because of a lack of similar assets trading across markets. Arbitrage opportunities in binary options are to be picked from those available during off-market hours in associated markets or correlated assets. The unique “all-or-nothing” payoffs of binary options allow for time-based arbitrage opportunities. High variations enable a high profit potential but also bring in the potential for losses. Because of its high-risk, high-return nature, binary options trading is advisable for experienced traders only.