Arb'ing an option chain against the underlying

D

d0rian

Just wondering whether the following arbitrage idea has a 'name' (as I'm clearly not the first one to have thought of something like it), and whether there's actually any merit to it. Yes, it requires a lot of capital to make work, but big banks clearly have the means.
  1. Build a position in, say, 500 deep ITM contracts with a delta of 1.
  2. I'm looking at the Level 2 quotes for a stock currently trading at $20.00. In the market depth window, I can see there are ~21,000 shares offered at different price points all the way up to $21.20 (with an avg price / share of $20.80)
  3. The 500 DITM option contracts I'm assuming have been bought for this example are currently trading at $5.00.
  4. Place a market order for all 21,000 shares currently offered, which would sweep the LAST price up to $21.20.
  5. With a delta of 1, the DITM option contracts should then trade for ~$6.00. Now, assuming you could find a buyer for all 500 contracts, dump them at this "artificially" inflated price, essentially having manufactured a $50,000 gain.
  6. Yes, you "overpaid" for the 21,000 shares of the underlying, but if your option position was big enough (in this case, 500 contracts representing 50,000 underlying), your gains seem like they'd easily offset the loss you'd take when you'd presumably sell those 21,000 shares back into the market. (Not to mention the fact that your big order will probably move a bunch of automated bids on the underlying upwards, further helping to offset the loss you'll take selling them back.)
Drawbacks I can see:
- Requires a lot of capital (but big institutions have the means, as noted)
- Would have to be executed very quickly (but in this day and age I can't imagine this couldn't be solved)
- Will you have a market for a 500-contract option sale before the underlying re-adjusts downward? (If the bid sizes are typically smaller -- like of the 20- or 50-contract variety, you may need to buy a bunch of different delta=1 contracts, with dif maturities)
- Requires a thin-to-moderately traded stock (so that a single buyer could move the underlying with one big order)

Am I missing anything? If this is all absurd, feel free to let me know that too.
 
Few if any DITM are 500 up. Just because you buy something up to a price doesn't mean you could sell it there. You would have ~70,000 shares and no buyers.
 
in theory working, in practice probably not. there's simply no volume out there, neither for stocks nor for options.

1. you will get a hard time acquiring 500 options
2. you won't be able to sell your stocks & your options at the inflated price.

in the end you'll end up with positions you can only liquidate for a loss, i think.
and for those stocks that have volume (SPY, QQQ) you don't have enough money to drive the prices.

but try it and tell us if it's working :)
 
There was a firm that used to do this all the time. But the microstructure was different then (when the qqqs traded 100k up 5 cents wide).

The ditm options are generally wide because the only people who trade them would be trying to play some non-volatility game (div arb, financing arb, your idea)
 
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