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Forward and futures contracts Video transcript The word arbitrage sounds very fancy, but it's actually a very simple idea. It's really just taking advantage of differences in price on essentially the same thing to make risk-free profit.
So let's just think about a little bit. Let's say in one part of town there's some type of a market.
Let's say it's a market for apples. And let's say in that market, apples sell for-- just make up some price. And let's say in another part of town, you have another market.
December 18th, just might be an exception. Traders and investors could use a futures contract to speculate on or hedge against movements in the broad basket of large-cap stocks with a single trade. The mechanics of those products meant that for eight months of the year, those contracts settled at different time and on different days. June, September and December however, stock futures, options and options on individual stocks all expired within a few minutes of each other.
Another market's literally a fruit market. And we're going to assume that these apples are completely identical apples.
How could you take advantage in this price difference on these identical things to make a risk-free profit? And that's exactly what you would do.
You would go do this market over here, you would buy apples. And then you would go maybe ride your bicycle a couple of blocks to that other market over there.
At the time, I was Vice President of Leasing for a private investment company, and it was truly an unfortunate situation. The existing lease had pre-negotiated rent that was below market rent. All Joe had to do was provide written notice within the specified window of time, and the Landlord would be obligated to accept the below market rent.
And you would sell your 10 apples. You're buying for 10, selling at 5. And you could just keep doing that over and over again.
The Bottom Line An important principle in options pricing is called put-call parity. This parity states that the value of a call optionat a specified strike priceimplies a particular fair value for the corresponding put optionand vice versa.
And on every trip as many apples as your bicycle could carry you'll just continue to make money. And so this is what arbitrage is. And just imagine a side effect.
If someone did this enough, then what would do is it would increase the supply of apples here. So supply would increase in this market.
And on this market, the demand would increase because there's someone who just keeps buying from option opportunity market and selling into that market. So what's eventually going to happen when demand increases, option opportunity price will go up in this market. And when the supply increases in this market, the price will go down. So in theory, the more you do this, the more that you're going to make these prices come closer to each other.
Options Arbitrage Strategy - Put-call Parity - Python Trading
And eventually, you won't be able to make any profit at all. But while there's this discrepancy, you have an opportunity for arbitrage.
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