Authors:
Dmytro Matsypura
and
Vadim G. Timkovsky
Affiliation:
The University of Sydney Business School, Australia
Keyword(s):
Arbitrage, Box, Hedging, High-frequency, Leg, Margin, Offset, Option, Portfolio, Risk, Spread, Trading.
Related
Ontology
Subjects/Areas/Topics:
Applications
;
Artificial Intelligence
;
Knowledge Discovery and Information Retrieval
;
Knowledge-Based Systems
;
Mathematical Modeling
;
Methodologies and Technologies
;
Operational Research
;
Optimization
;
Optimization in Finance
;
Risk Management
;
Software Engineering
;
Software Project Management
;
Symbolic Systems
Abstract:
Having been constructed as trading strategies, option spreads are also used in margin calculations for offsetting positions in options. All option spreads that appear in trading and margining practice have two, three or four legs. It is well-known that the option spreads with three and four legs are combinations of two option spreads with two legs, and that hedging mechanisms of these combinations consolidate hedging mechanisms of their components. Although more complex combinations with similar properties can be traced in regulatory literature of 2003, they have not yet been studied and used. In this paper we develop a theory for the construction of multi-leg option spreads as combinations of well-known option spreads with two, three and four legs. We show how multi-leg option spreads with extreme properties can maximize arbitrage opportunities in trading options and substantially reduce margin requirements for option portfolios.