In general, arbitrage in trading means simultaneous buying and selling of a security in different market to capitalise on the price difference and earn a risk-free return. This can be applied in options and strike arbitrage is one such strategy.

Strike arbitrage can be executed with two options (i.e., simultaneously buying and selling two strikes) of the same underlying with same maturity but with different strike prices.

To understand this let us consider call options (CE) of a security, say stock A, trading at ₹100. The price of all call options with strike above ₹100 will ideally be lower than ₹100-strike call option (₹100-CE) i.e., higher the strike, lower the option price. For example, assuming that the strike interval is ₹10 and suppose ₹110-CE is trading at ₹50, the price of, say ₹120-CE, can be lower, may be ₹40. But this may not always hold true because of the supply and demand of options of each strike price.

For instance, when ₹120-CE is trading at ₹40, the ₹130-CE might trade at ₹45. There is a strike arbitrage opportunity here. One can buy ₹120-CE and short ₹130-CE and earn a risk-free profit irrespective of underlying’s price on expiry (excluding charges).

Suppose price of stock A is ₹105 on expiry, both ₹120- and ₹130-CE will become worthless, effectively earning a profit of ₹5.

But if it closes at say ₹150 on expiry, price of ₹120-CE and ₹130-CE will be ₹30 and ₹20, respectively. Here net loss in ₹120-CE is ₹10 (₹40-₹30) whereas net profit in ₹130-CE is ₹25 (₹45-₹20). In this case, the overall net risk-free profit will be ₹15.

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