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

Exercise arbitrage can be executed with two options (i.e. the simultaneous buying and selling of two exercises) of the same underlying with the same expiry date but with different exercise prices.

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

For example, when the 120-CE is trading at ₹ 40, the 130-CE can trade at ₹ 45. There is a strike arbitration opportunity here. One can buy ₹ 120-CE and sell 130-CE and make a risk-free profit regardless of the price of the underlying at expiration (excluding fees).

Suppose the price of A share is 105 on expiration, the 120 and 130-CE will become worthless, effectively making a profit of 5.

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

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