As for your question, what you describe is actually more suitable to be considered speculation than arbitrage unless you have found an anomaly in the price and in that case good for you :)

As for doing the exact trade with option is a little bit tricky because options are subject to more variables that affect their price (time, interest rates, volatility and etc..)

I think there are options on bonds, so in theory, you could buy options on the stock index and sell bond options. The problem would still be margin requirements by selling the option so it would be back to square one sadly.

I have a question regarding how to handle a potential arbitrage position. Let’s say that I think that the S&P 500 (or some other index) will outperform long-term U.S. bonds over the next year (or longer).

To profit off an outperformance of the S&P 500 versus bonds, I could sell short an ETF (e.g., TLT) that tracks long-term bonds and establish a long position in an ETF that tracks the S&P 500 (e.g., SPY). However, my understanding is that the money one “receives” from a short position cannot be used to purchase another position. Accordingly, one would either have to already have sufficient additional money in a brokerage account to purchase the long position or would have to borrow on the margin.

I actually did what I just described in early 2006 and made some money. However, the margin fees basically destroyed most of the potential benefits of this long-short hedge.

Are you aware of a way I could capture a potential outperformance by using options instead of purchasing simultaneous long and short positions to establish a hedge?

Thanks.