Regardless of the exact theoretical value, there ought to be a uniform progression of both individual option prices and spread prices in the market place. If this uniform progression is violated, a trader can take advantage of the situation by purchasing the option or spread which is relatively cheap and selling the option or spread which is relatively expensive.
Synthetic relationships can often enable a trader a make logical trading decisions without the aid of values generated by a theoretical pricing model. Let us examine the following example. The spot price of stock ‘X’ is trading at Rs. 101.50 and its call options are trading as follows;
Synthetic relationships can often enable a trader a make logical trading decisions without the aid of values generated by a theoretical pricing model. Let us examine the following example. The spot price of stock ‘X’ is trading at Rs. 101.50 and its call options are trading as follows;
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Is there anything wrong with these prices?If the trader creates a Butterfly Strategy by purchases 95 call for Rs.8, sell 2 calls of 100 for Rs. 4.80 and buy 105 call for 1.60 and the net call flows remains zero.
Now let us look the payoff diagram. If the stock ‘X’ remains 100 on expiry the trader can make a risk less profit of Rs. 5.00.
Consider a different type of relationship;
Underlying price Rs. 99.75 Interest rate =0
Let us create a Long Straddle with the following calls and puts prices;
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The Long Straddle is more valuable as the underlying price moves away from the spot prices. With the underlying price of Rs. 99.75, the 95 straddle is more valuable than 100 straddle, and this is reflected by the price of 8.95 and 7.65. The 105 straddle, being further away from 99.75, should also be more valuable than the 100 straddle. But the prices do not reflect the additional value. The 105 straddle is .20 cheaper than 100 straddle. Even though we do not know the theoretical price of 100 and 105, we know that 105 straddle is cheaper than 100 straddle. Here the option trader has to take long straddle position at 105 straddle and should sell 100 straddle which is expensive. There is no guarantee that this strategy will be profitable, but if we assume that movement is random, and then the sale of the 100 straddle and the purchase of the 105 straddle put the laws of probability heavily on the trader’s side.
