Dynamic Arbitrage, Part I
How do you take advantage of an underpriced option? Suppose stock A is selling for $50 a share and has a call option with strike price 50, expiration 30 days away, value $5 and ask price $2. At a purchase price of $2, this call is underpriced, and perhaps appeared in one of the underpriced lists on the site. How can you exploit this situation?
The usual way to exploit underpricing is to purchase the item. If you see a 3 bedroom 2 bath house available for $120,000 in a neighborhood where this sort of house typically sells for $180,000, your best strategy is to purchase it, dress it up if necessary, and sell it. The spread between your purchase price and the sales price is quite large and presumably will more than cover your transaction costs, your carrying costs, and the cost of upgrade.
When you see the house is underpriced, what you actually see is that the house is underpriced relative to the market in neighboring houses of the same type. And the real estate market is not very volatile compared to the stock market, so it is unlikely that the market will change so much during your short ownership that you will suffer a loss.
An underpriced option is similar, except that the stock market is more volatile than the real estate market, and you may find that the movement of the stock has taken the stock far from $50 a share at expiration of your option, to your possible disadvantage.
Nonetheless, you can merely purchase the call option and you will be making a “super-fair” bet, one which has positive expectation and which in the long run will earn money. But your profits will come in a series of losses (when the stock closes below 52 at expiration) and large gains (when the stock closes far above 52 at expiration). You might want to make your profit stream more stable.
To say that the call is underpriced is to say that it is underpriced relative to the market in the stock. For a given expiration time, the “value” of the call option, $5, is computed by looking at the characteristics of the stock, mainly its price and its volatility.
You can seek to protect your position from adverse movement of the stock by considering an arbitrage strategy, often used in such situations If the call is priced too low relative to the stock, you could just as easily consider the stock is priced too high relative to the call, and you might consider buying the call and selling the stock. This would be a simple spread and requires a bit of discussion, which we will continue in the next commentary.