Option Conversions
As a group, options are currently approximately fairly priced. The average Ratio among the Pisani 250 is .99, which means the implied volatility on average equals 99% of the historical volatility. In this environment you would not expect to find many underpriced or overpriced opportunities, and the tables bear this out.
You might imagine that in a bullish environment call premiums would be inflated and put premiums deflated, and that in a bearish environment call premiums would be deflated and put premiums inflated. But this is not the case. Call and put premiums with the same strike and expiration on the same underlying are always about equally inflated or deflated.
Notice the implied volatilities of the calls and the puts in the tables are always about the same. If these two volatilities differ significantly for a call-put pair (with the same strike price and expiration), a simple arbitrage called a “conversion” can be performed which will earn a riskless profit.
A conversion involves buying the call and selling the put if the put premium is too high relative to the call’s, and at the same time selling the underlying short to form a hedge, or selling the call and buying the put if the call premium is too high relative to the put’s, and at the same time taking a long position in the underlying. In either case, the three legs then form a perfect hedge.
There are “converters” in the market who look for such opportunities, and so the call and put implied volatilities never become much different. Suppose however you have bullish information. Should you purchase a call or sell a put? Looking only at the implied volatilities will not help with this decision, as they will be about the same.
Certainly if the options are underpriced, you will gain an additional edge on the upside and additional protection on the downside by buying the call. And selling a put naked is risky, whether underpriced or overpriced. So the straightforward strategy is to look for an underpriced call to exploit a bullish bias and an underpriced put to exploit a bearish bias.
For those of you who use insider selling and buying as background for your trades, note that insider selling has been high for some time in some of the underpriced options (see, for example, GPS or CIEN) on our list. To exploit a downside move in one of these underlyings, you would want to purchase puts on it, as these puts are priced below their fair value.