An Interesting Opportunity – Pt. II
To continue the discussion from last time, remember that ^SFE^ has about 35 million shares outstanding, while at the same time it owns about 35 million shares of ^ICGE^. So the SFE share price should be equal to the ICGE share price plus something, and it should under no circumstances be less than the ICGE share price. But in fact at one point ICGE sold for as much as 27 points more than SFE.
Let’s suppose that you observe this 27 point anomaly in the marketplace. There are various ways to exploit it using options. If you buy SFE (underpriced relative to ICGE) and short ICGE (overpriced relative to SFE), you have a position whose expected profit is at least 27 points, but it has unlimited exposure, since there is no limit to how far the market may misprice these two relative to one another. To protect your SFE long position, you could purchase an atm SFE put; and to protect your ICGE short position, you could purchase an atm ICGE call.
This produces the position (+1 SFE, +1 SFE put, -1 ICGE, +1 ICGE call). (Note: In the shorthand I use, a “+1” for a stock represents long one round lot and for an option represents one option, which is an option on a round lot.) How much do you expect to profit from this position?
The expected profit from the (+1 SFE, -1 ICGE) part of this position is at least 27 points, and the cost of your insurance is the total of the two options you purchase. It is conceivable that both the put and the call will expire worthless, so to be totally safe you would want to be certain that the cost of the SFE put and the ICGE call together does not exceed 27. But you might want to go further.
Note that Black Scholes does not say anything about this situation. The Black Scholes model, and others like it, tells you the value of an option relative to the underlying (stock, in this case). But here we want to know how overpriced one stock (ICGE), is relative to another stock, SFE; and more, we would like to know how large an edge exists in the position (+1 SFE put, +1 ICGE call). In other words, what is the expected profit of this position?
Black Scholes and standard models offer little help in such situations. In the next commentary I will show you some primitive tools for exploring them.