If an option is trading for less than parity, is it always a mispricing, waiting to be arbitraged, or are there other factors that can lead to this?
asked Oct 21, 2014 at 16:33
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3 Answers
Probably but not necessarily.
Your question could also be posed regarding cash & carry for commodities in contango: If I can take delivery on the gold now, short the gold next year and make delivery then, paying the storage fees, is this an arbitrage opportunity?
It is in the sense that you know your delivery and the money you will make, but it's not in the sense that until delivery (or execution in the options case) you are still on the hook for the margins due from price fluctuations. Additionally you need to consider what ROI you will make from the trade. Even though it's "guaranteed" it may be less than what you can earn from other "zero risk" opportunities.
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A stock that has a large dividend that is pre-ex dividend could easily cause the options to trade below parity because of the value of dividend. EG, stock @ $60, dividend is $2, $65 calls need to reflect the near term $2 drop in stock price on ex-date. Front month calls should trade below parity.– ssaltmanCommented Oct 21, 2014 at 18:55
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An announced dividend should factor into the price of the option for what is considered "parity"– MatthewCommented Oct 21, 2014 at 19:15
Defining parity as "parity is the amount by which an option is in the money", I'd say there may be an arbitrage opportunity. If there's a $50 strike on a stock valued at $60 that I can buy for less than $10, there's an opportunity.
Keep in mind, options often show high spreads, my example above might show a bid/ask of $9.75/$10.25, in which case the last trade of $9.50 should be ignored in favor of the actual ask price you'd pay.
Mispricing can exist, but in this day and age, is far less likely.
answered Oct 21, 2014 at 17:09
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1Presuming you you mean "mispricing" as a difference between market price and parity then it happens all the time... There is no "law" which says they must be in sync. They are in sync because the entirety of the market sees and acts upon them. So they occur constantly, but the likelihood that you will be the fellow to capitalize on it is very low.– MatthewCommented Oct 21, 2014 at 17:28
In the equity world, if a stock trades at 110 and is going to pay a dividend of 10 in a few days, an option expiring after the ex date would take the dividend into account and would trade as if the stock were trading at 100. (Negative) interest rates may also lead to a similar effect.
In the commodity world the cost of carry needs to be taken into account.
