I have an investment account where I'm currently holding about $200K in SPY shares (S&P 500 index). I'm a bit worried that we are in a bubble, so I'm looking into strategies to hedge my downside. Before I change my strategy, I just want to make sure I really understand how things work.

So I'm looking at options on SPX, which follows the S&P 500 and is settled in cash. For a downside hedge, I know that I can buy a PUT and keep my long shares, or I could just sell my shares and invest in a deep in the money CALL option.

Currently SPX is at 2055.74 and I can buy a MAR16 1500 CALL for $554.80. My problem is that this seems too good to be true. Isn't the intrinsic value of that option $555.74? It seems that if I buy it and the market stays completely flat, I make $94 for free.

Compared to the long stock position, the CALL option will make the same profit, but it caps the downside losses at %27. Plus, I only need to spend $50k on the option, I can put my other $150k into a money market account.

So what is the downside of the CALL option strategy compared to being long in the stocks? And why would the option trade for less than intrinsic value? Am I missing something?

P.S. I know the bid ask spread is large ($4), but does that matter if I'm sure I'd hold the option to expiration (in a year)?


2 Answers 2


The answer provided by Victor123 is wrong. The reason here is dividends. In fact, the higher the risk free rate, the less likely this outcome will be.

There are 2 circumstances that can lead to the value of an european option being lower than intrinsic value (these are also the two situations in which early exercise of an American option may make sense).

  • deep ITM puts in presence of positive interest rates: r>0
  • deep ITM calls in presence of positive dividend yield: d>0

Below is a screenshot from Bloomberg which prices the option at the time of the question. enter image description here

You can see how the option values that include time value (before expiration) are below the intrinsic value (green hockey stick) for current spot. Another thing to note is that the forward is below current spot (because of the dividend yield). Since you forgo dividends when you hold an option as opposed to the underlying itself, you need to be compensated for this. For deep ITM calls, this can actually lead to negative time value as is the case here. If dividend yield would be 10%, the option would cost ~433. The "computed return" from the other answer would be very different from the risk free rate in this case. There is also nothing risk free in buying a call option.

A related question with interactive charts and associated Julia code to replicate can be found here.

  • It also happens that these options are not traded at all, and the quoted price is for the last trade happening a year ago.
    – gnasher729
    Feb 17, 2023 at 7:56
  • 1
    No, this is not the case here. I used the vol surface derived from all options and that value would be very close to what you would trade if you bought this option. Also, quotes for SPX are not that stale. It's a common situation for dividend paying stocks (indices) with (high) dividends.
    – AKdemy
    Feb 17, 2023 at 8:18

You made 94$ on an investment of 554.80 *100 = 55480$ for an approx holding period of 1 year. So the % return is ~0.16%, which is not much better than the short term us treasury rate. The current 1 year treasury rate is 0.27%: http://ycharts.com/indicators/1_year_treasury_rate

So yes, you have a risk free portfolio, so you make the risk free rate. Remember this is an European option, so you are stuck for 1 year. if you found the same mispricing in an American option, then you found an arbitrage.

  • This is a great answer, but I don't quite understand your last sentence. In what sense is this a "misplacing"? You just demonstrated that the price accounts for the time value of the money, so it seems like the pricing is correct--the difference between the strike price and the current price, discounted appropriately by interest rates (and don't forget commissions). I also wonder about the dividends one would expect from SPX--you don't get those with the option, do you? What am I missing? (N.B. I have never owned options, so I am coming from a place of some ignorance.) Apr 1, 2015 at 22:23
  • Thanks. If this was an American option ( SPY instead of SPX), then you could buy the option,exercise it, end up with long position in SPY and sell it immediately for a risk free profit,a.k.a arbitrage.
    – Victor123
    Apr 2, 2015 at 2:38
  • Ah. Didn't understand that options could be exercised any time before their date. My ignorance is just a little less. Thanks. Apr 2, 2015 at 4:26
  • It's not a risk free portfolio because he's selling his SPY shares and buying the deep ITM call which has unlimited upside potential. In terms of the SPY arbitrage, you'd short the shares before exercising the call in order to eliminate leg out risk. Last of all, you are correct, you don't get the dividends if you are long the call so the call's value will drop in response to each approaching ex-div date. Dec 10, 2019 at 20:02
  • @RickGoldstein Victor said "If this was an American option". American options can be exercised prior to expiry. European ones can't. Dec 28, 2023 at 20:56

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