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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)?

Thanks!

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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.) – Rick Goldstein Apr 1 '15 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 '15 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. – Rick Goldstein Apr 2 '15 at 4:26

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