How To Capture Option Mispricing?

  • Market Overview

In today’s article we shall talk about the beauty of trading mispriced options. We shall also showcase a live example of the same. To begin with, let us understand the concept of options mispricing. In order to understand this, we shall take a close look into the Hedge Funds trading model. What they do is very interesting, they calculate the fair value of an option based on the contract they are trading and the estimated implied volatility. This is where things get interesting. Every time the price of the option rises above or falls below the fair value, they consider it mispriced. Most of these models consider 6 common factors that are responsible in the formation of an option price. For our convenience we shall consider just 5 and discount dividend over the life of the option.

Advantages Of Using Option Mispricing

There are strong advantages of calculating the empirical value of an option. Take for example, you are an option buyer, one of the primary threat you face is a gradual drop in volatility. Now imagine you can calculate the fair value of an option based on where volatility will stand, when the contract moves from T1 to Tn (T1 is the time of entry and Tn is the time when the underlying instrument achieves the target). The advantage is that, you will always have an advance data input of the option price ahead of time Tn. The beauty of such a model is, it will help you filter out un-necessary trades and automatically improve accuracy.

How To Simplify The Process

The most important part about hedge funds is that they consider volatility as a non-linear variable. Therefore they avoid the trap of historical figures. Rather, they work on plotting the covariance factors between the option theta and vega. This process is simple. Imagine you have an ice cube and you are observing how much time it takes for the ice to turn into water as the temperature shifts above or below the point of inception. Similarly, you capture the important data points of an option strike to capture the mispricing zones based on the covariance factors. Rest assured that even though you are not the market maker, you will have a formidable edge. If you are wondering why? It is because; institutions rarely sell undervalued option premiums or buy overvalued ones.

Execution Based On Mispricing

Take for example today; the 12000 weekly Put option was trading @55, which was way above its fair value around in the afternoon. In such circumstances, all you need to do is confidently sell the 12000 put and wait for the value to neutralize. So the Put was sold @ Rs.55. The Put climbed to Rs.63 max and started droping rapidly thereafter. It was later covered at 0.50 paise. The biggest advantage of trading options, based on valuation is that it incorporates news and events during live market hours as well.

ORIGINAL POST

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  • Samir Jha @Samir Jha
    Ridiculously shameless article just to get views...
    Like 0
  • aswini ku @aswini ku
    Only false claim with false image
    Like 0
  • Anand Bhide @Anand Bhide
    Your post does not talk about the fact that how did you arrive at Rs. 55 not being fair value for 12000 put at mid afternoon when spot nifty was hovering around 19990 levels. Fall of 45 points was well within reach.
    Like 1
  • DINESH GUPTA @DINESH GUPTA
    could not understand anything
    Like 2
  • Utsah Mehra @Utsah Mehra
    not at all clear
    Like 1
  • Deepak Kumar @Deepak Kumar
    could not understand
    Like 2
  • vinod nasery @vinod nasery
    hi , really didnt understand  purpose of  this article ?
    Like 1
    • rahul rawat @rahul rawat
      in the same situation I made a profit if 52000/-
      Like 1
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  • Dennis Felix @Dennis Felix
    I think you can only understand your post and no one else. kindly don't waste your time in posting which no one understand.
    Like 6
  • Rahul Chauhan @Rahul Chauhan
    i never see your posts making sense in terms of how anybody can be benefitted with what you talk about. selling an overpriced option and buying the undervalued... very simple to sound but it doesn't give you a direction or strategy to trade with. Plz try to be more specific and explanatory in ur posts. And trust me, never ever sell an option "confidently"
    Like 2
    • rahul rawat @rahul rawat
      in the same situation I made a profit if 52000/-
      Like 1
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  • Rahul Sahu @Rahul Sahu
    when 12000 put was at 55 then nifty spot is at around 11950 . so the intrinsic value of 12000 put was 50 and 5 rs for its premium which was tradind around 55.
    Like 3
  • dhruv singh @dhruv singh
    this all sounds hunky and dory...tel us the methodology rather than giving theory gyan..we need formulae rather tha. observations. it might be easy for you but for anybody who saw nifty at 12 in the afternoon would never have sold this option ..
    Like 3
  • Pranab Paul @Pranab Paul
    good article.
    Like 1

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