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DITM SPX calls trading less than intrinsic

Discussion in 'General Discussion' started by DavidF, Jan 25, 2016.

  1. DavidF

    DavidF Well-Known Member

    As part of an SPX M3 iron butterfly I´ve been rolling down calls with spikes in VIX. With recent volatility I haven´t been as DITM as I am now (March 1500s) and the market price is now about $400-500 less than intrinsic ($3750 with SPX at 1992).

    I´d assumed this wouldn´t happen as it would open up arbitrage opportunities. And as a hedge opportunity would be more economical than buying a teeny since the corresponding put costs about $400.

    I´ve attached a graph of buying a March 1500 call and shorting 2 x March /ES futures. If you held to expiration you´d have a free hedge that you´re guaranteed a $400-500 profit on (i.e., the loss on right of graph isn´t accurate) So what´s the catch?

    Screen Shot 2016-01-25 at 17.02.55.png
     
    Last edited: Jan 25, 2016
  2. AKJ

    AKJ Well-Known Member

    I'm not seeing that, though I may be misunderstanding..........

    As of this moment, I'm seeing the Mar ES future at 1888 and the Mar SPX 1500 Call trading 390.1 x 393.5. Intrinsic value on these Calls are 388, so there still remains a small amount of extrinsic value in these calls. Assuming you could get executed at Mid on the calls (which is unlikely given how DITM they are) you'd be paying 391.8, or 3.80 in extrinsic value. You would be all but guaranteed to realize this loss; the only scenario where you would win is if the SPX settles below 1500.
     
  3. DavidF

    DavidF Well-Known Member

    Thanks for input Andrew, but my understanding is that the SPX option prices are based on the SPX price, not the ES futures price, is that not your understanding? Otherwise the prices of /ES and SPX options at corresponding strikes would be the same. Following this I assume SPX option settlement values must also be based on SPX price, otherwise there would again be arbitrage opportunity.
     
  4. AKJ

    AKJ Well-Known Member

    SPX options should be priced based on the future expected price of SPX, not spot SPX.

    Interestingly, the sample trade you show, as constructed, used ES futures to offset the DITM call. If there truly is a mispricing, it would be possible to show the arbitrage.

    Regarding your point on ES v. SPX options, there are specification differences that lead to variations in pricing, though I would expect to be extremely small under most conditions. ES options are American style and result in delivery of the futures contract at expiration. SPX options are European style and cash settled. Both settle on SOQ on the third Friday of the month.
     
  5. DavidF

    DavidF Well-Known Member

    Ok thanks for clarification Andrew, I´m still confused but will read up on it. A question for you, if you look at the T Prem (time premium) on my OV martrx it has minus $4.6 for my March 1500 call. I´d always assumed a negative value meant there was no extrinsic and that I´d be paying less than intrinsic for the option. That´s not correct from your understanding?

    Screen Shot 2016-01-25 at 19.26.48.png
     
  6. Capt Hobbes

    Capt Hobbes Well-Known Member

    Factor in SPX dividend yield over that period (according to http://www.multpl.com/s-p-500-dividend-yield/ 2.28% annualized, so let's call it 0.38%) and see how the pricing looks if you discount SPX by that amount. Some 5 years ago when I was starting with options, I bought a DITM LEAP on Dell paying just the extrinsic value, and thought I scored a deal. Then I remembered the dividends, and they amounted exactly to the "missing" premium.
     
  7. AKJ

    AKJ Well-Known Member

    What Capt Hobbes said....

    RE OptionVue, I'm not an expert, but it may be possible to change your settings to tie your SPX options to the appropriate ES futures contract. I think there is a thread in the OptionVue forum discussing how to do this for VIX futures. Same concept would apply here for SPX options/futures.

    In practice, I would imagine that it is an increasingly rare occurrence for a retail investor to be able to buy an option that is trading below its Intrinsic Value (the Actual intrinsic value, not what our trading platforms report to us as Intrinsic value). Computers are much faster at picking up on these things than humans, and any temporary mispricing that may result from large capital flows into a particular option would most likely be picked off by computers in a fraction of a second.
     
  8. DavidF

    DavidF Well-Known Member

  9. AKJ

    AKJ Well-Known Member

    David, we're starting to get into the gritty details of option pricing theory, but I would comment that the article you have linked covers a similar, but still different issue from the situation you've raised with DITM SPX option pricing.

    A better corollary, for which you can find countless articles online, is the "apparent" violation of Put-Call Parity in VIX Options. A little research here may help clear up why Index Options price off of the closest expiry future, and not the spot.
     
  10. DavidF

    DavidF Well-Known Member

    Ok thanks a lot Andrew, going to do some more reading and brush up on this, thought I understood this but obviously don´t. I trade /CL futures and their options and previously traded volatility so am familiar with the term structure etc. What I don´t get is your comment that SPX options aren´t based on spot SPX (my assumption). IMO if they were based on the futures term structure, then they´d be priced the same as the corresponding /ES options. That´s how I understood it. Will read up!
     
    Last edited: Jan 25, 2016
  11. AKJ

    AKJ Well-Known Member

    I don't know ES options, but I would bet they trade at effectively the same price as SPX options. Any differences I would attribute to (1) bid/ask spreads and (2) preference to hold cash settled v. physically settled options. If the spread widened out, there's close to a pure arb between the two.
     
  12. DavidF

    DavidF Well-Known Member

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