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 import 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 over -valued 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 went up to Rs.63 max and later was rendered worthless. It was covered at Rs.0.50
Nifty 12000 Put Option Trade Of Weekly Expiry