An equity trader wants to understand if option traders identify mispriced strikes just as analysts and portfolio managers identify mispriced stocks in the spot market. Accordingly, this week, we discuss why traders in the options market look for relative mispricing, not for absolute mispricing.
Relative mispricing
The next-week 17900 Nifty call last traded for 139 points, whereas 18000 call traded for 95 points. How do you conclude which is mispriced? Identifying mispricing is important because options are wasting asset. That is, options lose value with each passing day. At expiry, at-the-money (ATM) and out-of-the-money (OTM) options have no value, whereas in-the-money (ITM) options have only intrinsic value. Options traders are, therefore, mindful of paying too much for an option. But how should you decide whether the price for a strike is reasonable?
Analysts have stock valuation models such as free cashflow models and relative valuation models. There is the Black Scholes Merton (BSM) model for options. But the model makes assumptions that do not hold in the real-world markets. So, comparing the model’s value with the actual traded price of a strike is not meaningful. It is, however, useful to apply the BSM model for identifying relative mispricing. Why?
The time value of an option has two components — time to expiry and implied volatility. Breaking this down further, the time to expiry must be the same for all strikes with the same expiry. We know that traders want to pay as little as possible for time value. So, volatility becomes the primary factor to apply for identifying mispriced options. You need a model to find out volatility priced into an option. Hence, the BSM model.
Using the model, you can determine implied volatility for a strike — the volatility that is implied by the option price. Note that each strike will have a different implied volatility; as implied volatility is a function of an option price — greater the demand for an option, higher the price and higher the implied volatility. A trader’s objective would be to pay the lowest implied volatility for an option to lower the loss because of time decay. Therefore, using the BSM model, a trader can choose the strike with the lowest implied volatility. Stated another way, traders use implied volatility to determine a strike that is mispriced relative to other strikes on the same underlying for a given expiry.
Optional reading
The rule on implied volatility cannot be applied in isolation. You must consider the liquidity of an option, especially if the options are European-style settlement; for, taking profits requires selling a long option position. Liquidity is centred around the ATM and immediate OTM strikes. It is, therefore, optimal to apply the implied volatility rule only on these strikes. Note that for short option positions, traders must choose a strike with the highest implied volatility. This is because mispricing for long position means a relatively underpriced strike and for short, a relatively overpriced strike.
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