Carry has nothing to do with decay. ITM euro-ex puts can trade at a discount to intrinsic value, = carry. They can appear to maintain +theta or gaining IV as the time to expiration nears and the ITM euro-put converges to intrinsic value at expiration. The rate of convergence is = the carry on holding the long put strike. It may seem as though vols are increasing, but it's already trading at a discount. Vol-strips can decrease rapidly, but the convergence will still be evident. This isn't an issue with american-exercise. Same-strike calls and puts decay at the same rate, arb[model] dependent[independent].
Gnome -- think of carry as an implied forward in the underlying shares. It trades contango = the carry to expiration. XYZ at $100 would reflect $4.75 in carry for one year. For option pricing purposes, XYZ is priced at 104.75 at one year out.
OK, think I got it. BTW... you option guys *seriously* violate my most sacred trading principle... KISS
I hear you with regards to KISS, but many traders unfamiliar with options would be tempted to sell that otm call thinking it was grossly overvalued.
RiskArb, Your observation reminds me of those recommendations to open credit spreads instead of their debit synthetics, to get interest on their cash, ignoring that usually they'll get a lower interest rate on their cash than the one priced into the options.
Exactly, good point. The difference between the otm bull put credit spread and the itm bull call debit spread is the box. Option arbitrage is simply leveraged lending or borrowing. It's truly interest rate arbitrage.
Riskarb: Interesting questionas an aside to your discussion. Are there any circumstances where you could sell a BOX and the firm would allow you to withdraw the proceeds from your account (assuming you used European options) and repay the funds before expiration?
There is a haircut assigned to the position. Repayment would involve offset and there is rho-risk which involves variation-req on the haircut[mtm loss potential]. Obviously no assignment risk as you imply. Countrywide or Fannie aren't sending you a loan book[long box]. =)
Riskarb: I've heard the term contango for many years and never knew what it meant. Is the definition, "carry to expiration"?
Not really, was using it as an analogy. Contango typically refers to futures markets in which the back month futures trade > front month futures. It can reflect storage costs, carry finance, new vs. old crop, etc... Backwardation = fronts > backs. http://www.google.com/search?source...=GGIC,GGIC:2006-04,GGIC:en&q=define:+contango