Yes, markets are often mispriced. But how do you know before hand which side to take to make money consistantly?
just keep telling yourself over and over again.. Market forces cause market prices , not models.. models only map the territory.. There is just a generally larger demand for otm put options as a result of most investors being long and purchasing puts for insurance..
Nothing is absolutely overpriced or underpriced in options, it is only relatively over or underpriced to where it has been priced before (as someone pointed out above). To further correct this statement for trading purposes, YOU have to decide whether it is relatively under or over priced based on your OWN forecast/prediction. If an option was overpriced then everyone would sell it and it would come down to "normal" pricing. Since this is not the case, the under or over pricing using IV is only a relative indexing that goes out the window when all of our individual perceptions come into the picture. OTM puts on SPX are under or over priced not based on IV alone. Overpriced to you selling the credit spreads but fine with me hedging a portfolio or taking a bullish position on the index. So bottom line, the answer to each question about over or under pricing.... it depends.
some people talk about under pricing calls during a bull market.. sure that is the case.. but that is relative to delta.. and not considerate of volatility ... It's path dependent.. a market can go up 200 points over a week or end up unch and have the same realized volatility as volatility is derived from the log of returns.. So sure if implieds are high you buy some calls and the underlying takes off in only one direction the options can seem underpriced.. But from the respect of implieds verse realized it might not have been...
If you compare the behavior of the market on those days, then it's obvious why option prices went up; that would be evidence that there was no under or overprice in either case. The only way to determine the effectiveness of the market at determining the true expectational value of options is to back-test the results of buying/selling them systematically over an extended time period. That options become more or less expensive is simply not evidence of over/under pricing.
Right today's underpriced vols are tomorrow's over priced.. And vice versa....a guy sells a call and Delta hedges... He breaks even and or makes a small gamma scalp... So he sees his pnl and thinks.. that option was over priced... Meanwhile the buyer of the call watches the underlying drift up an up and into profit... So theoretically both the seller of the call and the buyer can make money... The money comes from a different player in the market... That is the guy who shorted the stock to the call seller
The way I look at it is that the market priced a 20-point move for the week, and it ended up being 26 points.
I can understand that: you were willing to sell sell something underpriced because your belief in market direction overrode that consideration. Still... I was hoping you had an answer for my question: I have a question: is is better to buy underpriced otm calls or sell overpriced otm puts? On the one hand, I expect that the effect of put-call parity causes the put option chain to be more overpriced so that the otm puts are more overpriced than the otm calls are underpriced; but on the other hand, I would have to buy even further otm and more overpriced puts to offset the risk of selling otm puts, which cuts into the edge and also brings the added disadvantage decreased liquidity and other transaction costs. With otm calls, they may not be as mispriced, but there are none of those other disadvantages and costs. Also: while the otm calls will have infrequent wins, the losses will be relatively small; while the otm put spreads will have a high win rate, but the large losses can create a money management difficulty and sleepless nights.