Stock<>Index Option Arbitrage?

Discussion in 'Options' started by sondermark, Oct 28, 2011.

  1. Hi,

    I have been thinking about some options strategies lately.
    When looking at stock options they seem to generally have more premium/volatility priced in compared to stock indexes. Is this a correct assumption?

    If the above is correct it should be possible to “arbitrage” a profit by: selling e.g. put options on all 30 dow stocks and while simultaneously buying an index option.

    I guess I am overlooking something, anyone care to comment?

    Thank you in advance.

    Kind regards,
  2. Dispersion

    You're best to tinker with OTM calls rather than eat the index skew on short dispersion (in puts).
  3. ASE1245


    Dispersion theory typically looks for an opportunity to buy the parts and sell the whole. It's possible for the other side to line up, but more risk. The parts often have bigger moves while the index can stand still if some stocks in the index go up and other go down. Look at the day Apple came out with earnnings. The stock was down over 5% on the open,yet the Nasdaq was flat to up.
  4. Thank you for the answers so far I need to read up dispersion theory it seems.

    At expiration date the index will be the value of its components and therefore it seems that the put option I bought should offset the total risk of the options sold (on each index component). Why is this not the case?

    P.S. I promise to read up on dispersion ;)

  5. Read FDAX's paper and you'll understand...
  6. After reading up on the subject I am still convinced that it should work in theory. It seems to be similar to index arbitrage where one sells the index components and buys index futures if they get out of line.

    At expiration date we know that the index will be the value of its components. So if one can withstand the heat from initiation until expiration the profit should be:

    P = (Sum of premium collected on the stock options sold) – (Premium paid for index Option)

    This obviously only work if the combined premium on the stock options in the index is larger than the premium on the index options. Since this is known in advance one will only do profitable setups.

    Am I overlooking something?

  7. I have just calculated the implied volatility on all components of the DJIA and the index itself. According to my calculations the implied volatility of the components was on (weighted) average 17.55% higher than the index.

    To me it seems like an arbitrage opportunity if one can withstand the heat until expiration date.


  8. Post your exact trade, then we can crunch the numbers. The results will show your idea sucks.
  9. sle


    Really? Are you going to "crunch the numbers"?
    My impression was that you specialize in picking bottoms...
    #10     Oct 29, 2011