A couple of rookie questions here: I am assuming your example for USO is regarding call options, therefore the 86's would be more OTM than the 85's. I get it you are talking about the skew that can be seen for options with less moneyness? But by that rule of thumb then, most OTM options will be overpriced relative to nearer to the money strikes (due to this skew). Is this what you are saying? Also, what if you could sell the 86's for 42% IV but not be able to buy the 85's at 40% IV - is there no other means to determine whether the 86's you just sold were overpriced?
Could be calls or puts. Doesn't matter. The point is to think of it as buying or selling gammas @ IV. As an example, instead of thinking of it as buying 85 calls at 1.45, think of it as buying 85-strike gammas at 40% IV. If you can sell 86-strike gammas at 42% IV, then you have bought something at one price and sold something which is ALMOST the same thing at a higher price. Look at it this way. Gammas at the 85 strike are gammas at the 85 strike, whether in the form of puts or calls. If you can buy 85-strike gammas at 40% (in the form of calls) and sell 85-strike gammas at 41% (in the form of puts), that is an arbitrage. It's called a reversal. Is there another way to determine overpriced or underpriced? Nothing certain, but there are some guides such as historic range. Since the VIX was created in 1990 it has never been over 50% so if you ever see it approach that level, it's probably overpriced. Then again, during the '87 crash it would have been about 150%. Ya pays yer money and takes yer chances.
I see. What you have just described I have always thought of as a synthetic underlying position (either long in the case of long calls and short puts; or short in the case of short calls and long puts). With all the automated trading nowdays, it seems like this kind of free lunch would be *nearly* impossible to find.
You can see a reversal as buying the synthetic future at one price and selling the actual future at a higher price. Or buying the synthetic put at one price and selling the natural put at a higher price. Or buying the natural call at one price and selling the synthetic call at a higher price. Or buying same-strike gamma at one IV and selling it at a higher IV. All are valid ways of looking at it.
yes there are indicators, but there is also pattern recognition (PR) and applying that to determine if, in fact, that option is overvalued. this technique can have a greater than 99% success rate. i'll explain: for instance, anyone with even minimal PR skills can spot an increasenow thread instantly. recognizing this pattern and having read a few of these threads, the PR pro can see a young and clueless wannabe trader who feels that he is 'smartly' mining the collective knowledge (cough cough) of ET as a shortcut to figuring out what to trade, how to trade it, when to buy, when to sell, what indicators to use and, after a few hundred of these stupid threads... voila... he will have data mined/stolen the 'secret' and will be a successful trader purely based upon his 'clever' polling of ET. with a little age and experience in having run across people with increasenow's patterns, those with these PR skills can instantly ascertain that NO PUT shorting the trading career of increasenow is too expensive and he will buy it aggressively. as you can see, no indicators were used, the win % is greater than 99% and, to the skilled user of PR, the entire process is done in his head in less than a second. oh, and btw, studying and taking the right response to this post will help you more than any of the responses to your countless threads...
Dmo... as usual with your posts IMHO thatâs an excellent post on just about the only reasonable definition on how a strike may be over priced. As has been mentioned, calls and puts of the same strike are exactly the same option other then delta. c.chugani... long a call or long a put is not the synthetic equivalent of long or short the underlying by any means. Maxx ... using the B/S model on a particular option will not tell you if its over priced. All it will do is give you one somewhat accurate theoretical value based on the variables you used. Steveg... I agree whole heartedly that âToo highâ and âToo lowâ are simply subjective phrases and have no true answer.
It depends on what underlying I'm looking at, my position and what I need for the situation. I mean, there is just no pat answer here.