From the December 2013 issue of Futures Magazine • Subscribe!

Opportunities in equity options

An option pricing model can be the first step in finding profitable equity options trading opportunities. Using pricing models effectively, we can uncover discrepancies that we may be able to exploit with speculative positions. Pricing models may be applied to call options, as shown in “Wells Fargo calls” (below), or to put options, which will be described later. 

On Aug. 9, 2013, Wells Fargo shares were priced at $43.23. For strike prices ranging from $50 to $43, market prices for calls extended from 0.250 to 2.240 with premiums from $25 to $224. The model shows call prices predicted by regression analysis based on the market prices for nine strike prices. 

Price variations between predicted and market values are small, with the largest difference at $3.51 at $135 market premium. The column for price variations is the first place to look for potential trades: Buying undervalued options and hedging over short time periods with concurrent sales of overpriced options on the same equity. Buying the $46 strike at $95 and selling the $45 strike at $135 is an example that ended on Aug. 16 with the $46 strike at $83 and the $45 strike at $130, for a net gain of $100. 

Because this trade is hedged against movements in the underlying stock, it is possible to hold out for a profit, although the chance for larger gain is stronger close to the original buy and sell date.

A long straddle also is possible when there are underpriced options on both the puts and calls. Buy an undervalued call and put with the intention of profiting when the prices return to normal no matter the direction of movement in the underlying stock. Regression analysis may be used to value puts as well as calls; however, arbitrage pricing usually keeps puts and calls close to parity, as we explain later. 

A straddle trade in Starbucks options was possible on Sept. 6, 2013, with the stock at $71.57. The January 2015 $75 call and $70 put were underpriced by $9.28 and $13.08 according to regression analysis. By Sept. 12, Starbucks’ stock had increased to $75.67. Changes in the call and put prices were plus $212 and minus $134 respectively, for a $78 net profit before trading cost.

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