Exploitable difference in option premiums..

T

tikipoki

Looking over the charts my eye fell on the (european style) index options of the local market, finding that an ATM straddle on the index expiration lets say Oct.05 has a LOWER premium then an ATM straddle in the index expiration Oct.03 (lower premium per month).

Since these options cant be exercised until expiration date (where you pay/receive whatever your profits/losses are), Intrinsic value will be the same but premium will leak slower on the LONG TERM straddle, I got the idea to buy the longtermstraddle and sell the shortterm one, for the latter will have their premium decrease faster and intrinsic value will be the same..

looks so easy its ridiculous.. anybody got comments? for all I can see, this is free money.

regards,

Tiki
 
Are you saying that the price of the Oct 05 straddle is lower than the price of the Oct 03 straddle, or the implied volatility is lower in the Oct 05 than the Oct 03 ?
I cannot believe that the price of the Oct 05 is lower than the Oct 03.

Vega:D

And what index/security are you looking at ?
 
Okt03@32 price: 1.90, underlying: 32.7,

intrinsic value = (32.7-32) .7, premium is (1.9-.7) = 1.2, to be decayed in 1 month, so, monthly decay 1.2/1 = 1.2

Okt05@32 price: 9.00, underlying: 32.7,

intrinsic value = (32.7 -32) = .7, premium is (9-.7) = 8.3, to be decayed in 24 months, so, monthly expected average decay 8.3/24 = 0.35

so I expect the premium of the Okt03straddle to be down 1.2 by the end of the month, and the Okt05straddle premium to be down by .35, giving a difference of (1.20-.35) = .85

where do I get offtrack :p

Tiki
 
While its true that options in the nearer term will decay faster than those farther out, a position like you described leaves you open to price movement in the short term. A quick example would be if the stock moved up 2 or 3 bucks in the next month, the straddle in Oct 03 would increase more than the straddle in Oct 05 due to the fact that the closer straddle is more sensitive to moves in the underlying. Sorry Tiki, it's not quite that easy !!!!

One more thing that you need to consider, do not be under the misconception that options decay in a linear fashion, options decay exponentially, and the decay speeds up in a big way as you approach expiration, so don't ever make any kind of trade assuming that the options will decay in a linear fashion because unfortunately you will be very disappointed in the results. Hope this helps.

Vega:D
 
yeah the difference in sensitivity between the options is indeed the drawback :/ I should have thought of this myself... ah well :) back to the charts!

thanks for the input!

Tiki
 
Got me all excited at first !!! I thought you were saying basically the Oct 03 was trading at like $5 and the Oct 05 was trading $4 !!! I was trying to think of what kind if cost of carry or other factors was causing this discrepancy.....it's very rare but there may be something similar with long-term options on companies that are merging in the near future. Yep, back to the old drawing boards!!!!!!!!!!

Vega:D
 
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