What is the value of knowing the theoretical price as a retail?

G

gaussian

Suppose I've written a piece of software that calculates the theoretical price of an option using a model. I can then calculate an entire theoretical option chain for a given underlying, estimated volatility, interest rate, dividend, etc similar to a dope sheet you'd give to a floor trader to make markets.

Suppose then that I discover an option (or perhaps a set of calls and puts) are not priced correctly for the market under my model. How would a retail take advantage of this? For a big firm it makes sense because you could make a market on that option and arbitrage the difference away. But for a retail does this advantage really matter?

For example, a common retail strategy is to look at the VIX and compare it to SPX options IV for a given strike and month. If VIX is in disagreement with the volatility of an option that is a "mispricing" you can take advantage of by selling or buying an option and hedging away the greeks you dont want (iron condors, for example).

But in my example this is completely different. I know an option's theoretical value. If it's wrong it seems that the retail would only be able to take advantage of this through something like the VIX strategy above, rather than some sort of real arbitrage due to the inability to make a market using the price you've calculated.

Curious what options experts here think. It's been a slow sunday on my side of the world.
 
Different theo would mean a different implied. Depends on how different it is. Very tough for retail because you'd have to do size.
In the current environment with current liquidity and spreads - not that much. Most of the quantitative world disagrees with current implied - depends how much and for most - not what you make when your right, but rather what do you lose when you're wrong.
 
Theoretical is well... theoretical. Options chain are completely run by algos. There isn't really an arbitrage opportunity to be made off of theoretical value someone else calculates because they "believe" this is the right method. That being said, once in awhile an option trades way out of price by accident relative to other strikes.
 
NeedToLearn said:
Theoretical is well... theoretical. Options chain are completely run by algos. There isn't really an arbitrage opportunity to be made off of theoretical value someone else calculates because they "believe" this is the right method. That being said, once in awhile an option trades way out of price by accident relative to other strikes.
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Sure, I generally agree.

It was mostly a thinking question. If a market maker has a sheet they believe is the correct price they can act on it and trade in a way that makes them money. I was kind of curious if you could do the same as a retail.
 
NeedToLearn said:
Theoretical is well... theoretical. Options chain are completely run by algos. There isn't really an arbitrage opportunity to be made off of theoretical value someone else calculates because they "believe" this is the right method. That being said, once in awhile an option trades way out of price by accident relative to other strikes.
More...
Sorry could you explain what you mean by "by accident"?
 
ajacobson said:
Different theo would mean a different implied. Depends on how different it is. Very tough for retail because you'd have to do size.
In the current environment with current liquidity and spreads - not that much. Most of the quantitative world disagrees with current implied - depends how much and for most - not what you make when your right, but rather what do you lose when you're wrong.
More...

I think he would take the historical Volatility in the case of theoretical Price.
 
gaussian said:
Suppose I've written a piece of software that calculates the theoretical price of an option using a model. I can then calculate an entire theoretical option chain for a given underlying, estimated volatility, interest rate, dividend, etc similar to a dope sheet you'd give to a floor trader to make markets.

Suppose then that I discover an option (or perhaps a set of calls and puts) are not priced correctly for the market under my model. How would a retail take advantage of this? For a big firm it makes sense because you could make a market on that option and arbitrage the difference away. But for a retail does this advantage really matter?

For example, a common retail strategy is to look at the VIX and compare it to SPX options IV for a given strike and month. If VIX is in disagreement with the volatility of an option that is a "mispricing" you can take advantage of by selling or buying an option and hedging away the greeks you dont want (iron condors, for example).

But in my example this is completely different. I know an option's theoretical value. If it's wrong it seems that the retail would only be able to take advantage of this through something like the VIX strategy above, rather than some sort of real arbitrage due to the inability to make a market using the price you've calculated.

Curious what options experts here think. It's been a slow sunday on my side of the world.
More...

One part of the Edge in Option Selling is that Implied IV>Realized IV, this hasn't been true in Feb/March. But in a "normal" market you would sell options when Implied IV>Theoretical Volatility/Historical Voaltility, when it contracts you will make your share
 
Today most of the MMs whose quotes you see are running a vol book. As their book becomes unbalanced they will "generally" adjust their vols to attract good flow or offload bad vol. About half the viable quotes are three firms and then a lot of "me too" MMing so they meet their quoting requirement. Think about in some non-monoply products you might have well over a 100 MMs(not really unique MMs - just quoting on different venues to facilitate different rebate appetites) - drop out of the top 10 - 15 names and no one is there making markets today except where they may have to satisfy a firms router.
 
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