When studying covered call and put-selling option prices we learn that the market will correct any potential arbitrage opportunities. Arbitrage is the simultaneous purchase and sale of an option in order to profit from a difference in the price. It exploits price differences of similar financial instruments. This would not be fair and rarely exists and when it does, the market immediately corrects. In theory, the time value for calls and puts at the same strike and expiration (when at-the-money) should be the same to avoid these arbitrage opportunities. Frequently, however, we see put premiums at a lower price than the corresponding call premium. Why?
To understand this apparent aberration we must view a trade through the eyes of the market-maker, the specialist executing all buy/sell orders. If a market-maker writes (sells) a one-year $50.00 call option, the holder has the right to buy shares for that strike price within the next year. This means that the funds for the stock purchase must be borrowed at the current interest rate to buy stock making the cost of delivery greater than $50.00 and making the $50.00 call option now in–the-money, not at-the-money. Alleviating this situation would be any dividend distributions, if any, during the one-year time frame. Let’s say the cost to carry interest rate is 6% and the dividend is 2%, leaving an additional 4% cost to deliver. $50.00 becomes $52.00. The formula for future delivery of a stock is as follows:
Stock price + Interest Rate – Dividend distribution
From the perspective of a $52.00 stock, a $50.00 call strike is in-the-money and a $50.00 put strike is out-of-the-money and this explains why put premiums frequently appear lower than call premiums for at-the-money strikes. In theory, if a $52.00 strike price existed, the call and put premiums would be precisely the same.
What if the put premium was greater than the call premium for an at-the-money strike with the same expiration?
This would create an unfair arbitrage opportunity for the market-maker who would sell the put and buy the call (equal to a long stock position) and collect a net option credit. The stock can be sold and the option credit banked for a risk-free profit. However, we may see the put premium higher if the ex-dividend date of a dividend-paying stock was prior to contract expiration. Let’s have a look at an options chain for TSM, trading exactly at $23.00 at the time I created this screenshot:
Note on the top of the chart that the bid prices for the at-the-money call and put options were both $0.40 for the June contracts. However, the ex-dividend date ($0.40 was last dividend distribution) is listed as July 14th, prior to expiration of the July contracts. This makes the July call options less valuable and the put options more valuable because of put-call parity. Hence, we see a July call premium for the $23.00 strike at $0.65 and the corresponding put premium at $1.05.
Arbitrage opportunities are rare and are almost never available to retail investors. Markets will quickly self-correct when they do exist. When we see a discrepancy in put and call premiums for at-the-money strikes with the same expiration, they are often the result of interest rate and dividend distribution factors rather than true arbitrage opportunities.
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Negotiations over Greece’s debt deal and European Central Bank President Mario Draghi’s statement after inflation picked up that the Eurozone should get used to volatility resulted in global market downturns. This week’s reports:
- The US economy added 280,000 jobs in May, the most in any month since December
- March’s job gains were revised up to 119,000, while April’s total was reduced slightly to 221,000
- The unemployment rate rose to 5.5% from a seven-year low of 5.4%
- US labor force participation moved up to 62.9%
- Average hourly earnings rose by 0.3% to $24.96 in May, 2.3% higher than a year earlier.
- The US trade gap shrank by 19.2%, the sharpest drop in more than six years, to a seasonally adjusted $40.9 billion in April, reversing the trade deficit’s sudden growth in March
- US consumers bought more cars and light trucks in May than in any month since 2005
- US non-farm productivity declined at a 3.1% annual rate
- US consumer spending was unchanged in April following a 0.5% increase in March, according to the US Department of Commerce
- Initial jobless claims decreased by 8,000 to 274,000 for the week ended 30 May
- Continuing claims fell 30,000 to 2.2 million for the week ended 23 May, the fewest since November 2000
For the week, the S&P 500 fell by 0.7% for a year-to-date return of 1.65%.
IBD: Confirmed uptrend
GMI: 4/6- Buy signal since market close of May 11, 2015
BCI: Cautiously bullish favoring out-of-the money strikes 3-to-2
Wishing you the best in investing,
Alan ([email protected])