TSC Options Forum: Go Your Own Way

While a dynamic options marketplace has nuances (which include the cost of carry, such as prevailing interest rates and stock-specific dividend payments that can cause put prices to be slightly higher than corresponding call prices) that make some incremental price disparities actionable only to professionals or market makers, the basic concepts are important for all option investors. Looking at prices in terms of synthetic equivalents will often reveal alternative strategies at more advantageous prices.

My Brain's Too Small to Box Options

Probably the most fundamental way to build a relationship that creates an option chain relative to underlying stock price is the box spread. While the box spread's implications come intuitively to some people, it's not a simple concept to grasp. Not being mathematically-oriented myself, I still struggle with divining its implicit message of highlighting the mispricing, or "out of line" valuation, of specific options.

A box spread is a four-sided option spread that involves a long, a call and short put at one strike price, as well as a short call and long put at another strike price. Essentially, this creates both a synthetic long position and a synthetic short position using different strike prices.

If all option prices are "in line," a box spread represents a riskless position. For example, let's assume ABC Corp. is trading at $52.50 and you sell the 50-55 box, meaning you sell the $50 call and the $55 put and buy the $50 put and $55 call. If all strikes are trading at parity, or in line, this should net you $5, because you're creating a synthetic short at $55 and simultaneously a synthetic long at $50. At expiration the position must be worth $5. This relationship holds true among all strikes, so the 45-55 box is worth $10, just as the 50-60 box should be worth $10.

Once you understand this dynamic, if you're given the prices of three strikes you can determine the fair value of the fourth piece of the box, regardless of the price of the underlying stock. This helps you recognize when any one option price gets out of line; it can be bought or sold, then hedged using the other three strikes to create a risk-free arbitrage situation.