Option Bid Above Intrinsic Value
Today I saw a deep in the money option that had an intrinsic value of $34.40, yet both the bid and ask were above this (bid was $35.00 ask was $39.00). I searched/asked around and cannot get a reason as to why this may be. Wouldn't this be a case of arbitrage? The option has very low volume and little outstanding interest. My only thought is that somehow a timing issue arose between the underlying stock quote and the bid/ask spread. Thanks in advance.
Most likely the bid was just a stale quote, but it's possible there was a retail call buyer who hadn't gotten picked off yet. It is perfectly normal for the ask to be well above intrinsic value.
I fail to see the issue - if the option isn't expiring any time soon, it will still have time value, even if it is in-the-money.
You're considering just European style options, right? With American-style, you can exercise at any time.
Not all in-the-money options have time value. In fact, the way it's taught in options theory is that in-the-money options do not have time value at all, they are only composed of intrinsic value (refer to Natenberg: Options Pricing and Volatility). However, in reality, options that are in-the-money but not deep in the money can still have time value. (At least this is the case with crude/natgas futures/options, the area I'm involved in). The super high delta options (deep in-the-money) are only composed of intrinsic value, no time value.
Giving this a whirl but here it goes...
You could buy the underlying and sell the call (let's assume it's a call) and make a small profit. But there's interest rates and transaction costs. Let's assume you're talking about the following scenario:
$100 Call Underlying is trading @ 134.40 the 100 call is 35/39 (35 bid, 39 offered)
You buy the underlying @ 134.40, and you sell the 100 call for $35. If you get assigned on the call, you've already bought the underlying at 134.40, so you still make 60 cents. If the option goes way out of the money, you could lose quite a bit of money on the stock dropping if it goes further down than $35 from where you bought it. All you'll have to cover it is the $35 in premium you collected.
Here's the problem:
Considering this is equities, you'd pay/borrow $134.40 for the underlying, and you'd receive $35 in premium for the option. So you'd be paying interest on $99.40. Say the rate is just 4% - then each night on settlement you lose ~2 cents.(4%/256 trading days = ~.02%).
(Correct me if I'm wrong on the interest rate calculation there - never really looked at interest rates as they're negligible.)
If the option is just about to expire, maybe this would still make sense and the interest cost would be negligible.
Then you have transaction costs - I don't need to go over that for anyone to see how this wouldn't make sense alone just with transaction costs.
All this being said, there are times in equities, supposedly, when there are arbs that can be done in illiquid stocks. I saw a presentation once where a guy was showing where conversions and reversals were still possible on the screen in more illiquid stocks. Conversions/Reversals were something guys in the trading floor pits of the exchanges used to do a lot. Now with electronic trading, that's gone.
Maybe your scenario would work, but it's probably on an illiquid stock. Assuming you could still make money after transaction costs and interest costs, the profit is probably small, and on top of that there's probably not much size on the bid to make it worthwhile.
Please correct me if I'm wrong in any of this, I don't hold myself to be an expert or know-it-all, just putting forth what I can.
Did you check put- call parity? Also this does happen especially in illiquid names say you're a retail guy and can't afford the underlying like in silver, you wanted to sell the market short so you sell a call because you thought it was coming off, then it goes against and you need to get out of that specific strike so you bid in that ITM option
Firstly, like euroazn says, DITM options may, and often do, have time value. There's nothing all that unusual about this. Secondly, it's hard to draw any conclusions w/o actually looking at the specifics of the option. Finally, are you sure you're computing the "intrinsic value" using the correct forward?
The amount of time value deep in the money options have is miniscule, negligible. Once you start getting up into the 98-100 delta options, it's not even worth considering
Disagree there. If time value was minuscule than the option on the other side (aka way out of the money put) would be worth 0.
This is a sweeping generalisation and, like most such statements, it's false. If you want me to offer counterexamples, I can come up with a few.
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