Options Arbitrage and Valuation

I LOST $400?!? That’s IMPOSSIBLE!

We’ve all felt this way at some time on a trade. But in this case, it was actually true. Let me provide some background…

Options Arbitrage

We had our annual MTM Mastermind event in Chicago a couple of weeks ago. In that event, our more elite student traders and John and I trade together live and in person. We trade everything. I like to say at that event, “Give me an EKG chart; I’ll trade it!”

One trade that popped up was an OptionsRaider trade—a short squeeze on CLOV stock. I traded it following our rules and bought the corresponding calls. It worked out nicely. But as I further studied the options chain in CLOV, I noticed some of the far-out-of-the-money calls were… a little weird.

It turned out I could sell higher-strike calls (19-strike calls) for the same price I could buy lower strike calls (17-strike calls). I locked in a debit spread for free. Here are my fills:

What that means to a layperson is I’ve invested $0 into a spread that could be worth $2. So, on this 20-lot, I can either lose $0 or make a max of $4,000. (To be fair, I did pay about $28 in commission to execute the trade. If I had a true zero-commission brokerage, like Robinhood, it would have been entirely free.)

Theoretical Option Prices

That brings us to the $400. Your brokerage account Net Liq (short for net liquidating value) is based on your cash plus the market value of the positions in your account. Where do they get the market value of the positions? From market prices. Basically, the middle of the bid and the ask.

But here’s the rub… Illiquid options like these sometimes have, well, for lack of a better word, GOOFY prices. It can seem illogical, and it pretty much is. But there’s some method to the madness.

If a market maker happens to be short a lot of, say, the CLOV 19 calls, he or she won’t want to sell more. The market maker may even be more aggressive in wanting to buy them. So, the bid and the offer will be higher than one might expect. In fact, in really illiquid options, the offer may be ridiculously high, indicating the market maker doesn’t really want to sell any more at any reasonable price.

Likewise, if the market maker (or, importantly, another market maker) happens to be long a lot of another strike, in this case, say, the CLOV 17 calls, he or she may not want to buy them. So, low or no bid, and a low offer.

That creates an opportunity…and a temporary, perceived problem.

The opportunity is one can leg the spread sometimes for free, like I did, in turn “picking off” the market makers. #smileofsatisfaction

But the temporary, perceived problem is that after the position is on, those bid ask spreads can get out of line and the midpoint that generates the mark your position value—and thus your P&(L)—is based on can be out of line and not reflect the true “value” of the position.

This spread, being so far out of the money, had a theoretical value of close to zero (it’s a free-“ish” lottery ticket trade, after all). But because of where the market maker bids and offers were, the spread was actually marked at less than zero.

Options Price vs. Value

In situations like this, a trader must (counterintuitively) rely on the theoretical value and NOT the price. On the surface, that doesn’t seem to make much sense. But what makes less sense is a debit spread being priced at less than zero.

So, when I noticed my CLOV debit spread being down $400, at first it caught me off guard. But when I looked at the prices in the option chain, it was clear they were out of line and not “real.” The theoretical value was “real.”

Case in point, if the spread expires out of the money, both options will be worthless and will expire AT ZERO.

So, we just have to do a little mental math (and talk ourselves off a ledge sometimes) to get the real picture. A solid understanding of option price vs. option value is the key.

And a big shout out to Chris L. from the MTM Community Chatroom for inspiring the discussion of this topic. Thanks, Chris! It’s a good one for traders to know about.

Dan Passarelli, Market Taker Mentoring

Trader Education