In this post I’m going to look ahead to the end of year rally that I’m expecting and what clues I’ll be looking at for an indication of whether that rally is the start of the next major move higher or just a retracement in an ongoing downtrend. But first I’m going to address the topic that is the title of this post; are options mispriced?
The answer to that question is of course they aren’t mispriced! If they were then the market participants would buy or sell those options until they come back into a fair value range. Right? Ok, let’s move on to another topic! Wait a minute…if options are always priced at fair value then where is there an edge? And if there’s no edge then should I always just utilize high probability trading strategies? And do those high probability strategies basically guarantee success? Unfortunately, high probability of profit strategies are far from a sure thing and they have multiple flaws which is why I don’t trade them. In fact, I trade just the opposite strategy. I find the edge exists in trading low probability of profit strategies while using price action and chart analysis to gain that elusive edge. Let’s look at an example of what I’m referring to. Below is the SPX chart over the past 3 months. There have been 3 declines of between about 6% and 7% (including the current decline) followed by a 2 week rally of 4%-5%. I can estimate the approximate expected probability of profit of buying a Call option that is 4% OTM (out of the money) by looking at the Delta of the Nov10 Call with a 4280 strike price.
Below is the option chain showing the Delta of the Nov10 Call with a 4280 strike price is .12 or 12%. Delta can be used in multiple ways and one of them is as an approximation of the probability of that strike being ATM or ITM (at or in the money) at expiration. We can also estimate that the Delta of the 4% OTM Calls with 2 weeks to expiry on both August 18th and October 3rd (the last day of the prior 2 declines on the SPX chart) was likely around the same 12% and yet both times SPX reached those strikes prior to expiry. The outcome with just a 12% probability of occurring did occur, twice, within 2 months. Probability would say that shouldn’t happen, should it? Well, unless it is possible that options are extremely mispriced at certain times.
Even if I wanted to add some extra time to a potential option trade to increase the probability that price will reach a SPX target price of 4280 I could still buy a very cheap option! Below is the option chain showing the Delta of the Nov17 Call with a 4280 strike price is .18 or 18%.
So why isn’t a higher Delta assigned to that 4280 strike when clearly the chart shows that, based on recent history, it’s certainly possible? Delta and option probabilities aren’t based on a chart so if I can find clues to the likely direction of price and a potential price target by examining price action then I can gain an edge in option trading!
Here’s the SPX daily chart marked-up with current support and resistance. I’m expecting support at the current 4100 price level but if buyer’s don’t step up then 4050 is likely next. I’ll continue to use 4100 as the key bull/bear line this week so IF price can get back above that level I’ll likely trade that with a 4200 target.
