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I have a question regarding if a Call option is overvalued compared to the call price and how you can benefit from the Arbitrage opportunity.

My thoughts are as follows:

Step 1: Short the call option Step 2: Borrow money to buy the underlying Step 3: Buy the underlying

Theoretically, have i understood the correct move in this situation and could someone provide a simple example?

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In order to set up an arb, you always need to be able to trade a put option with same strike.

(1) you sell the call option (2) you buy a put option of the same strike (3) you buy the underlying

(1) & (2) is equivalent to selling the underlying (long call & short put = short underlying), which you then effectively sell at a higher price than it is traded in the market for the underlying.

By buying back the underlying (3), you completely net out your position and lock in the profit

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  • $\begingroup$ thank you for your clear answer. How about if you have a undervalued/overvalued Put option? $\endgroup$ – kalle anin Mar 20 '19 at 15:17
  • $\begingroup$ Undervalued options will naturally be bought, overvalued ones sold. There are 4 possibilities: 1) sell put -> buy call to convert into long underlying -> sell underlying to lock. 2) buy put -> sell call to convert into short underlying -> buy underlying to lock. 3) sell call: see above. 4) buy call -> sell put to convert into long underlying -> sell underlying to lock. $\endgroup$ – ZRH Mar 20 '19 at 15:19
  • $\begingroup$ Also @zrh, dont you need to borrow money to finans step number 3? $\endgroup$ – kalle anin Mar 20 '19 at 15:19
  • $\begingroup$ when you buy the underlying you will not have to finance the full purchase price. after buying the underlying, you will lend it to someone against receiving cash, which finances your purchase (securities borrowing and lending). Done that way, you only need to come up with margin to cover your risks $\endgroup$ – ZRH Mar 20 '19 at 15:24

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