So I am working on strategies that depends on the difference between Actual market price of option and price derived using black and scholes model. For eg: Spot 19000 , strike 19200 . It is OTM call option where market price is 50. But using Model price is 57.20. That means price is at 7.2 discount. So people are less interested in this so, sell this OTM strike. Is this valid view ? Or Am I missing something ?. Can anyone please elaborate why there is difference between these two prices and what do difference mean and how can we use it ?
1 Answer
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Welcome to the world of options.
First and foremost rule of the game, you should imprint it:
The market is right, you are wrong.
This may seem absurd, but it's not. At least for the first ten years or so, until you are far more experienced in the game, you should always remember the rule.
What does this mean about your model: that either it is wrong, or that you are comparing your subjective views and prices to so-called risk-neutral prices (which are the closest thing to objective prices).
If it's the latter, that's OK in the sense that you are prepared to take a risk on the difference between your subjective view and the risk-neutral price.
But if your model is a risk-neutral price and does not match the market price, then you should try to find where you made the error.
Another possibility is the option price you are looking at is stale and/or very illiquid. For far OTM options you should not always trust ask prices, bid prices are probably more reliable.
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$\begingroup$ could you please explain what is risk-neutral price ? and you said Theoretical price must match market price. if it doesn't I should change the inputs to the pricing model. Means there doesn't exist strategies like I mentioned. correct ?. What I am confused about is why they both must match ? $\endgroup$ Aug 22 at 6:58
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2$\begingroup$ @NikunjGuna Well, if you are not familiar with risk neutrality, then I suggest you first try to read about and understand the Black Scholes model, which is the basis of derivatives pricing. $\endgroup$– FridoAug 22 at 9:07