By Grenblatt
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Additional resources for The Little Book
Example text
80 it may be considered undervalued or inexpensive. 80 the option had an implied volatility level of 20 percent. 30, the option may be considered expensive. 05 with an implied volatility of 25 percent, the historical norm, the 25 Call may be considered fairly valued. Of course, using implied volatility as a measure of how expensive or cheap an option is must be done in the context of some external factors. Remember, if the company is preparing to announce quarterly earnings, the implied volatility would be expected to be high relative to other periods of time.
Using a wide number of actively quoted S&P 500 index options, a synthetic 30-day option is created and the VIX is the implied volatility of that option. This results in implied volatility of the synthetic option contract, which is then reported as the VIX. The Formula and Calculations It is possible to trade the VIX with a cursory understanding of how the index is determined. Those who are satisfied with their understanding of the VIX and what it represents may skip ahead. However, readers who are more interested in how the VIX is calculated should be interested in the remainder of this section.
If at all price levels at expiration the long call position will be worth less than stock plus put position, then an arbitrage opportunity exists. The arbitrage trade would be to purchase the stock and put option while taking a short position in the call option. 50. 50. 4 Long XYZ Stock + versus Long XYZ 45 Put + Short XYZ 45 Call at Expiration Admittedly this is an overly simplistic example, but the hope here is to get across the idea of put-call parity and what happens when put and call prices get out of line relative to each other.