How do you identify and exploit option bound violations?

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AcadiFi · Accepted Answer

Step 1: compute all applicable bounds (lower/upper, parity). Step 2: compare to market prices. Step 3: if market price < lower bound, BUY the option and hedge; if market price > upper bound, SELL the option and hedge. Example violation: Quillmark Insurance stock S=$55, European call K=$50, T=1 year, r=5%, market call c=$4.00. Lower bound = 55 - 50*e^(-0.05) = 55 - 47.561 = $7.439. Market $4.00 < $7.44, violation of $3.44. Arbitrage: (1) Buy call for $4.00 [cost 4]; (2) Short stock for $55 [receive 55]; (3) Invest $47.561 at rf to grow to $50 [cost 47.561]. Net cash now = -4 + 55 - 47.561 = $3.439 (locked in, matches violation). At expiry: if S_T > 50, exercise call (pay 50, get stock, return to short), bond pays 50 which funds the strike. If S_T <= 50, don't exercise, buy stock at market (<=50), return. Bond pays 50, use <=50 to cover short, keep difference. Either way, the $3.439 initial profit is permanent. ```mermaid flowchart TD A[Spot violation] --> B{Below lower or
above upper?} B -->|Below lower| C[Buy option +
short underlying] B -->|Above upper| D[Sell option +
long underlying] C --> E[Lock risk-free profit] D --> E ``` Real markets rarely show clean violations; when they do, they're usually bid-ask, dividend, or borrow-cost related, not true arbitrage.

How do you identify and exploit option bound violations?

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