There’s no such thing as a free lunch — unless that lunch is coming courtesy of a mistake. Under the present scenario where trade wars and recession risks run rampant, market makers —essentially the bookies of Wall Street — are earning their paycheck managing liquidity and hedging for risk on both sides. In these current extraordinary circumstances, the hedging can be directionally and extremely biased.
Combine that with the unique geometry of debit spreads and you have a compelling circumstance where certain options strategies can be mispriced — potentially favorably for the retail buyer. To put it simply, a debit spread simply adds a credit component to a straight options-based acquisition.
For example, a bull call spread, while it may sound complicated, involves just two simultaneous transaction: on one line item, the trader buys a call option and on the second line item, the trader sells a call option at a higher strike price for the same expiration date. Subsequently, the proceeds from the short call partially offset the debit paid for the long call, resulting in a discounted net cash outlay.
This cash outlay is the most that can be lost in the trade. Yes, the short call features assignment risk but because you already own a long call at a lower, more in the money (ITM) strike price, the short call is covered. Therefore, bull call spreads are capped-risk, capped-reward opportunities.
As a result of the structure of these debit spreads, the composition of two opposing forces — that of debit buying and credit receiving — results geometrically in bounded payoff regions. These regions can expand nonlinearly, creating unique circumstances for mispriced options under certain conditions.
This sounds complicated at first but as we walk through each of these mispriced options, you’ll clearly see the opportunity — I’ll just leave it up to you whether you want to take action.
First on the list of favorably mispriced options is precious metals miner Newmont (NYSE:NEM). As a fundamentals-driven investment, NEM stock makes plenty of sense. Gold miners, which have previously lagged the underlying asset, have begun to play catchup in a big way. Thus, leading enterprises like Newmont may have serious legs.
What’s really intriguing, though, is that certain NEM bull call spreads appear mispriced, just waiting for the astute retail trader to take advantage. Specifically, investors may consider the 52/54 bull spread for the options chain expiring April 25. This transaction involves buying the $52 call and simultaneously selling the $54 call, resulting in a net debit paid of $140.
Should NEM stock rise to or above the $54 short strike price at expiration, the trader collects the maximum reward, which is nominally $60, representing a payout of nearly 43%.
Here’s the kicker: on Monday, NEM stock closed at $54.79, 1.46% above the aforementioned short strike price. Unlike other bull spreads where the stock in question needs to rise to be profitable, this transaction is already profitable on paper. Thus, you’re waiting for theta or time decay to accelerate to collect your 43% payout.
Finally, the breakeven price for this trade is $53.40, or about 2.54% away. What are the chances that NEM stock can perform better than a 2.54% loss over a two-week period? Try 65.73%, better than the probability of profit that market makers advertise at 60%.
In other words, this debit spread is mispriced by 5.73% in your favor.
Big data analytics firm Palantir Technologies (NASDAQ:PLTR) has been all over the map, making it rather ripe for mispricing adventures. This stinks for the bookies but can be a golden goose for you. Basically, what we have is a circumstance where market makers are edgy. They see high downside risk and therefore are willing to give you great odds to take the other side of the ledger.
With what the market is giving you, you may want to consider taking it. Check out the 88/91 bull call spread expiring April 25. This transaction involves buying the $88 call and simultaneously selling the $91 call, resulting in a net debit paid of $205. Should PLTR stock rise to the $91 short strike price, the trader collects the maximum reward of $95, a payout of over 46%.
With PLTR stock, the kicker is that the security closed recently at $92.62, or 1.78% above the short strike price. I use the term risk inversion to describe such transactions. This is a debit spread where you already start in the money, thus making theta your ally.
Also, the breakeven price for this debit spread is $90.05, about 2.77% below the current market price. The chances that PLTR will do better than not lose 2.77% over a two-week period is 63.4%, much better than the 58.2% probability of profit that the bookies run.
Therefore, this option is favorably mispriced by 5.2%.
Financial services giant Robinhood (NASDAQ:HOOD) represents another candidate for favorable options mispricing thanks to its wild gyrations. Sure, HOOD stock gained over 18% on a year-to-date basis, representing one of the better tech-centric players. At the same time, it’s fair to point out that it’s been down since late February, creating lots of nervous looks among market makers.
Right now, there’s a heavy incentive to play the long game — and with the deal becoming sweeter by the day, it’s tough not to want to grab it. Specifically, astute traders may put on their crosshairs the 42/43 bull call spread expiring April 25. This transaction involves buying the $42 call and simultaneously selling the $43 call, resulting in a net debit paid of $68.
Should HOOD stock rise to the short strike price, the reward is $32, a payout of over 47%. The kicker is that on Monday, HOOD closed at $44.14, 2.65% above the short strike price.
Notably, the breakeven price for the above trade sits at $42.68, 3.31% below the current market price. The odds that HOOD stock will perform better than a 3.31% loss over the next two weeks clocks in at 63%.
That’s better than the 60% probability of profit that the bookies assigned, meaning that this HOOD bull spread is 3% favorably mispriced.
