Spreading lets average traders exploit option mispricing without stock positions

Evidence

However, any floor trader on the Chicago Board Options Exchange could practice “spreading” (Black 1975a, pp. 39-40; Galai 1977, pp. 189-194). This operation which appears to have been practiced widely involved using the model to identify pairs of options on the same underlying stock, in which one option was, according to the model, underpriced relative to the other. Traders could then buy the underpriced option and sell its overpriced counterpart, and applying some simple arithmetic to the numbers on Black’s sheets showed how to minimize exposure to the risk of fluctuations in the price of the underlying stock: one made the sizes of purchases and sales inversely proportional to the deltas of the options in question. — Donald MacKenzie, An Engine, Not a Camera, 733

Categorization

• DEFINE: Defines ‘spreading’ as a model-driven arbitrage technique using delta-proportional position sizing.
• XREF: Connects to the performativity thesis: Black’s sheets themselves supplied the arithmetic traders used, making the model operational for market participants. — connects to: Derivatives let investors trade an asset’s attributes without the asset itself — Andrew deWaard, Derivative Media: How Wall Street…, 486; Spreading’s robustness to volatility estimates made it viable for floor traders — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 734; Swap spreads mean-revert, letting traders bet on widening to profit. — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 1301

Broader Connections

• Derivatives let investors trade an asset’s attributes without the asset itself #expands (0.80) — Andrew deWaard, Derivative Media, 486