Pleoni, if the Almighty imparted this secret to you, you're all set... In a situation that you describe (i.e. you know the distribution has fat tails, but the mkt is effectively mis-pricing it) you should be buying outstrikes like there's no tomorrow. Clearly, if we go with your assumption, around expiry the distribution that gets realized is the one you, but not the mkt, expected, so you make money. Things to take into account are the usual issues of trade mtm vs pnl at expiry, i.e. you could be wrong all the way there and even get stopped out, in spite of possibly being right at expiry. To quote a famous dictum "mkts can remain irrational longer than you can remain solvent".Again, Sep Euro$ (similar for Sep Sht Stg, for that matter) is the best example that I can point to, even though the situation was the opposite. Because of all the LIBOR issues, on the one hand, and the way people were expecting the Fed to act, the mkt was pricing in insanely fat tails. Any model would have suggested that outstrikes were massively overpriced. However, selling them proved hazardous to many people's professional health, as they went even more insanely bid, when people scrambled to cover their exposure to various improbable scenarios. Selling an option is, of course, different to buying one, but you get the idea.So arbitrage it ain't, but rather a view on either the implied or realized distribution (depends on the horizon).
Last edited by Martinghoul
on August 27th, 2007, 10:00 pm, edited 1 time in total.