Currently I am trading european style index options. I am pricing my options using black scholes. For some reason I always have a tendency to put on Reversals (Buy call, sell put, sell future). Can anyone guide me why do i tend to put this position on even though I am running my interest rates very low close to zero. Somehow I am just naturally pricing my calls higher and puts lower than the actual market. Is it because black scholes model compounds interest rates and does not using simple interest? How would I just use simple interest than compounded interest using black scholes? Any help is appreciated.Thanks in advanceD

QuoteOriginally posted by: devitoCurrently I am trading european style index options. I am pricing my options using black scholes. For some reason I always have a tendency to put on Reversals (Buy call, sell put, sell future). Can anyone guide me why do i tend to put this position on even though I am running my interest rates very low close to zero. Somehow I am just naturally pricing my calls higher and puts lower than the actual market. Is it because black scholes model compounds interest rates and does not using simple interest? How would I just use simple interest than compounded interest using black scholes? Any help is appreciated.Thanks in advanceDI'm not sure what's going on here.First, if you see an Exp[-r*T] then just make R=1+r and use R^-T instead. But I think this seems to be the least of your problems.This is more than a little problematic:"For some reason I always have a tendency to put on Reversals (Buy call, sell put, sell future). Can anyone guide me why do i tend to put this position on ... "Does this mean that you accidentally put trades on all the time? Like, "oops! I just did that Reversal again! Why do I keep doing that? I had better post on Wilmott. Maybe someone else knows why I keep doing that. Oops! I just traded another Reversal! Why? Whhhy?">>Somehow I am just naturally pricing my calls higher and puts lower than the actual market. Is it because black scholes model compounds interest rates and does not using simple interest?>>No it's the vols. You need to use lower vol for the calls and higher vol for the puts.

Yeah you are probably right, instead of making things more complicated maybe I should just go back to basics and see that the market is using lower volatility for these deep calls relative to the same strike put. I am new at modeling and I thought may be i was doing something wrong with the interest rate part.Anyways I will test out the simple interest as well, and this is all I need to use : Exp[-r*T] then just make R=1+r and use R^-T.Whats most commonly used simple interest or compounded interest for pricing european style index options.Does anyone know the pros and cons for using either method.Thanks for your reply Papercut.D

devitoYou haven't said which market it is you are trading - but I want to suggest that you look at the carry cost. Make sure your forward agrees with the market . you can check what the market's forward is from put-call parity at any strike but probably most useful if you look ATM.

I use to trade in European markets, recently i have moved to the wild east, and am setting up a trading operation in emerging markets like Thailand, Malaysia, India. I will focus on the carry cost and make sure my fowards lines up with ATM combo's.I thought of simple interest because it doesn't seem like anyone out here takes their cost of carry of options premium into consideration, and me compounding that thought might be over pricing my deep calls, but yeah it probably might just be that my forward does not line up with the market.What are the standard approaches used in market places when it comes to compounding or using simple interest and what are the pros and cons.Thanks D

that explains it I think. If its hard to short the market everyone will want to hold inventory of stock - this means that forward price will be lower (to account for the stock borrow fee). So if you are constantly buying calls and selling puts you must have an edge in the stock borrow market.

In regards to this, i was only speaking of trading index options, european style. I use index futures to hedge, and most of the people use futures to hedge their options. Besides it seems like stock futures are very liquid in these asian countries, and its alot easier and cheaper to trade stock futures than the stock.

Sorry if my original reply was smart-alecky, I didn't understand the bigger picture. It looks like daveangel is bang on, I think.

No worries Papercut, thanks for replying and making me think in another possible solution. Just for my knowledge can u please let me know What are the standard approaches used in market places when it comes to compounding or using simple interest and what are the pros and cons of it.CheersD

if the futures and options have the same expiration then you are ok and its probably a genuine arb. but typically futures will trade in one expiry (front month) and options will have different maturities in which case you are taking a punt on the roll. probably best to take a punt like that more explicitly.

Right now I am trading options and futures of same expiry. Yeah if I was having this problem with trading different expiry options with different reference month future, then it would be roll, in which case, i would always mark my position as and when i would keep accumulating it. That brings me to my next question. I haven't started trading options in different maturities, but when i do trade 2nd and 3rd month options, which i will be starting fairly soon, I will be using front month future as the reference to price and hedge my option trades for other maturities. In that case I would constantly need to adjust my forward for 2nd and 3rd month as to where the market would be pricing it. In other words, my difference in forward prices would be similar or same as the difference in future spreads between those months, and my ATM combo differences, my rolls would be also equal to future spreads or they should be in line with.As for the over pricing the deep calls, may be market out here is underpricing it, because it is expensive to exercise options here at expiry, maybe in order to avoid that people start selling em , the obvious deep (20 - 30% strike away from ATM strike) calls.D