Arbitrage with mispriced Put Option.

[rus1bus]

If you have an overpriced Call, the arbitrage strategy would be to Sell the Call and Buy the underlying, right?
Yes. Quite intuitive.
Similarly, if you have an overpriced Put, the arbitrage strategy would be to Sell the Put and Buy the underlying, right?
Wrong, though intuitively it looks correct.
The correct strategy would be to Sell the Put and also Sell the underlying.
This is because by selling the Put, you are giving a right to the buyer to sell the underlying to you. And if buyer exercises its right, you will be long in the underlying at that time. So, you need to be short the underlying now.
I just stumbled here while attempting a question and wanted to share with you all. I think it is one of those tricks, Exam would love to test us on.

 

[idreesz]

Thanks for that

 

[cpk123]

look at it another way…
P+S = X/(1+rf)^t+C
So C and S are on opposite sides of the equation. So if you sell a call, buy stock or vice versa.
But P and S are on same side - so they move in the same direction. you sell put - you sell underlying as well.
Thanks for sharing though!

 

[job71188]

Anytime there is a question involving the Call-Put Parity, I write it down. When you are actually looking at it, the questions get a lot easier.

 

[rus1bus]

cpk123 Wrote:
——————————————————-
> look at it another way…
>
> P+S = X/(1+rf)^t+C
>
> So C and S are on opposite sides of the equation.
> So if you sell a call, buy stock or vice versa.
>
> But P and S are on same side - so they move in the
> same direction. you sell put - you sell underlying
> as well.
>
> Thanks for sharing though!
Yes, this reasoning makes it more intuitive. Thanks CP.