A tool that estimates theoretical fair value of European options and identifies potential arbitrage opportunities is a significant asset in options trading. It uses the prices of a call option, a put option, an underlying asset, and risk-free interest rate to determine if their current market values are aligned, based on the theoretical relationship that must exist between them to prevent riskless profits. For example, the tool might indicate an overpricing or underpricing scenario involving a specific stock’s call and put options with the same strike price and expiration date, relative to the current stock price and prevailing interest rates.
The importance of such a tool lies in its ability to quickly evaluate pricing discrepancies and potential mispricings. Benefits include improving trading decision-making, enabling the identification of arbitrage possibilities where profits can be made with little or no risk, and providing a quick assessment of options valuation relative to a theoretical baseline. Historically, these calculations required tedious manual computations, making the quick identification of arbitrage opportunities challenging. The advent of automated calculations greatly increased the efficiency and accessibility of this kind of analysis.
