Trading Derivative Mispricings
Overview
Payoff Diagrams
Spread Trading
The most common type of trade strategy centered around derivative mis-pricings is a
spread strategy.
That is, the trader buys or sells the mispriced derivative, and then buys or sells some other asset
(possibly another derivative) to hedge the unwanted risks in the position.
A common example may be to buy a future for a given date, and the sell a future on the same contract for a later date.
In this case, the trader believes that at least one of the futures is mis-priced (say the later date is overpriced),
and she has created a position that is relatively hedged to the movements of the underlying assets.
Delta Hedged
Similar to spread trading, a trader could hedge their position by buying or selling assets that have a combined delta equal in
size to the option being hedged, and opposite in sign.
Volatility Spreads
Volatility spreads are trades that constructed to primarily benefit from mispricing the underlying volatility.
The two most common volatility spreads are
