Options, SV, IV, Probabilities and Low Volatility Moves

[wayneL]

I thought I would open this thread basically about volatility analysis and/or trading, as it relates to taking positions in the real world.

... Especially when going short gamma (Selling options), but not excluding considerations when long gamma. (Buying)

Could it be that our analysis using the standard OPM could lead us into trouble especially when analysing probabilities, Vis a vis low volatility trends.

Should we, could we, you some other bottle of analysing potential moves and how that could affect option positions.

Market makers are all over this type of analysis and perhaps we should be thinking along the same lines as retail traders?

 

[wayneL]

Bumpitty bump.

Options,contrary to popular opinion, do not reduce risk, in fact there are increased risks *overall* in the form of greater contest risk.

However, they enable us to take the straight out linear risk/reward profile and reshape risk non linearly.

That's what many don't grasp initially, to their ultimate detriment; because of a misunderstanding of where risk lies

Hence, any strategy on a *random basis will be less profitable that naked equities (or other non option instruments) in the long term, because of of contest risk.

But once again, if we reshape the risk reward intelligently and consistently get it more right than wrong, we can crank up returns.

 

[wayneL]

No takers... Dayum!

Okay.

A) Consider the risk reward of straight long stock and its payoff diagram... Let say xyz @ $100

B) Next, consider the payoff diagram of the ATM, near expiry long calls.

C) Then, consider the payoff diagram of the same ATM, near expiry short puts.

A = B + C

Any lightbulbs turning on?

 

[cynic]

Presuming American style exercise, this would seem to be a needlessly risky, synthetic long position!

 

[Value Collector]

No takers... Dayum!

Okay.

A) Consider the risk reward of straight long stock and its payoff diagram... Let say xyz @ $100

B) Next, consider the payoff diagram of the ATM, near expiry long calls.

C) Then, consider the payoff diagram of the same ATM, near expiry short puts.

A = B + C

Any lightbulbs turning on?

With out knowing the dividend that would be paid on A, or the net debit or credit of holding B+C it’s impossible to know which position would be the best to hold long term.

although I would assume A) might end up generating more in dividends and franking credits than B+C. (Unless I am missing something).

In general I favour holding A + C, and using the cashflow from dividends and premiums to pay for the purchase of an stock if the C’s get exercised or rolling them no longer looks like it will generate net credits.

 

[wayneL]

With out knowing the dividend that would be paid on A, or the net debit or credit of holding B+C it’s impossible to know which position would be the best to hold long term.

although I would assume A) might end up generating more in dividends and franking credits than B+C. (Unless I am missing something).

In general I favour holding A + C, and using the cashflow from dividends and premiums to pay for the purchase of an stock if the C’s get exercised or rolling them no longer looks like it will generate net credits.

The option pricing model takes account of dividends, so even when a dividend Is payable, A still = B + C

A + -B reduces volatility, but if pricing is accurate, will not increase returns over the long term, because of opportunity cost. It may even reduce returns because of increased contest risk.

 

[Value Collector]

The option pricing model takes account of dividends, so even when a dividend Is payable, A still = B + C

A + -B reduces volatility, but if pricing is accurate, will not increase returns over the long term, because of opportunity cost. It may even reduce returns because of increased contest risk.

So the other side of the coin must be that the counter party willing to accept the higher volatility over the long term must be able to increase their over all return at the expense of the person that wishes to reduce volatility while accepting a lower return.

I think that principle is at the heart of all insurance, we all know that over our life time most of us will pay more in car insurance premiums than we collect in pay outs.

but the main reason we have the car insurance is to reduce volatility and avoid massive out of pocket expenses of written off cars, but the insurance company takes the volatile side of that bet, knowing that over time they should come out on top.

 

[wayneL]

So the other side of the coin must be that the counter party willing to accept the higher volatility over the long term must be able to increase their over all return at the expense of the person that wishes to reduce volatility while accepting a lower return.

Not usually.

When you're trading options your counterparty is almost always an RT (market maker) and they will hedge off their Delta risk immediately... Or someone who has included your option as part of one or another spread strategy.

It would almost never be somebody who has taken the exact opposite trade to you.

I think that principle is at the heart of all insurance, we all know that over our life time most of us will pay more in car insurance premiums than we collect in pay outs.

but the main reason we have the car insurance is to reduce volatility and avoid massive out of pocket expenses of written off cars, but the insurance company takes the volatile side of that bet, knowing that over time they should come out on top.

It's a fair point. One thing that has come out of behavioral finance is that people do not like volatility.

However the option pricing model only prices volatility, it does not price trendiness. Prices can move a hell of a long way in a low volatility trend which can be extremely costly if you're on the wrong side of that move.

This goes to my original point and even if one's goal is simply to reduce volatility, indiscriminately applying a strategy in a systematic way will most likely get their @ss handed to them in the long run.

Which means that you have to be good at one or more of these things... predicting direction, predicting volatility, and how to dynamically hedge andor deftly change the shape of the risk profile.

...or know when just the get the hell out of Dodge.

 

[Value Collector]

Not usually.

When you're trading options your counterparty is almost always an RT (market maker) and they will hedge off their Delta risk immediately... Or someone who has included your option as part of one or another spread strategy.

It would almost never be somebody who has taken the exact opposite trade to you.



It's a fair point. One thing that has come out of behavioral finance is that people do not like volatility.

However the option pricing model only prices volatility, it does not price trendiness. Prices can move a hell of a long way in a low volatility trend which can be extremely costly if you're on the wrong side of that move.

This goes to my original point and even if one's goal is simply to reduce volatility, indiscriminately applying a strategy in a systematic way will most likely get their @ss handed to them in the long run.

Which means that you have to be good at one or more of these things... predicting direction, predicting volatility, and how to dynamically hedge andor deftly change the shape of the risk profile.

...or know when just the get the hell out of Dodge.

Market makers are just the middle men, for them to hedge off their risk they need some body or a group of some bodies to take that other side of the trade.

It is very much a zero sum game, if one person is being paid to take on extra risk, some one some where must be finding that and having there risk reduced, even if it passes through multiple middle men in between.

If you are good at judging how likely a company is to survive and thrive vs shrivel and die, and you have a balance sheet that can deal with volatility you can make money taking on risk when the market is over paying you to take it, which they often do, because the options are priced based on volatility not actual risk.

 

[wayneL]

Market makers are just the middle men, for them to hedge off their risk they need some body or a group of some bodies to take that other side of the trade.

Not necessarily. At least not in the options market as RTs will often hedge off their Delta risk with stock.

the reason for this is very simple. There will not be equal numbers of public buyers and sellers at each strike and expiry.

This is the role of RTs, to take up the other side of the trade when there is no other side available in the public.

That's why they are called market makers.

It is the same another derivative markets such as cfds. If the public is net long in xyz, what do you think cfd company (ie the market maker) is doing to hedgr off their risk?

 

[Value Collector]

Not necessarily. At least not in the options market as RTs will often hedge off their Delta risk with stock.

the reason for this is very simple. There will not be equal numbers of public buyers and sellers at each strike and expiry.

This is the role of RTs, to take up the other side of the trade when there is no other side available in the public.

That's why they are called market makers.

It is the same another derivative markets such as cfds. If the public is net long in xyz, what do you think cfd company (ie the market maker) is doing to hedgr off their risk?

So how does that work with them taking the other side of a put options contract?

eg. If I sell 500 contracts of FMG $25, and pocket $100K.
How is the market maker going to hedge away the other side of that with stock in a way that generates the $100K needed to pay me?

I know a lot of capital protected funds etc would pay the market maker to take the other side of my trade, in that situation I am providing them the insurance.

But I am wondering how the mechanics of it work where you are saying that maker makers can make the other side of the trade disappear without some one some where taking the risk of the other side of my trade.

 

[wayneL]

In simple terms,

So how does that work with them taking the other side of a put options contract?

eg. If I sell 500 contracts of FMG $25, and pocket $100K.
How is the market maker going to hedge away the other side of that with stock in a way that generates the $100K needed to pay me?

I know a lot of capital protected funds etc would pay the market maker to take the other side of my trade, in that situation I am providing them the insurance.

But I am wondering how the mechanics of it work where you are saying that maker makers can make the other side of the trade disappear without some one some where taking the risk of the other side of my trade.

It would depend on the rest of his book. But looking simply at that particular trade he could do a conversion to lock in his profit from the spread.... Or could decide to take on some long gamma and buy shares.

It would depend on the RT's model and forward view of direction and vols.

More likely would be a consideration of his entire book

 

[Value Collector]

In simple terms,
It would depend on the rest of his book. But looking simply at that particular trade he could do a conversion to lock in his profit from the spread.... Or could decide to take on some long gamma and buy shares.

It would depend on the RT's model and forward view of direction and vols.

More likely would be a consideration of his entire book

If the marker maker does a conversion, doesn’t that mean that he has to sell a Call to fund the purchase of the put he bought from me?

In that situation doesn’t that mean that my original claim is correct, eg the market marker is a middle man and there has to be some body or some bodies taking the opposite side of my position, or in this case probably it’s me taking providing down side insurance on Stock that was purchased to essentially do a covered call.

what I mean is that the market marker is locking in his fee in the form of a fixed profit, but the risk hasn’t disappeared it’s just been transformed and past along to another person, in this case the person who bought the call.