kdo

Profiting from Risk Aversion

Sorry Geoff, my comments were actually a little more pointed towards other comments on the board. My comment was basically to point out the idea, that if there is no way to make money in options, there is also no way to make money in stocks either. A pure random walk making options impossible to make money at indicates that there is in fact zero return to stocks as well. It wasn't really meant to be a trends mantra or anything to slight your idea. I certainly am not one to claim that all prices are equal at all times. I think it's an insightful thing you've picked up on. But what I will add, is that a real trend may skew what volatility says the range of outcomes theoretically should be and what may actually happen. If the return comes on average from both being long the call and short the put, a real trend may skew where the return is coming from one that you expect "shorting the put" to one that you do not expect "long the call", because that excess volatility you are noting may be a signal of change to come, not just a volatility anomoly to be taken advantage of by selling vol.

I remember seeing some study a while back from some investment bank about running a covered call strategy. What was interesting is that the study said you should not sell the call under volatility extremes and that history shows you do better by just retaining the long position temporarily. What that would indicate is that under those extremes, you get more return on average from owning the call, than from selling the put.

You wrote: "Thoughts on Market Volatility". So you've already laid out exactly what I'm talking about in many ways.









On Nov 28 06:30 PM Geoff Considine wrote:

> To Greg Harris:
>
> Yes, being net long the call (whether you are long the stock or just
> the call) allows you to grow when the broader economy makes money.
> You don't need to believe that there are no trends--i.e. that the
> market is a pure random walk to make my case here. BUT, when market
> volatility becomes irrationally high, I will believe that the call
> value exceeds the true growth potential for certain stocks---THAT
> is my whole point. This does not detract or even bear on put-call
> parity. The long-term expected return for the S&P500 is positive
> over the long-term---but the implied vol is SO high on some stocks
> that this is priced in.

Profiting from Risk Aversion

I have a couple of comments:

1) Options are sort of theoretically a 100% zero sum game. Arguing that no money can be made on them is the equivalent of saying there are no return to stocks. The law of put-call parity gives:

+(long)Call -(short)Put + (strike/rfr for time x) = long stock.

So, a long stock position is derived from being long the call and short the put and what you can get by putting the rest of the money at the RFR. So short call, long put is synthetically the same as being short. If this was not true beyond transaction costs, it would give rise to arbitrage opportunitites. It is a zero sum game only in the sense that someone has essentially swapped with you the future value of the underlying security which is really not extraordinarily different than someone simply selling the security, sitting on cash instead and banging their head on a wall when the security goes up in value. Except in this case, if they didn't hedge their exposure to you they truly are a loser in the transaction. But many options positions are taken to hedge exposures in the first place and thus are very useful even if/when they are the loser. In the case of option dealers, they are of course hedging their underlying exposures and making their money from spreads rather than bets.

What put-call parity would suggest to me, is that if there is an underlying trend to the position (say upwards), you are likely to gain some amount of your gain from owning the call and some amount from selling the put and of course the reverse is true if the trend is down.

If we are going to claim there is no trends anywhere and that market volatility determines everything, then I suggest you look at a graph of the S&P 500 over the last 100 years. Or banks in the last one and a half. Citigroup volatility in 2007 did not predict it could come anywhere near $3/share within the next year. I am not claiming one should follow trends, the much harder thing is to identify them and understand why they will continue or break down. Sometimes the easiest thing is to simply understand why they will reverse and to prepare for the reversal. But to argue they don't exist is to put your head in the sand. The long term trend of money supply and earnings power from that money supply, is up.

In fact, I like to think about this when making any of my own positions, because the option positions are actually the components that derive the long or short position. Do I like selling the put? Do I like buying the call? Sometimes a desire to go long will suddenly find a disagreement emotionally at the idea of being short the put and realizing that I only like the call, but in fact I also may not like the price of the call, since it has to be supplmented by selling the put I don't feel comfortable selling. It has helped keep me out of trouble on occasion.