Are naked puts really this safe????

[tyrant]

Quote from MasterAtWork:

Ah, ah, Dmo you are tenacious. Portfolio insurance sounds as a good reason, but if that was the reason, people would try to reduce the cost. Why those people never learned a call purchasing and a short future would be cheaper than the symmetric put? 20 years after?

Hi MAW,

Can you give an example of how a call purchasing and a short future would be cheaper than buying a put? If that is true, is it possible to profit from arbitrage? If not, is the transaction costs including slippage the main reason that there is no arbitrage profit?

Thanks

 

[beep1]

Quote from dmo:

I think you're raising the question of the most sensible way to hedge, and wondering if the way it is commonly done - with OTM options - really makes more sense than doing it with DITM options.

It's a worthwhile discussion, but for purposes of understanding the skew I think it's more important to know what people are actually doing. Did you see the graphic I attached to a post a few pages ago? It shows clearly that a lopsided majority of volume at each strike is the OTM over the ITM. So whether it makes sense or not, the majority of put buyers are buying the lower strikes, and bidding up the volatility down there in the process.

the original reason for my comments was due to your comments that volume was lower on DITM side, and you used it to provide evidence that portfolio insurance uses OTM option on long side for puts and short for calls.

my original point is that it is not conclusive as one should expect this discrepancy if one were to hedge with DITM options as the number of contracts sold should be smaller because of deltas.

a second point (which i did not make in my latest post): if a portfolio manager was to use DITM options, he may also proceed with the synthetic position, which will show up as higher volume on the OTM side (which will be short put, or long call).

conclusion: if one does not know the actual activities on OTM options AND the possible corresponding operations on underlying, volume analysis on options provide NO information on whether managers use long or short volty to hedge.

do you see the significance of the last point?

 

[atticus]

Quote from beep1:

conclusion: if one does not know the actual activities on OTM options AND the possible corresponding operations on underlying, volume analysis on options provide NO information on whether managers use long or short volty to hedge.

do you see the significance of the last point?

I don't, your conclusion is fatally flawed. It's only significant to the author.

 

[atticus]

Risk-reversal pricing is a method of pricing skew primarily in otc markets. Typically quoted at 25-deltas up/down.

The 25-delta put vol is priced against the 25-delta call vol in any market. A + result suggests callvol/putvol > 1. Calls are puts, puts are calls. The ~25-delta call can be made into a ~-75-delta put simply by trading a futures contract. To buy the put synthetically you would buy the call and short a futures contract. Futures = -100D + the call delta to arrive at a -75 synthetic put delta which is equivalent to the natural -75D put. The same-strike combination shares gamma. The advantage over the otm put is a discounted volatility due to the index vol smile. In reality, it's still a costly put in premium terms, natural or synthetic due to the >delta.

Same strike combinations must trade at ~equivalent volatility. A deep otm put at 30% volatility reflects a deep itm call volatility of 30%, provided they share a strike. The put is dominant, as the OI is dominated by the otm option, but the same-strike call must share the volatility for parity to remain inviolate. Remove carry and the RFR from the equation.

 

[dmo]

Quote from beep1:

the original reason for my comments was due to your comments that volume was lower on DITM side, and you used it to provide evidence that portfolio insurance uses OTM option on long side for puts and short for calls.

my original point is that it is not conclusive as one should expect this discrepancy if one were to hedge with DITM options as the number of contracts sold should be smaller because of deltas.

a second point (which i did not make in my latest post): if a portfolio manager was to use DITM options, he may also proceed with the synthetic position, which will show up as higher volume on the OTM side (which will be short put, or long call).

conclusion: if one does not know the actual activities on OTM options AND the possible corresponding operations on underlying, volume analysis on options provide NO information on whether managers use long or short volty to hedge.

do you see the significance of the last point?

Assume the futures are at 1200. Are you saying that the 1300 call volume might really be synthetic put buyers?

I guess it's possible - I can't prove otherwise - but it just seems to defy common sense. Too tortured. You know the expression - "when you hear hoofbeats, think horses not zebras." (Not true in Kenya I guess).

Besides, portfolio protection is not just a matter of puts or calls - much more importantly it's a matter of premium - gammas and vegas. If futures are at 1200 and you're worried about a drop, you don't want premium up at the 1300 strike - that's not going to do you any good in the event of a crash. You want premium down low, the lower the better. If there's a crash, you want that premium to be right in the heart of the action. Think of it as real estate - location location location. In the event of a crash, the best real estate to own is at the low strikes. In a crash, premium down low becomes a Park Avenue penthouse during the great NY real estate boom. Premium at high strikes might as well be a tenement in the Bronx - it's just not situated to benefit from the action.

 

[JSHINV]

Nope. If you have the cash, its just like it's a covered call. Thats why IRA accounts allow cash secured puts. You know that. But, does everyone posting here know that? "Not to worry, I'll just sell some more puts."

Quote from vhehn:

so is there some evil force in selling naked puts that force you to do it with leverage?

 

[JSHINV]

BTW, to me if they are cash secured, they are not really naked puts. They are covered with cash.

Quote from JSHINV:

Nope. If you have the cash, its just like it's a covered call. Thats why IRA accounts allow cash secured puts. You know that. But, does everyone posting here know that? "Not to worry, I'll just sell some more puts."

 

[hlpsg]

Quote from dmo:

This is a misconception. Market makers don't come up with a mathematical theory or a distribution and then stubbornly stick to it, the market be damned. They just make markets based on the public buying and selling, which is what really creates the skew. Market makers are infinitely pliable.

Here's an example of how it works. Let's say it's the first day ever in the S&P500 options pit. The market makers start off with BS prices. There are 50 days remaining and they're using a volatility of 20%. We'll assume an interest rate of 0 for simplicity. Futures are at 1200. Theoretical prices are as follows:

1100 puts - 5.01
1300 calls - 6.58

Throughout this particular day, the futures don't move. Somebody comes in and asks for a market on the 1100 puts. The market makers make a market of 4.90 bid at 5.10. The public buys a few hundred lots at 5.10. A little later someone else asks for a market in the 1100 puts. The market makers have sold all they want to sell at 5.10. So they give a market of 5.10 bid at 5.30. The customer buys a few hundred at 5.30.

Meanwhile, someone asks for a market on the 1300 calls. MM's give a market of 6.50 bid at 6.70. The public sells a few hundred at 6.50. A little later the public asks for a market again. This time MM's give a market of 6.30 bid at 6.50. The public sells a few hundred more at 6.30.

At the end of the day, it looks like this:

1100 puts - 5.30 bid at 5.50, settle at 5.40 - IV is 20.45%

1300 calls - 6.10 bid at 6.30, settle at 6.20, IV is 19.63%

And voila - we have a skew. Purely the result of market forces - greater buying in the put, greater selling in the calls. This much is known, and indisputable.

The next question is - why is there so much more buying in the put than the call?

At this point objective fact ends and theory begins. Nobody can say with absolute certainty why. It seems obvious to me that it results from the fact that the world is long stock, which puts a premium on the put as insurance against a market decline. But that's just my best guess - I can't prove it.

Interesting. Truth be told, I really don't know the answer and am definitely not at your depth of expertise, that was just a theory I had in my head to explain the skew in a way which made sense to me.

I hope I have not misunderstood your explaination, but if your theory/observation is true, and we see most stocks/stock indices having a volatility smile with far OTM calls and puts having very high IVs compared to the ATMs, what does this imply? It has to imply that someone is buying lots of these options (not just the puts but the calls also) and there're more buyers than sellers?

Intuitively, I would think there'd be more sellers of OTM calls than buyers. Unless institutions had some reason to want to buy far OTM calls.

 

[dmo]

Quote from hlpsg:

Interesting. Truth be told, I really don't know the answer and am definitely not at your depth of expertise, that was just a theory I had in my head to explain the skew in a way which made sense to me.

I hope I have not misunderstood your explaination, but if your theory/observation is true, and we see most stocks/stock indices having a volatility smile with far OTM calls and puts having very high IVs compared to the ATMs, what does this imply? It has to imply that someone is buying lots of these options (not just the puts but the calls also) and there're more buyers than sellers?

Intuitively, I would think there'd be more sellers of OTM calls than buyers. Unless institutions had some reason to want to buy far OTM calls.

There's actually no "smile" of volatility in index options. Starting with the lowest strike, every higher strike trades at a progressively lower IV - all the way up to the highest strike. So the far OTM calls actually trade at a lower volatility than the ATM's. Instead of a smile, the "curve" looks more like a flat board with the far right side lower and the far left side higher.

 

[hlpsg]

Quote from dmo:

There's actually no "smile" of volatility in index options. Starting with the lowest strike, every higher strike trades at a progressively lower IV - all the way up to the highest strike. So the far OTM calls actually trade at a lower volatility than the ATM's. Instead of a smile, the "curve" looks more like a flat board with the far right side lower and the far left side higher.

This seems to be more true of the longer term options than of the nearer term. Why is this?

I've attached an example of the SPX volatility curves of different expiration months.

Even as far out as the MAR09, there is still some evidence of a smile on the upside. This smile is very obvious for months closer than MAR09.

I did the same for RUT, and the smile is evident in the SEP08 and OCT08 options.

For NDX, up to and including the OCT08 expiration, you can see evidence of a smile.