Buying deep OTM call options on value stocks

[ironchef]

Modern portfolio management and the whole idea of being able to quantify risk-adjusted returns is bullshit. Volatility is not risk. Volatility is opportunity to buy things for less than they're worth.

As a non economist and one without formal finance training, I have the same question on volatility vs risk of an asset. To me, initiatively, modern portfolio theory make a lot of sense but I question if volatility can represent risk as you mentioned?

I often thought about what you said: When an asset/asset class is more volatile, it is usually defined as more "risky" because in a down market, it drops more than a non volatile asset. But for someone with a long view perhaps it is really not as risky (e.g., small cap index) as volatility indicated. Might it then make sense to purchase it during those down markets?

There are many legitimate shortcomings of modern portfolio theory, but since it does not claim that volatility is risk it doesn't make much sense to criticize that.

May I ask: how then does MPT define risk? I saw a lot of write ups using the Beta of the stock to calculate risk vs return. Isn't Beta a measure of volatility?

In any case, Scrooge, thanks for providing me some foods for thoughts. On a side note, I agree with the others that ATM may appear expensive but from a probability and statistically sense it is not necessarily so. Intuitively, as I go higher and higher in strike (more OTM), I will reach a point where the strike is so high that the probability of the stock reaching that strike is zero and the option will expire worthless every time. There must be an optimum strike price for risk vs return for each situation but I am not smart enough to know what that is.

Regards,

 

[tradelosses]

Options are almost always too expensive. that's why selling them tends to be profitable

 

[1245]

Options are almost always too expensive. that's why selling them tends to be profitable

Not always true. An option can be priced low/high vs future price movements of that underlying or vs some other assets that replicates it or is highly correlated. You just have to focus on your strategy and your edge and do what makes sense to you.

1245

 

[newwurldmn]

I personally believe there is a strategy in what Scrooge is saying. However, it would require a lot of fundamental work (which most Elite Traders don't believe in). LEAPs aren't that liquid, so long/short funds don't use them to express their views as much (meaning that there are likely to be vol mispricings); and having some fundamental understanding of the company can refine your view of the distribution the stock can take.

 

[ironchef]

So I have a strategy that involves identifying great companies at a low implied volatility and low price relative to intrinsic value and then buying some 1 year deep OTM call options. It worked pretty well with Wells Fargo in April 2013 when I tripled my money in a month. The whole black scholes model assumes the random movements of the market are unbiased. But if you find something where the movement is definitely biased in a particular direction, and that option is long dated enough for that bias to be relevant, then black-scholes can be very wrong... Empirical studies have found that on a long term average, writing puts is the most profitable, calls are neutral, and buying puts is unprofitable. That's about what you would expect a priori from the combination of two things: 1. the long term upward bias of stock movements, 2. fact that implied volatility is higher than realized volatility. When you're trading puts, both factors work in the same direction, but when you're trading calls, they cancel out. Unless you find a rare situation where ivol is low and the upward bias of the underlying is high, like I try to do. I guess you could also do the reverse of that and sell calls when ivol is high and there's a downward bias. I did that with TSLA lately and also made bank... lately I've been looking at buying Hormel 37.5 Jun calls but IB wants 5x the price of the calls in margin, what the fuck? It doesn't do that on other tickers.

I think generally what you said made some sense to me. But the devil is in the details. With so many smart people trading, the market should reflect all of what you said (via IV skews? among others) and there should be no advantage either ways when you make a statistically significant number of trades.

On a short term and non statistical sample basis, every scheme can claim success.

Regards,

 

[1245]

With so many smart people trading

That is making a big assumption that I find is not true over all. It is true that electronic MM keep prices generally in alignment, but those MM have a global dispersion model, and don't care about the future, as long as they can hedge in the next few seconds. If the world were so efficient, why would the VIX change as much as 10% on many days with no news? Why would hundreds of traders chase after OTM calls with market rumors of a takeover, only to see IVol drop the next day?

There is a lot of gambling and emotion with options that creates opportunity.

 

[ironchef]

I personally believe there is a strategy in what Scrooge is saying. However, it would require a lot of fundamental work (which most Elite Traders don't believe in). LEAPs aren't that liquid, so long/short funds don't use them to express their views as much (meaning that there are likely to be vol mispricings); and having some fundamental understanding of the company can refine your view of the distribution the stock can take.

I really appreciate what you said. It is the missing piece in Scrooge's strategy, though I don't agree with his DOTM part.

Thank you.

 

[ironchef]

That is making a big assumption that I find is not true over all. It is true that electronic MM keep prices generally in alignment, but those MM have a global dispersion model, and don't care about the future, as long as they can hedge in the next few seconds. If the world were so efficient, why would the VIX change as much as 10% on many days with no news? Why would hundreds of traders chase after OTM calls with market rumors of a takeover, only to see IVol drop the next day?

There is a lot of gambling and emotion with options that creates opportunity.

I am not familiar with the detail working of the market, what you are saying is if the counter party is the MM, they don't care about the long view, applying only the no arbitrage principle for their price, and as a result just hedge away any risk they have and make money on the spread and commissions?

Thanks for your response allowing me to learn something new.

 

[1245]

One other think to consider with the topic,"Buying deep OTM call options on value stocks."

Everyone can have their own description of a value stock, but I think we can all agree they tend to have lower growth and pay higher dividends. The advantage to buying "value" stocks are their expected dividend flows and lower volatility than the market. Buying OTM calls means you lose the dividend flow. The OTM calls will likely be low priced, dollar-wise, because there is a low expectation of going in the money. There is also the expectation that the stock will move less. I would think I'd be more interested in buying OTM calls on volatile stocks, because a stock portfolio would have added risk, while the OTM options have a defined risk.

 

[1245]

I am not familiar with the detail working of the market, what you are saying is if the counter party is the MM, they don't care about the long view, applying only the no arbitrage principle for their price, and as a result just hedge away any risk they have and make money on the spread and commissions?

Correct. Most of the markets you view are MM markets supplemented with customer orders. They will move their markets to supply/demand from multiple factors, not just that strike. They don't really make their money on the spread, as they rarely expect to buy on the bid after the sell on the offer. They are constantly hedging and altering their markets to attract buyers and sellers. They have what they consider "fair value" at that point in time vs everything else, and want to buy below that value and sell above, then hedge. They don't look at their position after they trade, only over all risk how every they value it.

"supply/demand from multiple factors" When I say this it sound very general. An example would be if they are selling a lot of options in QQQ, they might raise their option prices in a few of the components to get long options as a hedge.