Expectancy of ITM options

M

Muffhands

Hey ETs

Question for you:

So I understand that options are priced perfectly to reflect all possible outcomes. They generally all have an expectancy of zero over many many trades. For instance, if you sell a delta 0.10 option over and over again you will win 90% of the time and then 10% when you lose your larges will be large and the expectancy will converge to zero.

Does this also apply to using deep ITM options as a stock replacement? When you purchase a deep ITM option, you are essentially just long the stock, and the prob of the option becoming ITM does not seem to have as much of an effect because the option is priced based on the intrinsic value, although there is the extrinsic component. Any input here?

Thanks
 
Re-read and think about the statement "are priced perfectly"!
IMHO: A YES and a NO are both valid perspectives! -- Perhaps if you rephrase your "expectancy" to risk-adjusted expectancy, then it may be more accurate. -- since Implied Vol > Realized Vol on average.
The pricing is only as good as those placing the positions! -- Sometimes they are good, some times, not so much, but in general, and over time, they get better!
Making generalizations about specific outcomes can be "problematic"! (I think you already understand this, so pardon the absence of insight here)
 
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If I remember my CFA material correctly, options are priced so that a delta-hedged option position will return the risk free rate, assuming realized volatility ends up equaling implied volatility. It's just reversing the Black-Scholes equation and solving for i (risk-free int rate).

So, if you have a differentiated view on forward volatility relative to IV, your delta hedged option position would earn above the risk-free rate.

An ITM long option is more analogous to a leveraged stock position, although Black-Scholes also comes into play, due to the fact that options expire. That is above my paygrade though!
 
Muffhands said:
So I understand that options are priced perfectly to reflect all possible outcomes. They generally all have an expectancy of zero over many many trades. For instance, if you sell a delta 0.10 option over and over again you will win 90% of the time and then 10% when you lose your larges will be large and the expectancy will converge to zero.
More...
this statement probably applies to all strategies in the long term.
does it matter?
 
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Depends on the instrument.. but regardless you’re going to bleed the difference between the implied vol you’re buying and the realized vol. Backtest buying 10d SPX calls over the long haul and get back to us with your results.. it won’t be pretty.

ITM calls are going to be expensive relative to value especially depending on the current skew you’re buying into because of put/call parity. But you do get the benefit of a leveraged position and an absolute cap on risk. Movement of underlying will largely dictate your returns. All in all I was never able to find convincing evidence that deep ITM is on par with a levered long. More cons than pros vs. just trading the underlying at that point.
 
Try weighted deep in the money strangles if you want to target only vol because they also greatly reduce the vega convexity problems of out the money options. To the point of options versus stocks for delta an undeniable advantage is the leverage is mostly not charged for properly (in BS u need a massive stock position to replicate it) but there are better reasons. If you want to sell 10 million of apple with a target of x where x is less than the distance to the 10 delta strike. You could sell a 90 delta call in 10mm and the premium is 80bps of time value (the put price) plus the intrinsic value (the distance between the strike and the current spot). You make any delta move up to the strike plus the premium at expiry. Why is this less good than selling 10 million of apple using a 1 delta contract + any associated carry charges? If i look in 1 month im better off everywhere except 80bps through the strike assuming it costs you nothing to fund the 1 delta short which is wildly generous. To conclude in-the-money options are excellent ways to express delta views. I hope they don't start charging extra funding.
 
or at least i think it is worth considering for old school traders who make their money, often very successfully, in directional trading
 
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