Fundamental options question...

[Martinghoul]

For whoever is interested in expressing their view on a fundamental aspect of options (if anyone)... This arose from an argument we were having with someone on another forum.

It is often posited that realized vol is lower than implied vol and that relationship is statistically significant. This would imply that options are systematically overpriced. You could think of a few reasons why this might, in fact, be the case (aversion to mtm volatility, various behavioral biases etc). However, given this is a known condition, it should be arbed away, unless there's a fundamental supply/demand imbalance.

So, here's my question, in your view are options systematically too rich or too cheap?

 

[OddTrader]

A good question is the beginning of wisdoms!

 

[gkishot]

Quote from Martinghoul:


So, here's my question, in your view are options systematically too rich or too cheap?

For what symbol?

 

[Martinghoul]

Quote from gkishot:

For what symbol?

For all and any symbol/instrument/mkt...

 

[MTE]

This is the eternal debate, so to speak, between premium buyers and sellers. Buyers lose money most of the time, but then get a home run. Sellers, on the other hand, make money most of the time, but then get wiped out on that one trade where options turn out to be underpriced.

So, I guess, on average over a long period of time, options are fairly priced.

The key is to be a buyer when they are underpriced and a seller when they are overpriced.

 

[RF Global Macro]

Pro's sell hope. Lot's of buyers.

 

[nazzdack]

Quote from Martinghoul:
-----It is often posited that realized vol is lower than implied vol and that relationship is statistically significant. This would imply that options are systematically overpriced.
-----However, given this is a known condition, it should be arbed away.....
-----are options systematically too rich or too cheap?

1) The belief that options are "systematically overpriced" relative to their underlying is a deception. That's an improper apples-to-oranges comparison.
2) To "arb" it away would probably entail too much in the way of fees, slippage, capital losses and a desire for static implied volatility levels to make it worthwhile.
3) Are options systematically too rich or too cheap? Neither. They're priced "fairly". Why? Because in today's environment, options have become the "underlying".

 

[Martinghoul]

Yes, for sure...

Question is whether, in your view, there's a systematic supply/demand imbalance between buyers and sellers.

Here's my take. In general, vol supply comes from entities that are, structurally, in the insurance biz (insurers proper, asset managers, etc). These entities are able to sell vol with impunity because they don't mark to mkt. Regular investors who do mark to mkt, on the other hand, should be, by definition, buyers of options. To me, it seems like in modern finance, there are more buyers of options than sellers, so options appear systematically rich.

 

[Martinghoul]

Quote from nazzdack:

1) The belief that options are "systematically overpriced" relative to their underlying is a deception. That's an improper apples-to-oranges comparison.
2) To "arb" it away would probably entail too much in the way of fees, slippage, capital losses and a desire for static implied volatility levels to make it worthwhile.
3) Are options systematically too rich or too cheap? Neither. They're priced "fairly". Why? Because in today's environment, options have become the "underlying".

What are you talking about?

I am referring to the comparison between ex-ante value of options and their ex-post, realized return. Again, you just need to look at implied vs delivered vol to see the phenomenon.

I have no idea what you're referring to when you say 'options have become the underlying'.

 

[MTE]

Quote from Martinghoul:

Yes, for sure...

Question is whether, in your view, there's a systematic supply/demand imbalance between buyers and sellers.

Here's my take. In general, vol supply comes from entities that are, structurally, in the insurance biz (insurers proper, asset managers, etc). These entities are able to sell vol with impunity because they don't mark to mkt. Regular investors who do mark to mkt, on the other hand, are, by definition, buyers of options. To me, it seems like in modern finance, there are more buyers of options than sellers, so options appear systematically rich.

There cannot be more buyers than sellers as each contract has a buyer and a seller. You may say though that buyers tend to pay the ask, hence systematically overpaying for options.