IV Smile and Firm Fundamentals

@.sigma, I am thinking out loud here.

Aren't they simply stating the obvious: The market is efficient, all the prices, be it underlying or their derivatives include all the information available and are priced accordingly? As a trader all I care is how do I trade this? If they are correct, the only way I can trade and make money is when new information comes out and affect the "fundamentals". I only know two ways, I am lucky or I have inside information. They are telling me I was extremely lucky to come out ahead so far.

Not very reassuring for a retail trader with no way to get inside information.

By the way I didn't download the paper because I didn't want to register.
 
.sigma said:
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3639312

Link to the article
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Quickly went through this paper. The aspects I appreciated most of this paper were their methodology, references, and thought provoking ideas.

As far as the additional returns due to the fundamentals metrics they tested, meh.

I believe there are more impactive metrics, especially in the rhelm of the intangible.

A brief list tangible metrics to consider for testing:

1) Sales growth rates - Company performance
2) Price to sales ratio - Market valuation
3) Age of company - Long term growth potential and potentially favorable trading dynamics

I believe the ability to “Quantify” intangible metrics provides the greatest potential edges.

A brief list of intangibles for quantifying for consideration for testing:

1) Executive management styles - Bean counter, dynamic bean counter, process oriented, innovator, to name a few. Subset consideration is management style match versus sector or industry.
2) New product evaluation - The ability to identify a potential game changing product or service early usually requires active use of that product and specific industry knowledge.
3) Legislative changes - Can have profound positive or negative impacts on entire sectors or industries.

Another area I would like to explore is how to effectively structure option trades to take advantages of expected changes in implied volatility curves.

For reduced exposure to market volatility, spreads based on the tangible and intangible considerations combined with appropriate leverage may yield outperformance or at least risk adjusted return outperformance.

Thanks again for posting this thought stimulating paper.
 
First off,thanks for the thread.Interesting topic.Without having read the paper as of yet,I will say that market cap and industry probably has a greater influence on skew than any fundamental ratio..Obviously capital structure will have an impact,such as onerous debt to equity ratio levels,insufficient interest coverage etc.Altman Z score is a decent indicator to bust risk..

IMHO,fundamentals do not have a major impact on skew with relatively healthy major large cap stocks..Takeover risk is muted as opposed to a small cap biotech..

None the less,thanks for the post.Look foward to reading the paper
 
lightfightercap said:
I think the takeaway is in this paragraph on page 15/16: "The coefficients of the profitability, dividend-price and book-to-market ratios are positively significant, while the coefficient estimates are negative for the liquidity, investment, size and momentum, suggesting those fundamentals perform differently in determining the volatility smile shape, especially its symmetry. For instance, a firm with a smaller size suffers different downside and upside risk, resulting in a steeper volatility slope."


Also, this paper explains that they might be the first to lay out this relationship, although I doubt market makers would miss a pattern like this if it exists.

"In explaining the volatility curvature, skewness is negatively while kurtosis is positively significant. Stock with a smaller liquidity, profitability, investment, size and momentum, with a larger dividend-price ratio and book-to-market ratio has a significantly larger volatility curvature. The systematic ratio is significant in explaining the curvature"

This is also important; risk, which is of course associated with fundamentals, accounts for most of the volatility smile. This is consistent with what we already know about volatility.

Trading might look like this: Trading equities based on fundamentals likely to have an extreme smile at certain times should be limited to selling, equities with a shallow smile should be limited to buying.

Just getting closer to the way a MM might evaluate an option, if its valid/reliable, imo
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Assuming I understand and can do all of the modeling of IV vs fundamentals, how do I trade the information?

You probably will say if the IV is different from market, I can trade and make money. But how do I know the model is accurately enough to predict the future? After all I cannot use today's fundamental to predict the future value of the underlying to any significant level of accuracy and now I am using it to predict the future value of options?

After 7 years, I accept the fact that the only times I can make money in options are when the market makers, the market are wrong and I am right. So the challenge has always being on the lookout for being more right than everyone else. That is a tall order.
 
ironchef said:
Assuming I understand and can do all of the modeling of IV vs fundamentals, how do I trade the information?

You probably will say if the IV is different from market, I can trade and make money. But how do I know the model is accurately enough to predict the future? After all I cannot use today's fundamental to predict the future value of the underlying to any significant level of accuracy and now I am using it to predict the future value of options?

After 7 years, I accept the fact that the only times I can make money in options are when the market makers, the market are wrong and I am right. So the challenge has always being on the lookout for being more right than everyone else. That is a tall order.
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I have a one track mind, anything I read or do has to tie to trading. I am asking for guidance on how to apply the knowledge to trading.

I am not arguing against the study, in fact it is wonderful to be able to tie the option prices to some fundamentals of the underlying and it gives me some ideas to try out.
 
ironchef said:
Assuming I understand and can do all of the modeling of IV vs fundamentals, how do I trade the information?

You probably will say if the IV is different from market, I can trade and make money. But how do I know the model is accurately enough to predict the future? After all I cannot use today's fundamental to predict the future value of the underlying to any significant level of accuracy and now I am using it to predict the future value of options?

After 7 years, I accept the fact that the only times I can make money in options are when the market makers, the market are wrong and I am right. So the challenge has always being on the lookout for being more right than everyone else. That is a tall order.
More...

I sometimes have a hard time believing that a retail trader can compete with the resources of a market maker, that there could ever be an informational asymmetry in favor of us rather than a firm that makes money specifically ensuring they have a systematic advantage over especially retail traders

How might you prove such an asymmetry exists, since we can't know what kind of information a market maker has? Do you have examples of situations where you have information a market maker does not?

This seems like a tall order as you say; is it really possible?
 
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