IV Smile and Firm Fundamentals

[lightfightercap]

Question:

Why trade delta neutral in a binary event?

Typically, we assess the probability of the binary event, if it is, in our opinion, different from market, we vote (bet)?

If you establish a delta neutral set up, you are essentially trading volatility and not directional?

Sure, if you are uninterested in direction but interested in collapsing or ramping IV, or some derivative of IV. These are the only types of trades I do.

Also, only one side can hemorrhage/lose at a time with two sided neutral strategies, so you can add the profit from one side to the loss you are experiencing on the other; this loss scenario is the most important to negate. Technically you are taking on more risk by playing both sides, but the actual risk to your portfolio is sometimes less and not priced into the options, although I assume sometimes it is. Depends how many neutral bets are being placed, I guess, but I could be wrong. This is why the margin for selling a strangle is less than the sum of margin for both individual options.

I would caution against managing trades whatsoever once you place them when trading binary events. Either they work as planned or they don't, but you give up whatever edge you may have had when you start placing trades under anything except ideal conditions.

How do you assess the probability of a binary event causing a price or other move different than anticipated?

 

[ironchef]

How do you assess the probability of a binary event causing a price or other move different than anticipated?

Appreciate your response, I learned something from you, thank you.

But let me answer your question: We dig into the fundamentals, be it FDA application of a drug, or the likelihood of shareholders approval of a merger/buyout. If our probability computation is different from what is priced into the options, we trade. A couple of examples: CELG/BMY and GILD/Remdesivir. One the jury is still out: BMY/RT.

Do you have any examples of delta neutral binary event trades?

Regards,

 

[.sigma]

If I replace the GBM/Gaussian in BSM with power laws, what is the equation I now use for my excel option price computation?

You can’t replace it. BSM ASSUMES GAUSSIAN.

If you want a different distribution you use a different pricing model

 

[ironchef]

You can’t replace it. BSM ASSUMES GAUSSIAN.

If you want a different distribution you use a different pricing model

Which pricing equation uses power laws? Can I program that in excel?

 

[.sigma]

Which pricing equation uses power laws? Can I program that in excel?

that’s the problem, pricing models don’t use power laws, or I’m not aware of any at least.

plus what are you trying to accomplish by programming power law option models in excel?

 

[.sigma]

Fundamental Analysis as a Trading Strategy:

“Fundamental analysis is usually the purview of large informed capital interests, which have the means and commercial contacts to analyze fundamental data more accurately than anyone else. The large amount of capital that these informed interests control can move the market price in the direction of expectations, at least over the short run. Speculation based on fundamental analysis, therefore, may be considered the domain of the large informed capital interests. By its character, successful fundamental analysis excludes the majority of small nonindustry speculators from participation, since they have neither large capital nor inside or informed industry information about supply and demand conditions.” - Allen Jan Baird

 

[.sigma]

Speaking of cross hybrid’ing market analysis, the infamous P/E ratio is a hybrid. Both technical/fundamental. Diving price by earnings, valuing the underlying. Interesting.

 

[ironchef]

what are you trying to accomplish by programming power law option models in excel?

Brokerage historical options data don't go beyond 6 months. Having a good option model that provides more accurate historical option prices allows backtest outcome that can better assess the validity of a strategy.

Buying data is OK but has limitations. Having the ability to calculate/derive gives one more flexibility to look at what drives the outcome.

 

[ironchef]

Sure, if you are uninterested in direction but interested in collapsing or ramping IV, or some derivative of IV. These are the only types of trades I do.

In your experience, is it easier to trade IV than directional?

Also, only one side can hemorrhage/lose at a time with two sided neutral strategies, so you can add the profit from one side to the loss you are experiencing on the other; this loss scenario is the most important to negate. Technically you are taking on more risk by playing both sides, but the actual risk to your portfolio is sometimes less and not priced into the options, although I assume sometimes it is. Depends how many neutral bets are being placed, I guess, but I could be wrong.

My experience was I paid dearly for taking both sides. My counter party usually took into consideration the neutrality and priced accordingly. If I trade directional he/she could to first order eliminated the directional bias through hedging and won't mind being wrong on direction?

Of course, it is amateurish reasoning and I need someone to tell me if I am wrong.

 

[.sigma]

Brokerage historical options data don't go beyond 6 months. Having a good option model that provides more accurate historical option prices allows backtest outcome that can better assess the validity of a strategy.

Buying data is OK but has limitations. Having the ability to calculate/derive gives one more flexibility to look at what drives the outcome.

you know what’s interesting? Options have been traded on exchanges well before the implementation of the Black Scholes Merton Model. How did these traders price options? Well it was more of a heuristic methodology. A feel for where spot was in relevance to your strikes. Moneyness was a feeling, not a mathematical output.

the more I study the more I’m realizing that these models are created for the benefit of academia and scholarly publishes, more so than benefiting reality.