Long term options (LEAPS), should have a proportionately higher time value?

[Robert Morse]

So being off by 5% is acceptable? That's more than one option on a 1000 share hedge. Plus it only gets worse the longer-dated you go. Cox Ross is a bulletproof model, but it gets adjusted for Leaps.

Yes, it is. Have you considered that it is also based on assumptions that will be off too. Interest rates, dividends, Vol skew, etc. These are just estimates that should be used by retail clients as estimates. Making trading this complicated only detracts from more important items like stargegy, entry, exit etc. It is not necessary for a trader that wants to do a simple spread, buy a single option strike or do a buy - write for them to have that kind of detail all made from assumptions.

 

[ajacobson]

I use Greeks to hedge and to set expectation so accuracy is a plus. You don't save any money if your model is off and the price to get it a correct model is about the same. No trader should be satisfied would just "good enough." A 5% error would get a vendor an opportunity to correct their product or lose the business!

 

[newwurldmn]

I use Greeks to hedge and to set expectation so accuracy is a plus. You don't save any money if your model is off and the price to get it a correct model is about the same. No trader should be satisfied would just "good enough." A 5% error would get a vendor an opportunity to correct their product or lose the business!

I don’t agree. You can geek out on your model accuracy and miss out on the big picture. Of course everyone needs to determine how precise they have to be. At the extremes, an OTC dealer needs more precision than a buywrite fund.

 

[ajacobson]

Having a better model/estimate does mean you have to lose sight of the big picture. A 5% better hedge would cover all of our brokerage and telecom so we can't settle for close enough and I would argue nobody should.

 

[sle]

Having a better model/estimate does mean you have to lose sight of the big picture. A 5% better hedge would cover all of our brokerage and telecom so we can't settle for close enough and I would argue nobody should.

I think the argument is that everyone has to decide which are his primary risk factors and level of edge relative to these risk factors. Once you have that idea, then you can hedge out stuff that had much higher contribution while lower contributing risk factors such as divs etc can be left unhedged. E.g. if you are trading a 10 year S&P put delta-neutral, forward (discount rates/div blending etc) is a factor that contributes more than say implied volatility, so it makes sense to pay attention to these factors. If you are trading the same option untied as a large delta bet (a la you know who), all of the fuss around proper dividends is very much secondary to your delta risk.

 

[ironchef]

The longer the time, more chance something unexpected may happen (thus more volatility).

Besides, over a long time things may change so much that they become even more "unpredictable".
Although we just can't predict.

Thus LEAPS are underpriced, and short term options overpriced?

Here is an observation from an amateur retail's perspective:

As a retail I don't have all the fancy tools of the market makers to assess/hedge/arbitrage the options of various expiries, but my observations over the last 6 years playing options is the market on popular options are efficiently priced. In fact LEAPS are likely overpriced to compensate for the "unknown-unknown" you mentioned.

Checked the SPY option chains this morning. ATM call IV for 3-18-2019 is 7.9%; for 1-15-2021 is 16.5%; for 12-15-2021 is 17.5%. So, MM charged you > double for the LEAPS options.

As amateur retails we "play the leverage game" buying/selling single legs, under/overpriced is actually comparing if long dated options are cheaper/overpriced compare to buying the underlying on margins. If this is the way you trade, trading popular high volume options is likely not very profitable comparing to trading the benchmark underlying.

Comments are welcome.