Option Pricing Efficiency

[spindr0]

Quote from jazzguysoca:

The reason I'm asking is that I'm considering adding options to a stock trading strategy in order to increase my Calmar ratio and protect myself from Black Swans, and am trying to get a handle on how much of my annual returns I'll have to give up for that privilege.

ie: If adding married puts to my longs will only cost me ~2%/year, then its definitely something I should be doing. But if the costs are more significant, than it might be too prohibitive.

Portfolio analysis is also above my pay grade. But be that as it may, I think performance measurements like the Calmar Ratio are a bit esoteric and not necessarily that relevant. You can raise the ratio by lowering your maximum drawdown but that's just a statistic - you can still lose money consistently despite doing that.

Back to options. They're very versatile and when combined in various ways, they can produce similar returns of other positions. In this case, put protected stock is equivalent to buying calls. I think that if you ask anyone who has experience with options about the likelihood of making money by trading long options, they'll say that it's not likely unless you have a serious edge in your timing and selection. Apart from the slippage and commissions that you've mentioned, time decay is a killer.

IMHO, if you're going to explore hedging, I'd also take a look at collaring positions to offset the cost of the protection (sell OTM call to buy put). You can place the collar anywhere you want.
If limiting the upside is a concern, selling further calls will give you more room to profit but the offset is a higher cost of protection. If your portfolio is large enough, you can reduce the cost of hedging by using correlated index options (naked OTM calls/long puts).

 

[dcvtss]

Quote from spindr0:

IMHO, if you're going to explore hedging, I'd also take a look at collaring positions to offset the cost of the protection (sell OTM call to buy put). You can place the collar anywhere you want.
If limiting the upside is a concern, selling further calls will give you more room to profit but the offset is a higher cost of protection. If your portfolio is large enough, you can reduce the cost of hedging by using correlated index options (naked OTM calls/long puts).

Every time I have tried this the skew slants the R/R so much that I feel like I might as well just pay for the puts and not limit the upside or just sell the underlying if I am that concerned about it taking a nose dive. Maybe if you leg in it is better but then there are risks associated with that too. Has this been anyone else's experience?

 

[spindr0]

Quote from dcvtss:

Every time I have tried this the skew slants the R/R so much that I feel like I might as well just pay for the puts and not limit the upside or just sell the underlying if I am that concerned about it taking a nose dive. Maybe if you leg in it is better but then there are risks associated with that too. Has this been anyone else's experience?

How does the collar slant the R/R so much? It would seem to me that if you collar, then the only issue is if you have an edge in selection. If so, you make. If not, you lose. In both cases, limited, but they edge is the difference.

Legging in is good for those who can do it, bad for those who can't . Collaring is good for those who work well in the middle, bad for those who have better timing, selection, money management and luck. There's no "one size fits all" answer.

If you're looking at simultaneous execution, you're better off trading the equivalent which is the vertical.

 

[jazzguysoca]

Quote from Martinghoul:

Jazzguy, I think you're taking the whole concept of mkt efficiency to a rather uninteresting extreme. In theory, a randomly chosen portfolio of any instruments, not just options, will return the risk free rate less transaction costs, if sampled over a large enough number of iterations. If you're trying to look into systematically using options to protect your portfolio, that's a subject that has been much studied in academia. The outcome of most such studies is, unsurprisingly, that there's no free lunch.

Hmm.. I had never thought of it from that perspective. My guess is that if you were to randomly sample a basket of Nas100 stocks you would end up with an annualized return in the area of the rate of inflation. And since inflation factors into interest rates, then I suppose it follows that those sampled returns would be some factor of the risk free rate.

Note that I never expected a free lunch; I assume that I will have to surrender some return for the cost of the puts. I'm just trying to get a sense of how much said lunch is going to cost


Also, I'm sure that hedging a stock trading system with puts is neither an original idea nor an "exciting" one from the standpoint of someone who seeks to trade option with an edge.

However, if I can transform a simple EOD momentum system with a 50% annualized return / 50% max drawdown into 30%/10% via the use married puts / synthetic calls, I'd find that quite exciting. Why? Because I can use portfolio or prop margin to scale it up to a 60%/20% or 90%/30% system.

 

[jazzguysoca]

Quote from atticus:

Expectancy is the same for buyer and seller, if it's not already been mentioned.

Interesting...So you're basically saying that the expectation of both option sellers and buyers is zero (sans transaction costs)?

But doesn't this contradict the Black Scholes model? My understanding of the BSM is that basically option buyers can expect to pay (and option sellers can expect to collect) the current risk free rate (sans transaction costs), regardless of the current price, strike, volatility, etc of the options in question.

From a non-option traders perspective, it seems to me that a option buyer should expect to pay some premium for transfering a portion of risk to the option seller (who should expect a premium for accepting that risk). The BSM model seems to reflect this perspective, assuming I'm understanding it correctly.

 

[jazzguysoca]

Quote from rew:

It's been a while since I read Natenberg or Sinclair but I don't recall anything about selling options at random giving you the risk free return. The theoretical option price sets the option price to the present value of its expected value at maturity. The ask is set a little higher and the bid is set a little lower, so traders without an edge who buy at the ask and sell at the bid will lose a little bit whether they buy or sell.

Even if you could earn the risk free rate of return by selling options without an edge you'd be nuts to do so -- you'd make the same money buying a Treasury bond and sleep much better at night.

I don't believe there is anything about buying/selling options at random in either of the books; That was just a thought experiment whose outcome I felt was implied by the Black-Scholes formula. So far no one has gone on record to claim otherwise, so I'll assume it holds for now...

Obviously I'm not advocating that someone who is seeking T-Bill returns should sell calls and puts in a Monte Carlo fashion as a option trading strategy. He'd most likely end up with better than T-bill returns, but would pay for those with a terrible Sharpe.

Obviously if you want T-Bill returns, you should buy...(wait for it)...T-Bills, lol.

I'm just trying to get a sense of how much of one's return will need to be surrendered to add married puts to an existing successful stock trading strategy.

 

[atticus]

Quote from jazzguysoca:

Interesting...So you're basically saying that the expectation of both option sellers and buyers is zero (sans transaction costs)?

But doesn't this contradict the Black Scholes model? My understanding of the BSM is that basically option buyers can expect to pay (and option sellers can expect to collect) the current risk free rate (sans transaction costs), regardless of the current price, strike, volatility, etc of the options in question.

From a non-option traders perspective, it seems to me that a option buyer should expect to pay some premium for transfering a portion of risk to the option seller (who should expect a premium for accepting that risk). The BSM model seems to reflect this perspective, assuming I'm understanding it correctly.

No, it contradicts your interpretation. There is no +bias for sellers. BSM states that the vol surface should be flat, but of course it is anything but (flat).

 

[jazzguysoca]

Quote from spindr0:

Portfolio analysis is also above my pay grade. But be that as it may, I think performance measurements like the Calmar Ratio are a bit esoteric and not necessarily that relevant. You can raise the ratio by lowering your maximum drawdown but that's just a statistic - you can still lose money consistently despite doing that.

Actually, if you have access to leverage, the Calmar Ratio is extremely important statistic (assuming its positive - there's obviously no point in leveraging a system with negative return). A high Calmar combined with leverage allows one to dial in whatever absolute return desired, subject to the amount of risk one can withstand. Its a key metric (but not the only one) in my backtesting / system development process.

 

[atticus]

Quote from jazzguysoca:


I'm just trying to get a sense of how much of one's return will need to be surrendered to add married puts to an existing successful stock trading strategy.

Then compare the volatility of the underlying shares (stat-vol) to the volatility of the atm/otm call (implied-vol) that you're buying synthetically (long spot/long put; "married put"). That will give you a very rough prediction to expiration.

 

[jazzguysoca]

Quote from atticus:

No, it contradicts your interpretation. There is no +bias for sellers. BSM states that the vol surface should be flat, but of course it is anything but (flat).

Are you speaking from a short term/instantaneous or long term perspective?

ie: I have no doubt that each day, option pricing swings way outside of what is predicted by the BSM. But over time those swings would tend to cancel each other out, no?

Its seems contradictory to me that option sellers would receive no net premium at all for accepting Black-Swan risk, but then I've never traded an option contract yet in my life.

(Note I'm not disagreeing with you on this, just trying to learn something).