Options on options

[mutluit]

Quote from rocky_raccoon:

If you're a seller and you choose what option to sell: $3 on the UL or $.002 on the 2nd degree option, while your potential loss is about the same, which one would you choose?

My point is that no one would sell an option for $.002 if a similar option could be sold for $3.

Of course a buyer would rather buy .002 option but who would sell it to him?

Now, if you change IV in the BS formula you would arrive to the values of all tree degrees options to be very close to each other.

I understand your POV.
But following this logic does create arbitrage where it shuldn't... So, something must be wrong, isn't it?
And, whether adjusting the IV is the answer, I'm not sure, maybe it really is.

 

[rocky_raccoon]

Quote from mutluit:

I understand your POV.
But following this logic does create arbitrage where it shuldn't... So, something must be wrong, isn't it?
And, whether adjusting the IV is the answer, I'm not sure, maybe it really is.

I was just following though on your prices example. It does present an arbitrage opportunity by the way it is calculated. That's why I asked my question. If we remove arbitrage, then all three options will have to have the same price but in this case there is no need for N-th degree options.

 

[mutluit]

Quote from rocky_raccoon:
I was just following though on your prices example. It does present an arbitrage opportunity by the way it is calculated. That's why I asked my question. If we remove arbitrage, then all three options will have to have the same price but in this case there is no need for N-th degree options.

Yes, I understand, thx.
It's a complicated field, and I'm not a researcher, so I'm shelving these not yet ripe ideas of mine, and instead will take a look at the already existent barrier option products that was mentioned in the other postings.

 

[rocky_raccoon]

Quote from mutluit:

Yes, I understand, thx.
It's a complicated field, and I'm not a researcher, so I'm shelving these not yet ripe ideas of mine, and instead will take a look at the already existent barrier option products that was mentioned in the other postings.

Correct me if I am wrong, but these barrier options look similar to OTM butterflies or condors. In case of OTM condor, UL must trade between inner strikes (similar to barrier condition) for the spread to be profitable. Of course, the spread does not lose value immediately if UL get out of the inner strike range but the overall idea is similar.

 

[atticus]

Quote from rocky_raccoon:

Correct me if I am wrong, but these barrier options look similar to OTM butterflies or condors. In case of OTM condor, UL must trade between inner strikes (similar to barrier condition) for the spread to be profitable. Of course, the spread does not lose value immediately if UL get out of the inner strike range but the overall idea is similar.

Up and out calls are similar to a bullish fly, but the barrier (KO) strike differentiates. The fly may mean-revert and will retain some value outside the wing-strikes, but the KO call does not invert gamma and is dead if knocked-out prior to expiration.

 

[asap]

Quote from sle:

Not true. Exotics do tend to isolate specific risks and you can frequently find something that has higher statistical edge then regular options. For example, up-and-out calls have been statistically advantageous, especially if you have the right screening approach.

all i said was options are priced for perfection and complex exotics required further hedging because the asymmetrical payout scheme they provide, hence market makers have to increase their margin (bid ask spread) on those products.

hence, expectancy, ceteris paribus, is always better (yet negative) trading calls and puts outright than with packaged exotics.

if you have a screening method for increasing expectancy, you're better off using it with plain options instead of exotics.

 

[sle]

Quote from asap:

all i said was options are priced for perfection and complex exotics required further hedging because the asymmetrical payout scheme they provide, hence market makers have to increase their margin (bid ask spread) on those products.

hence, expectancy, ceteris paribus, is always better (yet negative) trading calls and puts outright than with packaged exotics.

if you have a screening method for increasing expectancy, you're better off using it with plain options instead of exotics.

Exotics are definitely priced imperfectly (it's an art, not a science), while margins on flow exotics (at least in equities) are paper-thin since the products are a commodity by now. Most index structured products desks survive either on fat retail flow (e.g. guys at Merrill) or on taking flow-style risks (that was my game). Also, because of the lopsided flow and specific risk preferences, there are a lot of structured products that have known mis-pricings, yet it's the kind of isolated risks that is very hard to exploit in vanilla options (e.g. continuous barrier options are not the same thing is a simple 1x2 or a fly).

I am not going to argue this much further, given that there is clear informational and educations asymmetry - up until this July, I ran an equity index book for a large IB.

 

[mutluit]

Quote from rocky_raccoon:
Correct me if I am wrong, but these barrier options look similar to OTM butterflies or condors. In case of OTM condor, UL must trade between inner strikes (similar to barrier condition) for the spread to be profitable. Of course, the spread does not lose value immediately if UL get out of the inner strike range but the overall idea is similar.

Hmm. Sorry, I don't have that much experience yet with options trading nor with barrier options to be able to make a comparision between them. I hope the other replies have attempted to address this issue.
BTW, I have given up on the barrier options idea, and any other exotic options, b/c it's too complicated / too time-consuming for me. At the moment vanilla options (basic long Puts and Calls only) are sufficient for me.

 

[sle]

Quote from rocky_raccoon:
Correct me if I am wrong, but these barrier options look similar to OTM butterflies or condors. In case of OTM condor, UL must trade between inner strikes (similar to barrier condition) for the spread to be profitable. Of course, the spread does not lose value immediately if UL get out of the inner strike range but the overall idea is similar.

The key difference is the value of continuous barrier observation and how that value relates to the skew. In general, continuous barriers are too rich.