Oh, THAT paper - he's not looking at far OTM puts but rather concentrates on the reachable strikes that can be delta-hedged and have some tangible premium. Personally, I think he does not really understand the options market and the driving forces behind it (most of the vol premium to the downside can be explained by correlation skew, IMHO), but it's not relevant here. The "black-swan hedges" are single digit delta that have no gamma or premium to speak of that would only be reached on extreme market event.
Profitability of Deep OTM options for "black swan" type volatility plays?
- Thread starter nxt7
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I agree,
There are better ways to make money in the market with options...rather then aiming for the 'rabbit' sprinter/hail mary approach.
Try a slightly more shorter, steady approach.
I didn't read that paper (yet)... but, are we discussing skew/smile here? And the reasons for it?
I remember once in Uni, my professor was skeptical about skew/smile... but then when I started in options trading it all made perfect sense.
You can't put everything down on volatility and use that as a single input. That's why Black&Scholes model has to be adapted to be workable in options trading.
IMO skew exists purely because of supply and demand. If an OTM costs 1/3 of ATM, you can buy a lot more insurance for a lot cheaper... so more demand. Also, puts are more expensive because market moves down a lot faster/panic down. And... the market is always net-long in stocks. Market moves up, net everybody wins... market down: net everybody loses. Therefore more demand for OTM puts than OTM calls.
This skew will invert to OTM calls in case of highly likely takeover risk.
As a market maker, you can sell some 'expensive' puts... and buy a shitload of very low value DOTM puts to lower your 'haircut'/downward risk.... say 50% down and vol spike...
In practice it makes sense....
I remember once in Uni, my professor was skeptical about skew/smile... but then when I started in options trading it all made perfect sense.
You can't put everything down on volatility and use that as a single input. That's why Black&Scholes model has to be adapted to be workable in options trading.
IMO skew exists purely because of supply and demand. If an OTM costs 1/3 of ATM, you can buy a lot more insurance for a lot cheaper... so more demand. Also, puts are more expensive because market moves down a lot faster/panic down. And... the market is always net-long in stocks. Market moves up, net everybody wins... market down: net everybody loses. Therefore more demand for OTM puts than OTM calls.
This skew will invert to OTM calls in case of highly likely takeover risk.
As a market maker, you can sell some 'expensive' puts... and buy a shitload of very low value DOTM puts to lower your 'haircut'/downward risk.... say 50% down and vol spike...
In practice it makes sense....
Actually, there are multiple components to the skew and each one explains a little bit. They are different for an index and for single stock. For an aspiring options trader, it's worth doing some simple excel work to understand each.
There is a realized volatility component - try taking some predictor of volatility (e.g. VIX index for 30 day vol) and then calculating realized volatility over the predicted period. The spread RV(t, T) - IV(t, T) is going to be highly correlated with ln[S(T)/S(t)] - this is your realized skew.
Then, there is a implied volatility component - plot the change of fixed strike volatility
IV(k, T| t + dt) - IV(k, T| t) as a function of ln[S(T)/S(t)]. It's a nice straight line and that's your implied vol (vega demand) skew.
So no, it's not PURE supply/demand imbalance. In fact, there are markets where there is structural supply of volatility when the market sells off and structural demand when it rallies and yet the skew persists in those markets.
PPS. Implied volatility for a single OTM strike is NOT the market prediction of the expected volatility. If the underlying moves in that direction, the P&L would be weighted by gamma through it's path. Instead, a close-enough prediction of the volatility along that path would be an average between the ATM implied volatility and OTM implied volatility. Just saying...
The paper isn't discussing skew/smile, it's another phenomenon entirely that appears to only exist in index options and specifically the S&P 500 puts and there isn't a great explanation for why it exists. Great paper when you get the chance to read it.
You have some serious patience if your gonna try to land a black swan event, hence where you get the name from. Option buyers look at serious gaps for EOD charts and day-dream about taking that massive slice of cheese from the market.
I guess this thread is just to talk about it.
From my basic understanding, just because you hit a small volatility event doesn't exaclt mean the option chains / IV aren't going to move with it. Now if you have entered in at low IV and you get a nice market move then you have got more than what you bargained for. However this doesn't (for the weeklies anyway) actually mean that IV will rise, hence the value of your options.
You might buy a directly ATM option and then land a once in a month volatility event and after the market moves seriously the new ATM option might be the exact same price!! Sure you might make a tonne of cash from the move however the IV may well not move at all.
I guess this thread is just to talk about it.
From my basic understanding, just because you hit a small volatility event doesn't exaclt mean the option chains / IV aren't going to move with it. Now if you have entered in at low IV and you get a nice market move then you have got more than what you bargained for. However this doesn't (for the weeklies anyway) actually mean that IV will rise, hence the value of your options.
You might buy a directly ATM option and then land a once in a month volatility event and after the market moves seriously the new ATM option might be the exact same price!! Sure you might make a tonne of cash from the move however the IV may well not move at all.
This is an interesting read; an interview with Taleb in which he discusses his beliefs around option buying. He is compared with Victor Niederhoffer, a man who he looked up to but whom inspired him to employ the opposite strategy in the market. He makes a good point about option buying. It's not as simple as just buying DOTM though.
http://www.newyorker.com/magazine/2002/04/22/blowing-up
http://www.newyorker.com/magazine/2002/04/22/blowing-up
Listen to sle, he knows what he's talking about...
In my space, you can do all sorts of work to figure out the dynamics of skew (represented often by the "backbone"). In fact, this is the holy grail, it's very hard to do and it's still very much a work in progress.
If you want to understand the theoretical reasons for the existence of skew, IMHO, behavioural finance offers some potential answers. Specifically, it's about the utilities of relevant mkt participants and the limits to arbitrage. Behavioural finance concentrates on both of these topics.
In my space, you can do all sorts of work to figure out the dynamics of skew (represented often by the "backbone"). In fact, this is the holy grail, it's very hard to do and it's still very much a work in progress.
If you want to understand the theoretical reasons for the existence of skew, IMHO, behavioural finance offers some potential answers. Specifically, it's about the utilities of relevant mkt participants and the limits to arbitrage. Behavioural finance concentrates on both of these topics.
But would those markets have an inverted skew? Like bond usually do, which have skew to their upside since panic selloffs usually buys into bonds? Or in merger/takeover situations?
I wonder how the skew in bond options is these days with such a low yield. I would think it's to their downside now...
Good points as well on that IV of OTM usually isn't the prediction of expected vol when we hit that level. Fact is, it can be all over the place... depending on panic, how fast the move is, etc. And yes... also market down vol down is a possibility. That's why I would never hedge a VIX trade with S&P500 futures... it works up to an extend and then it's out of the window...