I would venture a guess that it's not true and that there is consistent overpricing of implied volatility over realized, even for ATM options on boring stocks. Every convexity in the market has a slight risk premium to it, implied volatility is no an exception. If anything, event risk is probably fairly priced given that there are a lot of people thinking about it who really undestand the stock and the event.
Questions about credit spreads!!! Help me!
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Maybe for a price taker but I highly doubt that is true for a MM. In fact, there have been countless studies, I believe the CBOE did a white paper, showing that OTM calls are perpetually under priced due to the preponderance of covered call sellers. It's also why the call skew in most indices is negative, not flat. The market seems to be a net seller of upside calls and a net buyer of downside puts in general. And like I said, if there is any over pricing on ATM's, it's so slight that most retail traders will not capture it if they are price takers. Just my opinion of course.
(a) I don't buy the overpricing of the index calls. If anything, longer-dated index calls are mostly overpriced (even with the skew) in most situations. Synthetic ways of selling upside vol, such as up-and-out calls produced great returns, especially over the last few years. This must be one of the situations where theory and practice diverge
(b) If implied vol is fairly priced from the realized perspective, it's under-priced from the beta perspective. If I can buy vol that will realize at B/E in regular environment, it would be a free option in case of a market-wide blowup.
(c) I am not suggesting that you should always be short vol, I am just saying that fairly-priced convexity is almost impossible to come by, there is too much incentive out there to be long convexity. If by some miracle you have different utility curve (i.e. you have capital and can afford to wait), then trying to find rich convexity to sell is an easier and better expectation trade then trying to find cheap convexity to buy.
Quote from sle:
(a) I don't buy the overpricing of the index calls. If anything, longer-dated index calls are mostly overpriced (even with the skew) in most situations. Synthetic ways of selling upside vol, such as up-and-out calls produced great returns, especially over the last few years. This must be one of the situations where theory and practice diverge
(b) If implied vol is fairly priced from the realized perspective, it's under-priced from the beta perspective. If I can buy vol that will realize at B/E in regular environment, it would be a free option in case of a market-wide blowup.
(c) I am not suggesting that you should always be short vol, I am just saying that fairly-priced convexity is almost impossible to come by, there is too much incentive out there to be long convexity.
Long dated perhaps, most of the covered call community is front month. And yes, I do believe long dated calls are under priced as well although perhaps for different reasons then you. I believe long dated calls don't accurately reflect long term trends in risk assets especially in a world where the Fed is providing the put.
Beta is very hard to quantify. It would not surprise me if the market was offering cheap upside beta because truthfully, I've never seen a robust long term model that captures it. Not saying it's not out there, but it's harder then it looks.
Convexity maybe attractive but not when you have investors. If your "convexity" doesn't pay off quickly enough, well, you won't have to worry about convexity much longer. LOL.
Also, I'm not saying options are fairly priced. I'm saying they are not priced in such a way one can arbitrarily sell them with impunity without regard to value month after month and expect a positive return. I've always believed that as long as fund managers get a 2/20 to sell juice, they will do so and do so in size. The convexity is not an issue to them when they blow up as they don't have to repay their investors. We live in a giant financial world where the incentives lie in selling juice no matter how cheap because that is what pays.
Just ask Dr. Bury if it's worth it being long convexity. He got paid, but he'll never do it again with investors.
This has nothing to do with upside or downside, it has to do with risk premium. If the implied vol for a single stock is realising break-even in a low-vol (normal) environment, it's a free option in a blow-up environment. So, any implied vol would be a combination of "actuarial" volatility and "beta" volatility. While the actual value of that market (beta) component of vol is not clear, an option that is only pricing idiosyncratic volatility is a great buy. Think of it, for a sec, as a "selective" dispersion play vs index vol - it will all make sense.
This is a bit beyond the scope of this thread, but I don't think you undestand the business model of either large funds or banks well enough to make these statements. I will expand on that after the close, gotta go do work.
So sle, I should disclose that my thinking on these issues is heavily influenced by people such as Taleb. I will post something from him here to add it to the mix. I'm not saying he is right or wrong. Just that my views are influenced by his work.
http://www.project-syndicate.org/commentary/the-great-bank-robbery
"Mainstream megabanks are puzzling in many respects. It is (now) no secret that they have operated so far as large sophisticated compensation schemes, masking probabilities of low-risk, high-impact âBlack Swanâ events and benefiting from the free backstop of implicit public guarantees. Excessive leverage, rather than skills, can be seen as the source of their resulting profits, which then flow disproportionately to employees, and of their sometimes-massive losses, which are borne by shareholders and taxpayers.
In other words, banks take risks, get paid for the upside, and then transfer the downside to shareholders, taxpayers, and even retirees. In order to rescue the banking system, the Federal Reserve, for example, put interest rates at artificially low levels; as was disclosed recently, it also has provided secret loans of $1.2 trillion to banks. The main effect so far has been to help bankers generate bonuses (rather than attract borrowers) by hiding exposures.
Taxpayers end up paying for these exposures, as do retirees and others who rely on returns from their savings. Moreover, low-interest-rate policies transfer inflation risk to all savers â and to future generations. Perhaps the greatest insult to taxpayers, then, is that bankersâ compensation last year was back at its pre-crisis level.
Of course, before being bailed out by governments, banks had never made any return in their history, assuming that their assets are properly marked to market. Nor should they produce any return in the long run, as their business model remains identical to what it was before, with only cosmetic modifications concerning trading risks."
http://www.project-syndicate.org/commentary/the-great-bank-robbery
"Mainstream megabanks are puzzling in many respects. It is (now) no secret that they have operated so far as large sophisticated compensation schemes, masking probabilities of low-risk, high-impact âBlack Swanâ events and benefiting from the free backstop of implicit public guarantees. Excessive leverage, rather than skills, can be seen as the source of their resulting profits, which then flow disproportionately to employees, and of their sometimes-massive losses, which are borne by shareholders and taxpayers.
In other words, banks take risks, get paid for the upside, and then transfer the downside to shareholders, taxpayers, and even retirees. In order to rescue the banking system, the Federal Reserve, for example, put interest rates at artificially low levels; as was disclosed recently, it also has provided secret loans of $1.2 trillion to banks. The main effect so far has been to help bankers generate bonuses (rather than attract borrowers) by hiding exposures.
Taxpayers end up paying for these exposures, as do retirees and others who rely on returns from their savings. Moreover, low-interest-rate policies transfer inflation risk to all savers â and to future generations. Perhaps the greatest insult to taxpayers, then, is that bankersâ compensation last year was back at its pre-crisis level.
Of course, before being bailed out by governments, banks had never made any return in their history, assuming that their assets are properly marked to market. Nor should they produce any return in the long run, as their business model remains identical to what it was before, with only cosmetic modifications concerning trading risks."
Maverick74
I really appreciate your thoughtful posts.
Can you recommend some books or other resources specifically dealing with the real world math you speak of?
There are a ton of books out there ranging from stochastic calculus to derivations of the BS formula. It would be great to be able to sift through all this info to the math that is really needed to be a successful options trader.
I really appreciate your thoughtful posts.
Can you recommend some books or other resources specifically dealing with the real world math you speak of?
There are a ton of books out there ranging from stochastic calculus to derivations of the BS formula. It would be great to be able to sift through all this info to the math that is really needed to be a successful options trader.
More back to the topic of this thread. Here is an older article I found from Taleb on options that some of you will find interesting.
http://www.fxtsp.com/education/fx-t...ew-with-top-trader-nassim-nicholas-taleb.html
http://www.fxtsp.com/education/fx-t...ew-with-top-trader-nassim-nicholas-taleb.html
Very shortly before I have to dive back
On the hedge fund side, you are making a key mistake in thinking that fund managers actually care about returns (which makes sense, you are a prop trader after all). They mostly don't.
The majority of the large fund mangers only care about the size of AUM. Everyone knows that the way to get rich is to play the long game collecting 2 points on a few yards for years in a row and getting 20% of an occasional punt. Steady returns are simply another way to attract and retain capital, rather then a purpose of the business. Some funds have actually made a (honest) leap and became asset managers rather then funds (e.g. AQR).
Given that the key is raising AUM, simply being a naked seller of convexity is not the way to build a 10bn fund - you'd never pass DD. Instead, everyone wants (and builds) a multi-manager structure and manages it as a basket of options. For a long-term scam, you have to force tight risk limits on your managers and very few of them have room to sell convexity and many of them (especially LS guys) are actually hedging their market exposure.
I'll get to the bank business later.
On the hedge fund side, you are making a key mistake in thinking that fund managers actually care about returns (which makes sense, you are a prop trader after all). They mostly don't.
The majority of the large fund mangers only care about the size of AUM. Everyone knows that the way to get rich is to play the long game collecting 2 points on a few yards for years in a row and getting 20% of an occasional punt. Steady returns are simply another way to attract and retain capital, rather then a purpose of the business. Some funds have actually made a (honest) leap and became asset managers rather then funds (e.g. AQR).
Given that the key is raising AUM, simply being a naked seller of convexity is not the way to build a 10bn fund - you'd never pass DD. Instead, everyone wants (and builds) a multi-manager structure and manages it as a basket of options. For a long-term scam, you have to force tight risk limits on your managers and very few of them have room to sell convexity and many of them (especially LS guys) are actually hedging their market exposure.
I'll get to the bank business later.