Quote from Eric99:
From what I understand, Mav has Taleb's strategy correct. Tony Saliba (in 'Market Wizards', among other places) did similar things (short ATM, net long wings) and he was able to bring in theta most of the time yet profit from extraordinary events. His strategy was able to take advantage of rare upside events as well as the more well-known crashes.
Is this just leptokurtosis at work here? Overpriced options within 1 STD, underpriced beyond 2 STD? Not to take another thwack at the great expectancy debate, but would like to have Mav's comments on this. Note that if everyone know the distro is shaped this way, then Wall Street, with a few Cray computers in their respective basements, would have exploited the inefficiency way - again leaving zero net expectancy to pricing. Mav? Others?
Eric,
Here is the rub. ATM options are generally the easiest to price. They are the most liquid and there is a generally a consensus agreement on vol. As you go further out, you have less activity and a much wider discrepancy on what vol should be, hence the vol skew. You will also notice the variance of the actual vol on the strips (wings) is much larger then the ATM vols. In other words, the ATM vols stay relatively constant while the deeper strikes move around much more.
So here is the deal, the ATM vols are pretty efficient for the most part (think of having a large data sample to analyze). The OTM options are very inefficient (very small data sample).
The ATM options are not really underpriced or overpriced per se. You are really just dealing with the vig that goes to the MM. OTM options though are drastically underpriced. Not over any one single strike or option, but over a large range of strikes and options. I stated the reasons for this underbracing earlier. You simply cannot price an unknown event into an option (because it's unknown).
Now as to the reason why everyone doesn't just buy these options, this is very simple. For the most part, the hedge fund industry and for the most part, even those people on this thread, live in an instant gratification society. From the hedge funds stand point, they don't have the luxury of having a bad month, or bad quarter in hopes of making the big score down the road. Many hedge funds can lose investors after just a few bad quarters ( and by bad I simply mean underperformance relative to their peers). No one wants to hang around for the "grand finale" so to speak. This is the primary reason this edge cannot be exploited.
Think of it this way. Suppose an angel came down from Heaven and told you to stand in the middle of a frozen field outside the city of Chicago in the dead of winter every day for 3 hours. And one day in the future, this angel would return and give you a suitcase with 100 million dollars. So every day you stand in that cold, frozen field waiting for that angel to return. Surely you are ambitious and hopeful and believe the wait will be worth it. But after awhile, you will question your sanity. You will grow tired, You will being to doubt and at some point, you will stop going to the field. Even if you later learned that the Angel eventually showed up, you wouldn't care anymore. Your desire is gone.
That is the rub. Now many here will say, how can one possibly profit from such a strategy. Surely no one will want wait forever in the hopes of a 10 sigma event right? And to that end, you would probably be right. But the moral of the story here is not to profit from such an event per se, but rather to make sure this event doesn't profit from YOU! The idea to understand here is we are all vulnerable to this "angel" coming, only not so much in an angelic form, but rather in the form of disaster. All it takes is one event (that no saw coming) to wipe out a lifetime of earnings and hard work.
What Taleb was trying to explain is not necessarily how to profit from such event, but how to avoid being hurt from the event. It just so happens that such an event will bring a windfall profit to him. This is simply an ancillary benefit though. The idea is to find ways to profit from the markets while at the same time, not blowing up from the "rare event".
Many people seem to miss this point. So it's not a matter of how to trade this strategy but rather an understanding.
