Success in trading stocks a prerequisite for success in trading options?

[Profitaker]

Quote from CloroxCowboy:
For me that's enough proof that IV isn't doing what it claims to be (at least not very well). So any "fair value" derived from a flawed measure like IV will itself be flawed...and therefore not really "fair".

Fascinating !

So if (and I repeat IF) the future volatility of the underlying could be known in advance you still couldn't determine the "fair value" of an option on the underlying ?

If your answer is Yes, then that contradicts your assertion that IV is a flawed measure. If your answer is No, then I can recommend some good options books

 

[Maverick74]

Quote from CloroxCowboy:

Yes, I would agree that you can't use so much margin for an IC that the max loss would wipe out the account. Personally I would never open a position where the max loss would be > 5% of my account.

I don't agree that "options in liquid option chains tend to be priced fairly" because I honestly don't believe in the concept of fair value (as defined in this thread). All pricing models are flawed in some way. Using IV as an input to price is what I would call an "elegant flaw", in that all (for European options) or much of (for American options) the variability of the model is neatly consolidated in a single factor.

But IV itself has to be flawed, IMO, because it's largely fear-based. Invert an IV graph (available at CBOE website) and superimpose over the underlying price graph, and there's clearly a large negative correlation. For me that's enough proof that IV isn't doing what it claims to be (at least not very well). So any "fair value" derived from a flawed measure like IV will itself be flawed...and therefore not really "fair". It's the whole reason we can buy or sell option volatility for a profit. So suggesting that volatility plays are possible is inherently suggesting that fair value is an illusion.

I need to correct my earlier post: Rather than scalping and opening an iron condor at the same time, I meant to suggest opening a long straddle at the same time for black swan protection.

IC's are going to suffer far more damage in a flash crash then the stock example I gave. Especially if you use IB where they will auto-liquidate you at the worst prices. The stock example in most cases you would have had anywhere from 20 to 200 shares of SPY on. Even with a 10 pt drop that is only $200 to $2000. I would hardly call that a disaster. In fact, with the stock example, you might actually benefit in a flash crash. What if you were short 200 shares? You would have caught a lucky flyer. No such luck would result with an IC.

 

[SarahNGuyen]

Some unexpected knowledge about options (which I barely know) here, thanks everyone for sharing.

 

[Maverick74]

Quote from CloroxCowboy:

Yes, I would agree that you can't use so much margin for an IC that the max loss would wipe out the account. Personally I would never open a position where the max loss would be > 5% of my account.

I don't agree that "options in liquid option chains tend to be priced fairly" because I honestly don't believe in the concept of fair value (as defined in this thread). All pricing models are flawed in some way. Using IV as an input to price is what I would call an "elegant flaw", in that all (for European options) or much of (for American options) the variability of the model is neatly consolidated in a single factor.

But IV itself has to be flawed, IMO, because it's largely fear-based. Invert an IV graph (available at CBOE website) and superimpose over the underlying price graph, and there's clearly a large negative correlation. For me that's enough proof that IV isn't doing what it claims to be (at least not very well). So any "fair value" derived from a flawed measure like IV will itself be flawed...and therefore not really "fair". It's the whole reason we can buy or sell option volatility for a profit. So suggesting that volatility plays are possible is inherently suggesting that fair value is an illusion.

I need to correct my earlier post: Rather than scalping and opening an iron condor at the same time, I meant to suggest opening a long straddle at the same time for black swan protection.

Hey Cowboy, I noticed you only started trading options last year, in other words, you are a newbie. Last year you were asking questions about margin on covered calls. Fair enough. I want to suggest though since you really have not traded options long enough that you at least take what some of the more experienced guys here are telling you. Just a suggestion.

OK, on to fair value. Look, I'm of the same opinion as Nassim Taleb who believes options in general are severely under priced. All of them! But there is more to this statement. Over short periods of time and data sets, option values will appear to be over priced. It's a function of the small data set. This is because of the fat tails.

Over long periods of time, option prices resemble nothing even close to being fair. The reason for this is simple. The rare and isolated events that blow options up 100 to 1000 fold simply cannot be factored into the pricing equation. Otherwise there would be no buyers and no liquidity in the market. I actually posted about this many many years ago on here. Options are priced under normal conditions with the caveat emptor warning written below.

The concept of fair value is similar to the concept of god. You are not going to know what it is until it's too late. But all options have realized volatility at the end of any period of time and that we know after that period concludes. Therefore we can look back and see if the implied volatility at that time matched what the actual volatility was. Again, you will find under most circumstances that the realized vol matches the implied vol pretty closely. Except on those rare occurances where it's actually under priced by magnitude of orders.

As Taleb would say, the error is always to the upside, not the downside. In other words, sure in some circumstances the implied vol was 34 when it should have been 32. Nothing to write home about there. But on the upside you see examples where the implied vol was 25 and it should have been 200. As you can see, if one is going to error, they are better off assuming vol is priced too low rather then too high because the payoff for vol being a little too high is minuscule vs vol being too low.

 

[CloroxCowboy]

Quote from Maverick74:

IC's are going to suffer far more damage in a flash crash then the stock example I gave. Especially if you use IB where they will auto-liquidate you at the worst prices. The stock example in most cases you would have had anywhere from 20 to 200 shares of SPY on. Even with a 10 pt drop that is only $200 to $2000. I would hardly call that a disaster. In fact, with the stock example, you might actually benefit in a flash crash. What if you were short 200 shares? You would have caught a lucky flyer. No such luck would result with an IC.

I'm afraid you're using a strawman in that argument. Of course IB will auto-liquidate on a margin call, but as I stated earlier my personal max loss in an IC never exceeds ~5% of the total AV, it's not even using margin. So auto-liquidation doesn't apply to what I'd consider a sane style of IC. I can't argue that opening 90/10 risk-to-reward condors are a good idea, because they're not. Same for being so heavily margined that the max loss will trigger a margin call, not smart. But when my R:R is more like 30/70 and well below margin limits, your arguments are less convincing.

Also, maybe we should agree on a hypothetical account size for these discussions (I apologize if your previous example already had one...I missed it). Let's say for $100K account...you'd need to trade significantly more shares than 20 to 200 in order to make a decent yearly profit right? I'll let you pick the numbers, then we could begin to hash out the true risk of such positions.

The only thing I can really agree with in your response is that in certain situations a crash could be beneficial for an equity position where it wouldn't for options.

 

[CloroxCowboy]

Quote from Maverick74:

Hey Cowboy, I noticed you only started trading options last year, in other words, you are a newbie. Last year you were asking questions about margin on covered calls. Fair enough. I want to suggest though since you really have not traded options long enough that you at least take what some of the more experienced guys here are telling you. Just a suggestion.

I'm flattered that you took the time to investigate me, but I fail to see how it's material to the conversation at hand? Obviously it's some kind of ego-boost for you, and if that helps you feel more comfortable I don't mind. But what does it really matter if I've only been trading options a short time? Historical data is available to all, so I can easily look at all the market events that you were trading through. Perhaps you learned some valuable psychology through real trading (perhaps not also) that I can't get by simply analysing the data, but again...how does that really impact what we're talking about here?

I could just as easily "suggest" that since I've only been trading a short time and you imply you've been trading much longer, that I must be smarter than you since I'm grasping the ideas at a faster rate...but I'm not making that claim because it would be childish and I don't really know you...you don't really know me either. Let's keep our eyes on the ball, shall we?

OK, on to fair value. Look, I'm of the same opinion as Nassim Taleb who believes options in general are severely under priced. All of them! But there is more to this statement. Over short periods of time and data sets, option values will appear to be over priced. It's a function of the small data set. This is because of the fat tails.

Over long periods of time, option prices resemble nothing even close to being fair. The reason for this is simple. The rare and isolated events that blow options up 100 to 1000 fold simply cannot be factored into the pricing equation. Otherwise there would be no buyers and no liquidity in the market. I actually posted about this many many years ago on here. Options are priced under normal conditions with the caveat emptor warning written below.

The concept of fair value is similar to the concept of god. You are not going to know what it is until it's too late. But all options have realized volatility at the end of any period of time and that we know after that period concludes. Therefore we can look back and see if the implied volatility at that time matched what the actual volatility was. Again, you will find under most circumstances that the realized vol matches the implied vol pretty closely. Except on those rare occurances where it's actually under priced by magnitude of orders.

As Taleb would say, the error is always to the upside, not the downside. In other words, sure in some circumstances the implied vol was 34 when it should have been 32. Nothing to write home about there. But on the upside you see examples where the implied vol was 25 and it should have been 200. As you can see, if one is going to error, they are better off assuming vol is priced too low rather then too high because the payoff for vol being a little too high is minuscule vs vol being too low.

Honestly, I'm failing to see how this proves your theory that iron condors MUST be negative sum...or that "fair value" exists? Yes, I do understand what you're saying. Over the long-term, tails are fatter in reality than the option prices have implied and I agree. But if the short options I'm selling are underpriced, then the long options I buy as protection are similarly underpriced and it will net out, right?

I also agree with you that implied vol will usually end up to be a reasonable prediction of realized vol, but how is that a bad thing for iron condors? IV is not perfect and therefore I can exploit the imperfections in volatility using an IC. When IV ends up being wrong by orders of magnitude, I would prefer the protection that a sane IC provides over an equity stop that may not get filled. How is that foolishness?

 

[CloroxCowboy]

Quote from Profitaker:

Fascinating !

So if (and I repeat IF) the future volatility of the underlying could be known in advance you still couldn't determine the "fair value" of an option on the underlying ?

If future volatility was known in advance there would be no options market, or stock market, or any other market because everyone would know whether their bids or offers were correct and the "future losers" would never agree to trade at an unfair price. So yes, in that universe "fair value" of anything would exist on paper, it would just never result in a trade because each side would walk away with the same thing they had going in. In the real world we only end up having trades and markets for trading because both sides think they're going to win (or reduce their risk). So the argument is kind of a strawman right?

If your answer is Yes, then that contradicts your assertion that IV is a flawed measure. If your answer is No, then I can recommend some good options books

In that universe, IV is not a flawed measure. That's a pretty boring universe and I'm kind of glad it doesn't exist.

 

[MasterAtWork]

Quote from Maverick74:

Hey Cowboy, I noticed you only started trading options last year, in other words, you are a newbie. Last year you were asking questions about margin on covered calls. Fair enough. I want to suggest though since you really have not traded options long enough that you at least take what some of the more experienced guys here are telling you. Just a suggestion.

OK, on to fair value. Look, I'm of the same opinion as Nassim Taleb who believes options in general are severely under priced. All of them! But there is more to this statement. Over short periods of time and data sets, option values will appear to be over priced. It's a function of the small data set. This is because of the fat tails.

Over long periods of time, option prices resemble nothing even close to being fair. The reason for this is simple. The rare and isolated events that blow options up 100 to 1000 fold simply cannot be factored into the pricing equation. Otherwise there would be no buyers and no liquidity in the market. I actually posted about this many many years ago on here. Options are priced under normal conditions with the caveat emptor warning written below.

The concept of fair value is similar to the concept of god. You are not going to know what it is until it's too late. But all options have realized volatility at the end of any period of time and that we know after that period concludes. Therefore we can look back and see if the implied volatility at that time matched what the actual volatility was. Again, you will find under most circumstances that the realized vol matches the implied vol pretty closely. Except on those rare occurances where it's actually under priced by magnitude of orders.

As Taleb would say, the error is always to the upside, not the downside. In other words, sure in some circumstances the implied vol was 34 when it should have been 32. Nothing to write home about there. But on the upside you see examples where the implied vol was 25 and it should have been 200. As you can see, if one is going to error, they are better off assuming vol is priced too low rather then too high because the payoff for vol being a little too high is minuscule vs vol being too low.

It sounds very interesting, but...did Taleb make a killing during the crisis ? I mean in the real world ? Wait...I mean as a trader ?
You can't be serious.

Lots of recent models swap randomness with uncertainty, that means there is no distribution needed to price an option, and volatility lies within a range. Hence, there is a range of possible values for a single option. That way, no single fair price, thus no single fair value.

 

[Soon2Bgreat]

Quote from CloroxCowboy:

If future volatility was known in advance there would be no options market, or stock market, or any other market...

What exactly do you think the purposes of markets are?

 

[Maverick74]

Quote from MasterAtWork:

It sounds very interesting, but...did Taleb make a killing during the crisis ? I mean in the real world ? Wait...I mean as a trader ?
You can't be serious.

Lots of recent models swap randomness with uncertainty, that means there is no distribution needed to price an option, and volatility lies within a range. Hence, there is a range of possible values for a single option. That way, no single fair price, thus no single fair value.

Actually I believe he did. I can't speak for the magnitude of the profits but it's been written about all over the web. I believe 2008 was the best year his fund ever had. I should clarify, the fund he has an advisory role with. Much has been made that it's not "his" fund per se. I'm not going to argue over the semantics. Regardless, I believe his ideas are sound.