What strategy works like selling DOTM naked call?

[FullyArticulate]

Quote from rallymode:
I never said fat tails arent included but i am saying that they arent properly accounted for in any of the models known to man. ... I take it you arent familiar with Taleb's work.

They aren't included in any model known to man? You're incorrect.

I am familiar with Taleb's work. I also know his hedge fund (which buys extremely OTM options in the hopes of getting that black swan) is doing horribly, whereas funds (LJM for example) that sell OTM options are doing great. LJM has been making money selling S&P options for 15 years. Taleb has been losing money since his fund's inception.

If you can properly compute the odds of an event happening, it doesn't matter which side of the bet you take. How do you think a bookie makes his living?

1) He makes a best guess of an event occuring. (You can't tell me you can compute the odds of an option expiring ITM any better than a bookie can compute the odds of the Red Sox beating the Yankees)
2) He adds vig to take his profit
3) He will happily take either side of the bet.
4) He adjusts the odds as he sees how the public is betting.
5) He hedges by betting on a secondary market.

Sound familiar? A market maker selling options:

1) Makes a guess about the option expiring ITM using his best probability model.
2) He adds a spread to take his profit
3) He will happily take either side of the bet
4) He adjusts the prices based upon whether he is buying or selling too many of a particular option.
5) He hedges by buying/selling deltas or gammas.

To avoid looping this debate ad nauseum, let me see if I can summarize our points of view...

I argued that it's not just the risk/reward that measures the value of a bet but the probability of it winning. A bet to win $20 and lose $1000 which will win 99.5% of the time is a great bet.

You argued that it's impossible to compute the odds because no "model known to man" accounts for fat tails, therefore selling options is a losing proposition.

Sound right?

 

[rallymode]

Quote from FullyArticulate:



You argued that it's impossible to compute the odds because no "model known to man" accounts for fat tails, therefore selling options is a losing proposition.

Sound right?

I have said no such thing. Are you even reading my posts. Never in my ET history have i said that there is an edge in buying over selling or vice versa.

All i am saying, for the third time now in this thread, is that generally people misuse probabilities in the context of selling cheap gamma. Just because a bet may "appear" winning when you compare probability of expiring OTM with the payoff ratio doesn't always mean you will have expectancy after a large enough sample. Some of the reasons for this i have already mentioned in my previous posts.

If you think you have a model that accounts for fat tails and can sustain several consecutive VAR shocks in negatively skewed bets, that is fine. Prosperous trading to you.

 

[Maverick74]

There is no edge in selling naked options, period. Nuff said. Next topic.

 

[IV_Trader]

OK...here is my twisted take on odds and probs...Once I wrote an "arb" race track's system , which did the following :

1. Take a win odds on horse A ( lets say its 3:1)
2. Take a win odds on horse B ( 8:1)
3. mathematical calculate the odds of exacta ( horse A comes first , B second , lets say it 25:1)
4. Compare math's odds of 25:1 to ACTUAL odds on exacta , and place a bet if price is > 25:1 , which happened many , many , many times.

Why its happens ? because the SAME public that just awarded horses A and B with odds of 3:1 and 8:1 (hence , exacta odds 25:1) in the WIN money pool , placed completely diff exacta odds in EXACTA pool. Notice , WIN pool is always much larger then exacta pool . It also has much large $ distribution per entry ( 8 horse race has 8 WIN entry , but 56 possible exacta combinations).
So far its easy , now about options...

If OTM or FOTM or FFFFFOTM skew is exists , which vols ( odds of which pool ) should one use when calculates probs to reach/close ?
Heavy volume weighted ATM's ? Front month only ? OTM ?

 

[FullyArticulate]

Quote from IV_Trader:

If OTM or FOTM or FFFFFOTM skew is exists , which vols ( odds of which pool ) should one use when calculates probs to reach/close ?
Heavy volume weighted ATM's ? Front month only ? OTM ?

I like the arb you described.

I guess the short answer to your vol question is "neither". We already know the standard distribution does a pretty poor job of modeling equity behavior (hence the reason for volatility smiles in the first place). There are a variety of jump models which take into account leptokurtosis and flatten out the smile. But, changing volatility needs to be included as well (GARCH, for example).

GARCH + a jump distribution is a reasonable start at getting a vastly superior probability model, in my opinion. I have no problem selling options as long as the odds are in my favor and I can survive improbable events. At the moment, there are plenty of opportunities where the price of a long-shot option (and occasionally even the near money option) has been bid up enough to give you the statistical edge.

Maverick's view is pretty widespread and causes an edge to exist. If no one is willing to sell a call, but everyone is happy to buy one, the price goes up. Just look at the vol smile for the S&P options--really expensive puts, very cheap calls. Supply and demand overwhelms statistics in some surprising ways.

 

[Maverick74]

Quote from FullyArticulate:

I like the arb you described.

I guess the short answer to your vol question is "neither". We already know the standard distribution does a pretty poor job of modeling equity behavior (hence the reason for volatility smiles in the first place). There are a variety of jump models which take into account leptokurtosis and flatten out the smile. But, changing volatility needs to be included as well (GARCH, for example).

GARCH + a jump distribution is a reasonable start at getting a vastly superior probability model, in my opinion. I have no problem selling options as long as the odds are in my favor and I can survive improbable events. At the moment, there are plenty of opportunities where the price of a long-shot option (and occasionally even the near money option) has been bid up enough to give you the statistical edge.

Maverick's view is pretty widespread and causes an edge to exist. If no one is willing to sell a call, but everyone is happy to buy one, the price goes up. Just look at the vol smile for the S&P options--really expensive puts, very cheap calls. Supply and demand overwhelms statistics in some surprising ways.

Vol smile has nothing to do with a statistical edge. And a litte FYI for ya, for more people are selling the S&P options, then buying them, especially the put skew. And as far as selling options when the odds are in your favor, this statement is full of holes as you will never know the true odds or probability of the trade. This is the rub of the options pricing model. You can model volatility and stochastic volatility very well, even price jumps. But you cannot model fat tails effectively.

 

[FullyArticulate]

Quote from Maverick74:

And as far as selling options when the odds are in your favor, this statement is full of holes as you will never know the true odds or probability of the trade.

This is pretty much the definition of probability. What are the "true odds"?

Red Sox are 5:1 underdogs for the world series in '07. Why 5:1? Why not even money? Why not 500:1? What are the odds their pitching staff gets injured early in the season? Their best hitter gets traded?

Your statement still holds, "You will never know the true odds or probability"

So, why have bookies existed (and made awfully good money) for the last 2,000+ years? Because they have a probability model they believe in. I have a probability model I believe in. You don't have to believe it--it's my model, not yours. But I'm very happy to keep taking the money of people who overpay for options month after month. And to do so in a way that will allow me to survive the series of improbable events. There are hedge funds that have been around for 20 years that do the same thing.

To each his own.

 

[Maverick74]

Quote from FullyArticulate:

This is pretty much the definition of probability. What are the "true odds"?

Red Sox are 5:1 underdogs for the world series in '07. Why 5:1? Why not even money? Why not 500:1? What are the odds their pitching staff gets injured early in the season? Their best hitter gets traded?

Your statement still holds, "You will never know the true odds or probability"

So, why have bookies existed (and made awfully good money) for the last 2,000+ years? Because they have a probability model they believe in. I have a probability model I believe in. You don't have to believe it--it's my model, not yours. But I'm very happy to keep taking the money of people who overpay for options month after month. And to do so in a way that will allow me to survive the series of improbable events. There are hedge funds that have been around for 20 years that do the same thing.

To each his own.

Just to set the record straight, that is not what bookies do as I have many friends that are very successful bookies. Bookies make a 2 sided market. Bookies do not speculate on outcomes.

Their goal is to make a line that will draw the most 2 sided action. That is where they make the most money. If they are leaning too heavy on one side, they will lay it off on the Vegas books. I just wanted to clear that up.

As to all these funds that have been selling premium for 20 years. LOL. Look, there have probably been close 30k funds since 1970. Of which maybe 2 or 3 are around today that have been selling premium. Gotta love those odds!

Or as Taleb would say, you put enough monkeys behind a typewriter and one of them will write the "Iliad".

And lastly, how much money you have made in the past has no bearing on how much you will make in the future. Only a fool makes such a claim. I also love the assumption that people are overpaying for options. Overpaying compared to what?

 

[FullyArticulate]

Quote from Maverick74:

Just to set the record straight, that is not what bookies do as I have many friends that are very successful bookies. Bookies make a 2 sided market. Bookies do not speculate on outcomes.

That's what I've been saying ALL ALONG. If you get the odds right, you make a two sided market! If people are overpaying, you sell them options, if they're undercharging, you buy options from them!

You responded that you can never know the odds, therefore you can't decide which side of the market to be on. If that's the case, why are you trading options at all? If you believe no one can compute the odds at all, the only options you should be trading are at-the-moneys . If this is your trading strategy, fine, otherwise you are implicitly computing the odds every time you buy or sell. What is your model based on?

Or as Taleb would say, you put enough monkeys behind a typewriter and one of them will write the "Iliad".
I fail to see why Taleb is such a hero. His fund is a dismal failure proving people, in general, *overpay* for options. The odds are against him.

And lastly, how much money you have made in the past has no bearing on how much you will make in the future. Only a fool makes such a claim. I also love the assumption that people are overpaying for options. Overpaying compared to what?

Where did I say that the previous roll of the dice affects the next? I'm pretty sure that's what I've been saying all along as well.

Overpaying compared to a model you believe in. I'm pretty sure I said that too.

Putting words in my mouth and then arguing with them makes this whole discussion pointless.

 

[Maverick74]

Quote from FullyArticulate:

That's what I've been saying ALL ALONG. If you get the odds right, you make a two sided market! If people are overpaying, you sell them options, if they're undercharging, you buy options from them!

Uh, where are you saying you make a 2 sided market? I was under the impression you sold naked options. Has your strategy changed in the last half hour? The only way you can lock in vol is if you both sell an overpriced option and buy an underpriced option at the same time. Otherwise all you have is traded a delta. If you truly are trading vol, then trade vol. If you are trading direction, trade direction. But don't disguise the two.

You responded that you can never know the odds, therefore you can't decide which side of the market to be on. If that's the case, why are you trading options at all? If you believe no one can compute the odds at all, the only options you should be trading are at-the-moneys . If this is your trading strategy, fine, otherwise you are implicitly computing the odds every time you buy or sell. What is your model based on?

There are a million reasons to trade options. Trying to lock in vol trades is a very poor reason unless you are trading on the floor or you are a high frequency trader where you can make millions of individual bets, where a tiny edge will pay off over a long period of time.

I fail to see why Taleb is such a hero. His fund is a dismal failure proving people, in general, *overpay* for options. The odds are against him.

You have no idea what Taleb's performance is. I hope you are not as presumptuous in your own trading as to speculating on how well private funds do. Taleb, btw, was a big seller of options. He basically traded flys. Sorry to punch a hole in another one of your assumptions.

Where did I say that the previous roll of the dice affects the next? I'm pretty sure that's what I've been saying all along as well.

Overpaying compared to a model you believe in. I'm pretty sure I said that too.

No, overpaying or underpaying not as it relates to your model but to that of another option. Look, if you want to be a vol trader, that is fine. But you are disguising yourself as one while explaining something else entirely. In order to trade vol, only vol, this means you are locking out all other greeks, you need to offset all other greek exposure. Simply selling an option that you deem is overvalued because your "model" says so, doesn't not make you a vol trader. You have bought nothing else to lock in the vol difference. Why can't you understand this?

Putting words in my mouth and then arguing with them makes this whole discussion pointless.

I quoted your words this time so as there to be no confusion as to me putting words in your mouth. LOL.