- How do you look for opportunities?
- Step 2: Model Driven vs Systemic
- Variance Risk Premium
- Positional Option Trading
- Directional Trading with Options
How do you look for opportunities?
SSRN Papers, dont want crowded
Step 1: Know your type of edge
- Risk premium (like selling options) - usually there, smaller but stable. Akin to betting on an NBA game
- Market inefficiency - comes occasionally, harder to build a business on, but better returns, bet bigger
Step 2: Model Driven vs Systemic
- You have a model, compare it, and trade vs theoretical value. Smaller wins but less noisy.
- Systemic - you are dealing with uncertainties, you don't have a prediction for any specific trade, just the set as a whole. Much nosier, more profitable generally.
Variance Risk Premium
- Big funds trying to harvest this in non sophisticated way
- 20 or 30 years ago the VRP was so strong you could make money doing anything
In the future, it will still be there, but you will have to be sophisticated
- you are basically selling insurance. Why would this go away?
- its cyclical
- Short vol sellers dont have a very good story, long vol guys sexier
Positional Option Trading
- Organize your knowledge, that you already know.
- The structure matters. It's something to hang your worldview on.
- Also just fun when you write good prose, like a good golf shot
What does buyside & retail get wrong?
- Focus too much on structure, and not enough on just finding an edge
- Iron Condor is a dangerous trade
- you get feedback from PnL, but iron condors you will have a lot of winners and a few losers.
- you care about average, but you are getting mode
- You don't lose money because of delta, gamma, vega, etc. You lose because market moved, or it didn't
- EDGE —> Sizing —> Portfolio Construction
- Edge most important, smoothness second, correlation to rest of portfolio 3rd
Equity Factors as a source of return in options
- Take one of the legs of factors and use options on top
- market makers do not think in these terms at all
- GARCH model to forecast vol and then use that, worked 20,30 years ago. Not anymore
- its become an academic specialty
- only 8 papers on factor models & options
- option traders think short term, fundamental factors take years
"If I was completely starting over, I'd be looking ad fundamental factors in order to predict volatility. And I think there is probably an enormous edge in that. And it would also apply to commodities."
Directional Trading with Options
Risk Neutral Probability: Don't take into consideration drift
- Have to, otherwise you'd get some Arbitrage
- can still put return into pricing model. you can sub rate for return and if you care about direction, that's the way to do it
- you aren't in a arb free environment, others can take advantage of you
People backrest with a static vega amount, when the PnL would be dependent on vol level
- no great solution, but constant vega is not bad
So many degrees of freedom in Options
- Is there an optimal choice? How do you think about structuring
- You can get it wrong, but can't optimize it
- don't look at Expected Value, it will just lead you to teenies
- take into account Kelly Criterion
- Look at Probability of making money - technically shouldn't but i'm human
Options have expiration dates
- yes but strategies dont, you can roll structures
- Get out of a trade when edge is gone.
- same reason i dont believe in stops - get out when you are wrong, not when you've lost money
Options as a risk management vehicle
- emphasis on risk, not EV
- covered call is actually a retail strategy with edge (collecting VRP, increasing decreases)
- if you want to hedge, you should match products
- Best time to be alive, on average, has always been now!
- Maybe we won't have a vaccine soon...but the world will tend to get better again...