Hi guys, From time to time, when weighing the option of taking a short position in a stock vs. buying a put on a company you’re bearish on, sometimes I hear people saying that the options are “expensive.” This descriptor can connote a number of things, but what does it mean to you and on what basis do you hear options being described in this context? Also, how does a put option being considered “expensive” encapsulate anything about the option’s inherent feature of having a limited downside (in the case the stock goes on a bull run, all you lose is the cost of the option…and theoretically the opportunity cost of holding it), versus shorting the stock in which your downside could be theoretically infinite? Would be grateful to anyone with options trading/risk management experience who can comment on this topic. Thanks.
Implied Volatility. In markets like these, the volatility of the underlying is very high, so the implied vol of the options is extremely high, which makes options expensive.
Thanks HighYielder – I get the matter of implied volatility but is that all people are ever referring to when describing the option as “expensive”? Also, I can think of a number of securities where going naked short at this time could potentially carry an equally great “risk.” So as a follow-up, I’m interested in understanding how an experienced options trader/investor thinks about weighing the relative costs of a naked short vs. buying a put in the currently volatile markets – and how those considerations may differ in times when there isn’t as much volatility. Also saw your post on my other thread, feel free to drop me an e-mail at numi.advisory@gmail.com – thanks.
Sometimes I use the term when comparing options on two substitute stocks, and sometimes comparing a single stock’s put vs. calls. Just a relative value term as far as I’m concerned. After the earthquake in Japan, I looked at options on CCJ vs URA. Options on URA were way more expensive, relatively speaking, than CCJ even though URA was much less volatile.
Look at the value of options in a time of lower volatility, say 4-5 weeks, versus a couple of weeks ago. I made an options trade about a month ago and haven’t done anything since because they are so “expensive.” I get to that by looking at the difference between the price of the option and the intrinsic value (=strike price - underlying). If you looked a couple of weeks ago, that difference which is the time value (of which the volatility feeds into), was probably 2 or 3 times more than what it might have been a couple of weeks prior before the August 2nd debt deadline. I’m not sure how much sense that made. It made sense in my head at least.
Hi, numi. I do this stuff for a living, so maybe I’ll be useful for once. Options traders view risk in many dimensions, not just long/short. Put options give you delta, gamma and vega exposure, while naked shorts only give you delta exposure. So, puts and shorts are not completely substitutable. You could take a position on implied volatility and do something completely different with deltas. For instance, if you think that options are expensive but don’t want to take a delta position, you could sell puts and sell stock to delta hedge; this makes you short vega but delta neutral. So to answer your question: “I’m interested in understanding how an experienced options trader/investor thinks about weighing the relative costs of a naked short vs. buying a put in the currently volatile markets” - you need to look at specific sorts of risks, and not lump all risk into a fuzzy thing. Also, regarding implied volatility - it’s really much simpler than people think. Implied volatility is just a measure of option costs. Traders bid or offer on the $ price of options, and a volatility measure is *implied* from the market prices. So, when people say implied volatility is high, it just means that options are being bid up (take a minute to think about this).
Numi - You can make money on selling short in one way: Stock goes down You can make money on long puts in two ways: Increase in implied volatility and/or a down move in the stock. When someone says a put is expensive, I hope they are referring to the fact that the stock’s implied volatility is much higher than its historical volatility. That’s a correct understanding. If they are just saying that the option costs a lot in terms of premium, that’s an incorrect way of looking at it. Now with respect to going short the underlying vs. buying a naked put, you need to evaluate several factors. Your time horizon, your interest in levering, and volatility in the stock. If you think the stock will trend down but you’re not sure of time, you should get short the underlying. If you feel a stock will tank by a certain date because of earnings or another event or just because, you may consider the put the best option. If you feel like stock might whip around a lot and then eventually tank, puts might be the best option because you can reap the rewards from an increase in volatility. For example, look at some companies who own valuable patents. That industry has gone off the chain (in an up direction) yet volatility has increased substantially.
By the way… right now options are expensive. The volatility has driven up the value of most options. If you are trading them currently you see big swings in prices day to day. It’s been very scary for my portfolio as they can drop in value big time even if the stock is moving the way I want it to just because the perceived fear/joy in the market decreases/increases.
ChickenTikka Wrote: ------------------------------------------------------- > By the way… right now options are expensive. > The volatility has driven up the value of most > options. If you are trading them currently you > see big swings in prices day to day. It’s been > very scary for my portfolio as they can drop in > value big time even if the stock is moving the way > I want it to just because the perceived fear/joy > in the market decreases/increases. That’s why people shouldn’t have a book of just long or short options. There should be a mix, keep your short premium/long premium between .75 and 1.50 and you won’t have those huge swings.
That sounds like good advice. The thing is, my expensive premium options are just protection that I bought recently on winning bets. I’m all right watching them swing but it does make me cringe sometimes…
ChickenTikka Wrote: ------------------------------------------------------- > That sounds like good advice. The thing is, my > expensive premium options are just protection that > I bought recently on winning bets. I’m all right > watching them swing but it does make me cringe > sometimes… I understand, that can get expensive. You can always buy put spreads in a high vol environment… those lower put strikes that you sell in the spread should have some juice that they ordinarily wouldn’t. Obviously if your long stock just collapses, ala Dendreon, a spread won’t be as good as an outright put, but in almost all cases, that put spread will be better.
Err… so there are a couple of misconceptions in this thread, particularly with the understanding that some people have with respect to implied vs. realized volatility. Historical and realized volatility are related, but it’s more relevant to compare an option’s current implied volatility with it’s historical implied volatility, given the options maturity and moneyness - rather than comparing implied volatility to historical volatility of the underlier. If we were to determine how “expensive” an option is based on comparisons to historical volatility, you would be constantly selling lower strike options and buying higher strike options, since most volatility surfaces exhibit negative skew (which means that lower strikes are more expensive than higher strikes). Also, you don’t make money from implied volatility just because actual volatility is high (i.e. the stock price “whips around” a lot). For instance, lets say a stock starts at 100, then goes to 50, then 100, then 50, then 100. In this example, realized volatility is pretty high. However, implied volatility at the end will probably be around the same as it was at the beginning (implied volatility will generally rise as the underlier price decreases, and falls as the underlier price increases). So, if you held a put or call option throughout this time, you probably earned close to 0 (minus theta decay). Now, the exception to this would be if you *delta hedged* throughout these swings; then, you would have made money from the convexity of the option price with respect to the underlier price. However, this is not the same as saying that you will make money by holding an option through a volatile period.
ohai Wrote: ------------------------------------------------------- > Err… so there are a couple of misconceptions in > this thread, particularly with the understanding > that some people have with respect to implied vs. > realized volatility. Historical and realized > volatility are related, but it’s more relevant to > compare an option’s current implied volatility > with it’s historical implied volatility, given the > options maturity and moneyness - rather than > comparing implied volatility to historical > volatility of the underlier. If we were to > determine how “expensive” an option is based on > comparisons to historical volatility, you would be > constantly selling lower strike options and buying > higher strike options, since most volatility > surfaces exhibit negative skew (which means that > lower strikes are more expensive than higher > strikes). > > Also, you don’t make money from implied volatility > just because actual volatility is high (i.e. the > stock price “whips around” a lot). For instance, > lets say a stock starts at 100, then goes to 50, > then 100, then 50, then 100. In this example, > realized volatility is pretty high. However, > implied volatility at the end will probably be > around the same as it was at the beginning > (implied volatility will generally rise as the > underlier price decreases, and falls as the > underlier price increases). So, if you held a put > or call option throughout this time, you probably > earned close to 0 (minus theta decay). Now, the > exception to this would be if you *delta hedged* > throughout these swings; then, you would have made > money from the convexity of the option price with > respect to the underlier price. However, this is > not the same as saying that you will make money by > holding an option through a volatile period. 1) You should compare the current implied levels to both historical vol and historical implied. I worked for a vol arb shop and 90% of the guys didn’t even look at historical implied vol. HIV is more important for knowing when to enter and exit an option but as far as making money on the actual vol changes, historical is a better gauge. 2) I don’t necessarily agree. Let’s say VIX is 15 like it was a few months ago. Suddenly market drops 500, goes up 500, goes down 500, and closes the week up 500. The VIX will NOT be at 15, it will be higher than that. So if you’re long premium (even without delta hedging), I would venture the trader made money. Also, let’s say you’re long a 5 delta put. Stock price suddenly drops 20% and your 5 delta put is now a 50 delta put. You’re going to make money from the actual down move of the stock AND you will make money from a huge implied vol increase. There are two ways to profit there.
This is a great thread. I don’t feel like I have a great feel for using options optimally, although I do know a bit about selling OTM puts at fair-vaule entry levels, using calendar spreads to earn from higher implied volatility, selling covered calls to pick up extra premium on stuff that was most likely overvalued or topping. In mid July, I was thinking about buying GLD calls. The idea was that GLD was likely to move either dramatically upwards or stay approximately the same, but was more likely to go upwards. A call seemed to make sense, because one could make money on both the volatility change and the price action, and limit downside. Since I was buying, I thought I should buy expirations that are further out in time, because if it didn’t happen quickly, I wouldn’t have much theta decay and could close the position with relatively little cost. Was that a sensible analysis? Anyway, that was probably the right move to make - I would have made a bundle. But I held back because I wasn’t confident about doing options. If I had done it, I would be up 30-40% YTD, while risking about 5% of the portfolio. It’s a good ratio, but I don’t like to risk more than 2% on any one trade, so I didn’t do it. So, I think it’s time for me to get more comfortable using options. Elder says you have to get the stock, the ticker, and the time frame right to do options, and I haven’t practiced enough.
Options are fascinating. This was a really good read.
lxwarr30 Wrote: ------------------------------------------------------- > Options are fascinating. This was a really good > read. My thoughts exactly, Ohai is a boss.
Just to provide an additional example of how this manifests itself into an exploitable trade, say you target an ATM/OTM put spread of $3. In a time of relatively high volatility you might be paying $1 to execute the trade, and in lower volatility might be $0.75. Same $3 payoff if the stock dives through both strikes, but under the “cheaper” option scenario you quadruple your money while in the expensive case it only triples. Side-note, I’ve always thought volatility is a misleading term when it comes to options, i.e. the VIX goes down when the market goes up even though volatility measures variance both upward and downward.
Fantastic thread here guys. Just wanted to say thanks for all the good responses so far. Because options are far from my area of expertise, I want to take some time to digest the content on this thread before posting a follow-up. I’m a bit backlogged right now as I’m vacationing in Berlin, but just wanted to say thanks for all the insightful posts from people here that are way more informed on this topic than I am.
This thread rocks. Great read.
ohai Wrote: ------------------------------------------------------- > Now, the > exception to this would be if you *delta hedged* > throughout these swings; then, you would have made > money from the convexity of the option price with > respect to the underlier price. However, this is > not the same as saying that you will make money by > holding an option through a volatile period. This thread is still a bit sloppy. Let’s be clear. You’re not “trading vol” unless vega is your primary risk. If your PNL is sloshing all over the place from delta exposure, you’re not trading vol (or at least, not trading it well). The main way to trade vol is to hedge/eliminate delta exposure by trading the option and underlier together. (For instance, if you’re long a 50-delta call, you’d be short the underlier. If the delta of the option goes up to 60, you have to short more of the underlier.) Interestingly, your delta hedge is reproducing a synthetic option. (Sit and think about this, and/or go through an example if you don’t get this.) In our example, the delta hedge is replicating the deltas of a short call. Our delta-hedged long call trade is thus long the actual option vs short a synthetic option. This trade is long vega, and you make money if the realized volatility is higher than the implied volatility. (There are some higher order effects like gamma, but generally they are small unless the underlier’s price moves a lot.) Cool huh?