Are Option Buyers Lame Ducks?

This is a common perception. But is that true? Let’s explore. Let’s see why people who say option buyers are idiots feel the way they do. Here are a few reasons that comes to my simplistic mind.

1) Options are a time bomb. They keep losing time value. So, whatever the option buyer’s bet is, it comes with an expiration date. If the bet doesn’t payoff by then, it doesn’t matter if it does or not later. And in this process, the goods the option buyer has bought, keeps decaying in value, every moment the market trades (or for that matter doesn’t), all else (option greeks like delta, gamma, beta, vega etc), remaining unchanged.

2) Options, especially puts, being instruments of hedging, apart from instruments of speculation, tend to be overpriced. Essentially, the risk (or volatility of the underlying) is usually overpriced. Most of the time, the implied volatility of options is higher than the realized volatility. This is simply because the average market participant is more risk averse than is justified. But, considering tail risks, Nassim Taleb might argue that these are not overpriced.

3) Naked buying of options doesn’t require a lot of capital. If we talk about out of the money options, the capital required is even smaller. However, this naked buying affords the buyer the chance to multiply his money. This does lure a lot of innocent people, innocent at least of statistics. Markets however, are driven by demand and supply. The market price doesn’t depend on whether demand comes from barely literate gamblers or Bank of Sweden prize winners. And the company you keep does to a large extent determine your personality! There are too few in the real world like Matt Damon in Good Will Hunting.

If option buyers are indeed innocent, then option sellers must be surely smart/cunning. Really? The world of economics isn’t necessarily adversarial. Nor does its vocabulary work like English. The option seller is like a gambler who frequently ventures into the business of collecting dimes and nickels in front of speeding trucks and guess what — frequently manages to escape unhurt! That’s a daring man, but not among the smartest I know of. IMHO, he doesn’t value his life and limbs too much vis-à-vis dimes and nickels. By the way, the option seller does make money net-net, in the long term. If his business doesn’t endanger his life too soon that is. But it’s too risky. That doesn’t make it a bad idea by itself. So, let’s look at whether and under what circumstances, it makes sense to sell options. And let’s also revisit whether it’s indeed so stupid to buy options.

Here’s a summary of the last few paragraphs. Option buying is a low risk activity but with negative rewards on an average. Option selling is a terribly risky activity with positive (not big) rewards. There are 2 ways to still make good use of options.

1) Don’t do naked buying or naked selling. But, covered calls make sense in a market steadily rising in the long term. For instance, I’ve been doing a covered call on Bank nifty in India ever since corona struck. Guess what? This has made more money than what naked futures would’ve done. Covered call also makes eminent sense in an environment where imploied volatility is way higher than realized volatility.

2) Cash future arbitrages (with options used to mimic cash market positions with a leverage if possible) make sense in markets with high nominal intertest rates. This can be done in India with weeklys on nifty and bank nifty. The weeklys are settled based on the spot market value, which could be different from the futures market except during the last expiration day of the month.

3) Use put spreads and call spreads to action directional bets. Intuitively, it makes sense to use a credit spread (bullish put spread or bearish call spread) to action mean reversion type of strategies (high winning ratio but not characterized by outlying big winners) and a debit spread to action trend following type of strategies (less than 50% winning ratio but characterized by a few outlying winners).

4) Remember that puts and calls are not equal, though there is put call parity in theory. Out of the money puts are more expensive than equally out of the money calls, on risky assets like equity. There is a reason for this. Market crashes happen in a jiffy but market rises don’t. But sudden crashes are a lot less frequent compared to slow rises. But such disparity gives rise to interesting arbitrages. Take them when you spot them. There are many ways of constructing arbitrages out of these. Will dedicate an entire post to this.

5) Profit from the smile. We all know that implied volatility exhibits a smile over the spectrum of strikes. A simple way to profit from this is a reverse iron condor. However, this makes sense only statistically. Don’t expect it to work all the time. Size your bets to take into account the possibility of losing streaks. Kelly Criterion is a useful tool to do this.

6) Buy out of the money options naked, although it is not incredibly smart, and do it in a diversified way again. Statistically you should lose money. But black swans do occur, at least in some of the underlyings on which you have bought options. And when you do buy, try to buy them a little cheaper. These black swans (which are not technically black) occur because of the kurtosis in the underlying (wider tails than what is assumed by option pricing models) and will hopefully the multiple you earn will pay for the losses made by options that expire worthless. Remember, the black swans might never materialize and you might make a net loss. But that’s still ok if this strategy reduces the overall volatility of your asset basket so much that your overall sharpe will increase even if the return on this strategy is slightly negative. So, buying naked options isn’t as stupid as we thought after all!

The trick in option trading is to find mispricing, buy underpriced stuff and sell overpriced stuff while trying not to be exposed to anything other than this price differential as much as possible. You can use underlyings, futures, other options etc.

Happy trading.