Volatility Arbitrage and the Retail Revolution: Navigating the New Options Landscape
A Quantitative Approach to Options Trading: Exploiting Market Inefficiencies
The Modern Options Trading Landscape
In today’s financial landscape, platforms like Robinhood have made options trading increasingly accessible. The data raises concerns about putting options at people’s fingertips in a gamified format with minimal vetting.
For retail traders, calls and puts are essentially directional bets on share price movements. The appeal lies in leverage — one option contract controls 100 shares of the underlying stock. Buying a call gives exposure to the returns and losses of 100 shares at a fraction of the price. This amplifies both gains and losses and introduces multiple risk exposures.
In institutional settings, options are primarily used for hedging — paying a fee to offload risk.
For example, A QQQ holder might buy a QQQ put to hedge their shares. This is an oversimplified example, not a recommended strategy.
Fundamentals of Implied Volatility
Implied volatility (IV) represents the volatility of the underlying stock. A key principle in options trading is buying when IV is low and selling when it’s high. Comparing current IV to historical levels is crucial, typically buying when IV is relatively low compared to its historical range.
Concepts like IV Crush, where options are effectively priced in, and common trading ideas often become widely adopted. Other critical factors include Theta Decay, Days to Expiration (DTE), and Theta.
Options Market Mechanics
The options market operates on supply and demand principles. Buyers and sellers process information to reach fair prices based on rational expectations. This efficiency means option prices are generally fair, so complex strategies don’t inherently generate long-term profits when accounting for costs.
The options on retail platforms come from the broader options market. Terms like delta, gamma, theta, Black-Scholes model, and implied volatility describe option prices and their dynamics.
Options Trading Strategies and Risk Management
Options can be used for risk management, like selling covered calls to reduce return volatility. Complex strategies like iron condors, covered calls, cash secured puts, and straddles don’t inherently make money in the long term when considering transaction costs.
Instead of simplistic reasoning about stock movements, consider market-implied probabilities versus your analysis. If the market implies a 10% chance of a 5% increase in 90 days, but you estimate 20%, this might be a trading opportunity.
Advanced Concepts in Options Pricing
IV is compared to Realized Volatility (RV) to assess whether options are cheap or expensive.
The adage “sell high IV, buy low IV” is an oversimplification. High absolute IV doesn’t necessarily mean expensive options.
Volatility is the annualized standard deviation of log returns. Dividing IV by about 16 estimates the expected daily stock movement. For example, when GameStop’s one-year IV reached 212%, it implied a 13% daily movement for a year — an unrealistic expectation.
Market Inefficiencies and Opportunities
While option markets are highly efficient, they’re not perfect. Investors can make mistakes. Options are priced based on the market’s best estimate of potential outcomes for the underlying asset.
GameStop serves as an example. Plotting IV against RV shows periods of high IV — some justified, others presenting potential opportunities. The IV to RV ratio often indicates option expensiveness. Shorting GameStop options at peak IV levels was potentially highly profitable.
IV is derived from option prices, determined by supply and demand. Extreme demand, like during the GameStop squeeze, can drive prices to unrealistic levels, creating opportunities for informed traders.
Real-world Applications and an Example
An orange farm hedging against price decreases serves as another example. Their willingness to overpay for puts can create imbalances, for different reasons than GameStop.
While the options market is largely efficient, inefficiencies occur. The GameStop case is extreme, but similar principles apply on smaller scales daily. Options can be mispriced due to supply-demand imbalances from non-price-sensitive participants.
Keys to Successful Options Trading
Profitable options strategies aren’t about complex structures, but identifying mispriced options through research and relative value analysis. Understanding IV’s relationship to RV is key to finding potentially under or overvalued options in the market.
Disclosure
The information provided in this article is for educational purposes only and should not be considered financial advice. Trading involves risk, we encourage you to do your own research on options and consider seeking advice from a qualified financial professional before making investment decisions.
