That is absolutely a use of leverage and that is okay. I'm saying that people confuse the use of leverage with expected value and the worth of an option. First you have to decide if you will buy the option and then how much you will buy. What you determine the quality of your conviction either because the price crossed some barrier or your view is inconsistent with the markets; then you determine how many. If you had a 10,000 account, then buying 10,000 worth of 60% puts is definitely employing a massive amount of leverage. You should have been buying 10 puts (listed contracts) because that would be the notional of a fully invested short position. Since the conviction is high, you are willing to lever up the position. Leverage just explains your return within the context of your account size. I just think people confuse the amplification on their account size to the volatility of the asset they are trading and it's better to separate the two to understand where your pnl is coming from. In your example a 10,000 account guy is employing crazy leverage and a 1MM account guy is employing very moderate leverage. Same trade, same size, same dollar return, obviously different percentage returns. The 1MM account guy too less risk than the 10,000 account guy and the separation of profit and leverage demonstrates that. Otherwise it's easy to say I made 10,000% on this trade because my 10 cent option is now worth $10, but that hides how much one would risk on such a position and what it took for the underlying to get there. Not saying it's a bad thing to go employ a lot of leverage in this way, but you should be aware of what aspect of the trade is leveraged and what isn't relative to your account size.
Sure, the price level affects the volatility. With stocks and stock indices it is well known that realized volatility typically increases when stocks drop. But is that really a reason to price options at different strikes with different volatilities? Right now SPX ATM 1265 Dec puts have an IV of 24%, and SPX OTM 1125 Dec puts have an IV of 32%. Suppose a market maker sells one of each. Fast forward to December 15, option expiration day. Suppose looking back we find that the market did in fact go down and the realized volatility was 30%. Well, the MM probably did okay selling that 1125 put at 32% IV. But he certainly lost money delta hedging the 1165 put that was sold at 24% IV and realized 30%. The bottom line -- when all is said and done by option expiration all options for the same maturity see the same realized volatility, so if volatility is all that matters, they should all have been priced at the same IV. Now I think it's perfectly rational for the MM to price the 1125 SPX puts at a higher IV than the 1165 SPX puts. But that's because I think there are statistical parameters other than expected realized volatility that go into pricing options. There are many alternative formulas to Black Scholes. All of them take volatility as one of their statistical parameters. All but Black Scholes take at least one <i>other</i> statistical parameter. Some formulas take an explicit skew and kurtosis. Others take the alpha and beta parameters of the GARCH(1,1) model. Others take the volatility of the volatility, and so forth. If you use any of those alternative models to calculate the option prices at different strikes and them run them through the inverse BS to get the IV you'll get different IVs at different strikes. In short, the number we called "implied volatility" is an amalgamation of several statistical parameters, one of which is volatility, but the others are statistical descriptions of how the volatility can change. So I don't regard it as meaningful to say that options are priced by implied volatility, when that is really the result of the process, not the input.
One way or another, a market-maker is trying to estimate the volatility environment he's going to be exposed to over the life of the trade. It does not matter if he's using pure BS or some complex stoch vol model, in the end it all comes down to a vol level.
Nobody is assuming that anything is deterministic. Where did I ever say that? I did say that after the fact, at option expiration, every option of the same maturity but at different strikes saw the same realized volatility. That is true by definition. So before the fact we can imagine a universe of different price histories, with different and varying volatilities, but in each possible history the options at each strike see the same realized volatility. So if options were really priced only on the basis of expected realized volatility then no matter what your assumptions might be about the possible future price histories all options at the same maturity should have the same IV. My point is that you can't call each and every stochastic parameter that describes price movement "volatility". (Well, you can, I suppose, but then your use of "volatility" doesn't conform to its usual meaning.)
The underlying realizes the same volatility (obviously) but each option profits and loses differently. This is true even if they had the same implied vol. The reason is that as long as the vol isn't constant (every day it doesn't realize the same) then whichever strike has the most gamma on the biggest realized days will profit the most. Skew is an attempt to account for that phenomen as most of those big days tend to be at lower price levels. It has nothing to do with which model you use or what the actual realized volatility is in average. It has to do with path dependence of the stock price movement. If you play with some random stock price movements and options at different strikes (make up the prices if you need to) you will see this.
Free Thinker Registered: Nov 1999 Posts: 11364 10-20-11 06:09 AM -------------------------------------------------------------------------------- Quote from johnmarg: Another stock you may consider is RMBS. High IV every month, more than LNG and maybe less of a price swing and less likely to go out of business or drop to near zero. Just a thought -------------------------------------------------------------------------------- terrible choice. just a thought. ------------------------------------------------------------ Free Thinker Registered: Nov 1999 Posts: 11364 10-20-11 07:18 AM -------------------------------------------------------------------------------- Quote from johnmarg: There was no need to get snotty in your post to me. I just made an alternative stock choice and not to you. Of course you made a snide comment with no facts to back it up. -------------------------------------------------------------------------------- not my job to educate you but what do you not want a stock to do if you sell premium against it? ========================================= RMBS down 11 bucks . i guess i dont know what the hell i am talking about. how long will it take to recover 11 bucks selling puts for pennies at a time? as i said before. if you sell puts you dont want specific stock risk. eventually it will blow up in your face.
Hi Free, I sorta started this by suggesting LNG for selling puts then converting to owning stock and selling calls aganist it. I liked the fact at 6 not far from zero. It has done nothing but make money for me since, the stock is 11 or so (too hi IMHO I am dropping size 50% by letting half my stk be called away Fri. Just rolled my other calls to Dec today. RMBS did a black swan worst case today. BUT in defense of John who was just kindly sugesting anothe hi IV stk, black swans hurt most income strats even cal sprds get killed. Today RMBS is still over 100 IV and you can get a buck for a 8 Dec call at 8.25 So its more than pennies and chances are even after black swam a profit can be made. If its .75 per month for 10 months it would be back to profit, but lets say 20 months as 10 would be playing it perfect. There are worse outcomes, all the time. BTW think will Sell puts on RMBS today, as at 8 now fits my profile. Cheers
Hi Atticus, Thanks for the warning. I have not yet read the news, nor found out yet why RMBS dropped so much. Was going to do that before entering a position. Know some about RMBS in past but have not had a position in it for over a year. Cheers