Yup, so from this point of view it could be argued that in some cases MMs have unlimited risk to the upside, if GME suddenly opened 300% higher tomorrow, instead of climbing up, and an MM wouldn't be hedged using options. Theoretically MMs can also have extreme risk to the downside, if all stocks dropped by 30% overnight, as there is no way to hedge with shares after the fact. So my risk may be similar to MMs' risk, assuming that I'm hedging in similar way, though I have more freedom by not needing to trade every option like MMs do, so I can just pick the options that suit me. But I just chatted with couple industry pros that either worked or consulted to MMs, and they both said that MMs are significant buyers of cheap OTM options for hedging, so their risk is limited through options, not only by hedging with shares. This also shows that the options/gamma impact on meme stock runs and vice-versa, may be a myth, which was also disproved by the SEC, and also disproved by 100s of other stocks that run 300% up in a day or 1000% in a week but don't have options. MMs can either hedge with OTM options, or simply make the markets on the way up or down when there are no options. There are hundreds of such explosive stocks traded every year, just not optionable and not blowing up hedge funds, so not as discussed. This is what day trading firms like SMB capital have to trade every day anyway, as they can't make money on stocks that don't move. There is just no relation to options in most of those stocks as they aren't optionable. People who talk about GME gamma squeezes are meme option junkies and all they look at are options and make assumptions, having no clue what actually happens even if options didn't exist. Unless it's me who has no clue, and I also would like to understand what actually happens. Maybe different things happen at different times, so everyone can make some assumptions, but none of them matter and this isn't actionable.
I read through your previous journal last night. I'm impressed with your returns and that made me question my assumptions on the efficiency of the options market. I figured that it was not possible for a retail trader to place option trades that offer a high amount of potential payoff (possibly through leverage) and low risk. Why wouldn't those types of opportunities get picked off by market makers and large highly automated trading firms? A while ago in your other trading journal, you mentioned that you were working on an algorithm to interpolate option pricing for all OTM options based off of 3 to 5 option quotes along the same expiration. Were you doing that to identify mispriced options? For example, say you take all OTM call options for a given expiry. You curve fit using a quadratic equation across those options and notice that a particular strike, say the 400 strike of XYZ seems to be mispriced the most and let's say that the options appear more expensive than what your curve fit predicts. To take advantage of that, you could go long the 390 strike, short 2 of the 400 strikes, and go long the 410 strike. If the option is sufficiently far away in time, then the delta of that position should be close to 0 and the strategy would be to wait until the 400 strikes become fairly priced and then close the position to capture the inefficiency. The assumption for that strategy is that on average, market is efficient and those options are fairly priced. However, there might be times of inefficiency (possibly due to low liquidity before or after an event) where it is possible to perform an arbitrage such as what I just described. More likely, if the 400 strike is mispriced, the strikes close to it on both sides might also be mispriced and you might need to construct a more complicated setup in an attempt to capture the inefficiency. But do those opportunities even exist when considering slippage and commissions for the retail trader? I would assume that if it was that easy, the trading firms would be all over it and have a huge advantage of much lower latency, unlimited capital, and other resources. So up until now I just haven't considered looking for those types of trades even though it would be easy to automate. What do you think?
This question may be similar to why IV smile exists when it isn’t predicted by BSM, and actually it’s the source of everyone’s problems with trying to calculate option prices & vol surface that constantly shifts, while creating jumps/skews, and other phenomena. The main job of quants nowadays seems to be figuring out vol surface and skew dynamics, and there are hundreds of papers written on this, each with different findings, opinions, and conclusions. Some people like Cem Karsan specialize in just this domain and run funds profiting from related inefficiencies. Many more funds try but also can lose if they don’t get this right. While the profit/alpha may be created by institutional investors who simply want/need to or are required to hedge. Cost of hedging is expensive, adds large slippage, and is the necessary evil for many large investors and funds, so it should produce substantial alpha for someone else. Not really different from insurance companies collecting insurance from people who need it even if they won’t use it. Then the question is whether all of this alpha is harvested by MMs and automated trading, and whether there is no way to chip at it. Logically there is no monopoly here so chipping at it should be possible. While the smartest person I’ve ever chatted with who consults to MMs, simply told me that MMs don’t do anything creative, just the basic market making and delta+vega hedging. This would mean even more alpha available for the taking. And later I found that MMs also buy otm options for vega hedging, which adds an additional player that may be in need of buying insurance. Although I suspect that MMs can manipulate option prices, for example buying cheap hedges even at the last minute during an unexpected event, and then cranking up the IV and/or reshaping the IV surface, which can instantly make their hedges more valuable and basically would make it impossible for them to lose. At least I think I see sign of that happening in how the options are being repriced, and can understand certain aspects of convexity from studying how options get repriced during and post-event. This is what let’s me make free or nearly free bets on unexpected events before they may happen, or as they happen. Btw, during backtests I was also able to find/confirm that simply selling puts can generate alpha, again coming from institutions and anyone else needing to hedge. That alpha is fairly small and can easily be mishandled, but it seems measurable, and can be explained by the necessity of hedging and vol smile. I guess it could be an arb between standard BSM and vol smile where you’d be selling overpriced vol. You’d still lose on the market crashing, but you’d save a few bucks on those sold puts, so you’d have a bit of alpha besides beta. While I’m trying to focus on just the alpha while being somewhat neutral to beta. Anyway, that’s an argument for the existence of alpha, at least in one aspect. I’m still working on couple other forms of alpha that can be proven logically, but also being more dependent on beta. Basically you can beat any underlying’s returns, profit off theta while being hedged for crashes, but most of the time having to ride with the underlying when the market doesn’t crash, so still having substantial volatility. So that’s a different approach than I’m showing here, but I believe I could prove the existence of couple sources of alpha if I needed to. Lastly, couple years ago I’ve seen someone spraying exchanges with thousands of highly complex/mathematical options combos/orders that seemed to be the work of math quants, maybe even worthy of Rentech. And I found them because I came up with similar method but every time I tried to place an order, there was already another such order in the spread book, so I could see someone else’s limit price beyond my own. The option/combo structure had highly stable greeks, similar to buying a box and locking the profit, but it just wasn’t the box. Such combos can be used for market making, just as boxes could when they still worked. So that’s yet another potential source of alpha: market making using only options, without a need to hedge with shares, though small amount of shares can be used to hedge certain option/combo structures that have very stable greeks but have pockets of risk. Basically boxes will no longer work, but there may be other fairly stable option structures that might be used for market making or alpha harvesting, though having pockets of risks. Basically riskless opportunities are gone, but others can show up when taking some risk. Yet another method of harvesting alpha may be from the market’s efficiency itself! Market efficiency results in the IV following the historical or realized volatility, so some people specialize in trading just the volatility - buying it when it’s low while selling when it’s high. The markets, being efficient, allow some people to profit while other people lose… I’ll try to address your other questions later.
BTW, this is what Cem's website says about vol related strategies, with supposedly sufficient alpha to run multiple vol funds/strategies: https://www.kaivolatility.com/
So my current end of the week balance is totally ridiculous and false, showing 10% profit just today, again due to market makers removing their offers at the market close, so some options worth $0.10 are showing at TDA as being worth $2+ after hours, and I have plenty of these. Here is just one example from right now, after market closed: (some of these are options that I've traded 1-3 months ago and just left there because it's not worth getting out of, while acting as cheap hedges) And here is my today's balance showing me being up 10% today, but it only showed this way after hours, while the P&L charts below today's balance are showing more realistic P&L until yesterday (TDA's P&L charts are a day behind). During the day my balance was hovering around $250K, so I'll stick to that figure. The above P&L charts also show that I've lost a few $K in the last couple days since at one point my balance was showing as $255K, but that's again due to non-actionable mispricings, and it would be difficult for me to pocket that profit unless some stocks had stronger pullbacks. The chart is always a day behind, and it's possible that overnight my P&L chart will adjust to show today's balance closer to $250K, if TDA will use the day's average balance vs after-hours (not sure what they use). Anyway, my realistic balance during this week was hovering around $250K, so still at 25% profit since I got approved for portfolio margin on September 13. I still have a little juice left in my current holdings and getting to $260K seems possible by end of the year, excluding the silly & false mispricings.
Yes, so I measure several things to identify realistic option values, mispricings/overpricing/underpricing, and where the option prices should be to be truly arb-free. Over the years I've spent hundreds of hours smoothing the options chain (vol surface), but also developed my own math that lets me model the vol smile as it should be, not only as it is, so without using much of standard curve fitting but actually creating the "proper curve" or "proper smile" on which the options should lie, and to which options should fit. Here are couple option pricing curves that I model: (these aren't IV smiles, just option pricing curves that I had handy as examples in Excel, and which translate to IV smile and vice-versa) And I can generate such price or smile curves based on just couple known option prices, because any number of options dictate how other options should be priced to be arb-free. This involves the smile in the way that once a smile starts forming then it starts imposing some pricing & IV criteria on other options to be arb-free, so other options need to be repriced after pricing/IV is established for any couple options. This may not work as well when a smile doesn't exists, but once a smile forms then it needs to form in specific way, which actually explains the common shape of the smile usually looking like the smile. The smile can often look different, but a few option prices on that smile often dictate how it needs to look overall, at least on a portion of the options chain. My accuracy decreases the farther I go from specifically known/established option prices/IV, but generally I can curve-fit my own curve to any portion of the options chain. I do measure a few other things beyond that, which would either take me too much time to explain or reveal even more alpha then I may already be leaking So I'll stop right here, and unfortunately won't be able to address your last part of the question about specific trade ideas, or anything more specifically related to my trades, similar trades or recommended trades. But I may try to discuss/comment on some more basic/regular trade ideas in the future.
Thanks Guru. I really appreciate your thoughtful response. What you say makes sense. Given some options, it should be possible to compute other option values not using BS or other option model, but simply the mathematics of option payoff functions. I assume that you also need to know the underlying spot price in order to compute the curve. I can see how one could then come up with an iterative algorithm for solving for the curve and also computing which options are the most mispriced. Of course, I'm missing the details and need to think more about that process some more. Interesting idea. I have another idea too and maybe that's where calendar spreads come in. I think I have only traded one or two calendar spreads in my life. I always thought they were a big gamble because more than a vertical or butterfly, you have to make a pretty precise bet on where price will end up at expiration if you plan to hold them until expiration (of the short option). But maybe they could possibly be the best way to exploit the different-shaped smiles of two expirations. I need to give that some more thought. Strange how TD calculates option values based simply on the mid price. If that's really all they are doing, then they could at least improve their algorithm by simply looking up the chain and realizing that an 82.5 put trading at 0 bid, 4.65 ask is not worth 2.33 if the 87.5 put of same expiration is trading 0.41 ask. Even with out resorting to a pricing model, they could figure out the upper limit value of illiquid options by simply look at the real time pricing of other options.
Today TDA updated my balance in the P&L chart to a more reasonable value as of yesterday, possibly smoothing out the option pricing, or using an average balance from Friday. Though still showing wrong current account value after hours:
Calendars may not provide an edge vs the stock, but: a) They may be an easy way to trade volatility, especially if you buy them at low IV, or when market is down like now but you'd believe it'd recover later, which again would be a bet on upside volatility to increase. b) I like call calendars that are about 5%-15% higher than the current stock price, with the short leg expiring 2-3 months from now, and the long leg expiring up to 2 years later. Theoretically there may be slight edge here because if markets are efficient then simply buying any long LEAP leg should not work differently than buying shares (otherwise there would be an arb between LEAPs vs shares). So you're really investing into the stock using a long LEAP call instead of buying shares. But then you're lowering your cost by selling a shorter term leg. This may not be much, but it does lower the cost of the long leg, so it's a form of alpha. You'd still lose on the way down, but less than otherwise. While you really can't lose on the way up, and just need to get out when the stock goes too high, which also means higher call IV, thus basically trading the vol. c) I wouldn't trade calendars on questionable stocks, but mostly on NASDAQ and SPY constituents, which gives them a bit of more consistent upward drift than other stocks. d) You could hedge several call calendars with a single put or some short shares, or even a SPY put or short SPY shares if you own a mix of calendars. This is mostly to protect against bigger market crashes, though it would erode some of the profits otherwise. (this is just a rough opinion, along regular trading)
Thanks for the response. I can't really get the calendar trade to make sense. Say SPY 10% higher, long the 2 year LEAP call, sort the 3 month call. 10% higher than 460 is around 505. Shorting March 22 505 call is around 1.45. Long Jan 24 505 call is around 32. So if SPY drops, there's too much risk on the long call and the short call doesn't really decrease the premium enough. Right now the Jun 23 505 call is around 24. That's 6 months instead of 3, but assuming that the decay for 3 months is about half that, then the LEAP will lose about $4 over those three months, but we'd only collect around 1.45 from the short call. I diagonal might work a little better, but I'd want to sell further away than 10% for the long call. Maybe do 20% long call, 10% short call. If SPY goes a little higher then it makes sense, but that's more of a directional bet than a volatility bet and I'd probably resort to doing a +1x-2 ratio which is what I usually do for index exposure.