But what if there are a thousand people doing the same thing for 100 nights. Let's also assume the realized death toll is 1.6 deaths per drunk. In addition, the cops were selling get-out-of-jail cards in the event you killed up to 2 other people. All the drunks bought these cards even though they only needed cards for 1.6 deaths on average between them all. The drunks were willing to overpay because of the high marginal utility of the card. Terrible extension of the analogy, but I can only work with what I'm given.
This is already built in. If only probability of the outlier were considered (while ignoring the impact of realizing the outlier outcome), a 50 delta option would be completely binary.
There's also a difference between short /VX and selling premium. It's a chicken an egg thing. Does IV drive option pricing or does option pricing drive IV?
Doesn't matter, it's not accounting for laying off the risk via hedging in other instruments, something which commercials are going to be a hell of a lot more than speculative based funds.
Uhm what? So if you are saying it's already built in... then we are all on the same page that IV SHOULD be higher than HV... Look, if you sell IV at current level of 15 and the realized vol outlier of say 60 hits, you could lose your shirt. That's what I mean by upside/downside... risk/reward. Sell IV of 15, upside is max 15... (which will not happen, haven't seen realize vols of zero)... downside is potentially unlimited, but say more likely to reach 60... So on a day to day basis, IV is higher than HV and selling is a reasonable strategy... but it's that outlier that fucks it up. That's also why there is skew... and if there is skew, that means usually OTM puts are rich... selling them leaves you open, so MM would buy ATM pushing ATM-IV up. As said... there are reasons for higher IVs
Built into price--not IV. Expanding on my 50 delta option example, an actual 50 delta option has a range of possible values at expiry between 0 and lots. Its value is highly dependent on IV. A close approximation to a binary trade would be a vertical spread with the underlying splitting the two strikes which will be valued at half the width of the strikes (let's just ignore skew for a moment). This is independent of IV. So the outlier outcomes and impacts are built into the price--not IV.
I don't see it that way. To me price and IV in options are the same, at least for ATM it is. The only thing you trade with ATM straddles is the expected movement since there's no intrinsic value in it. And therefore the outlier possibilities are both in price and IV. If in your case you look at a 5 spread, where the underlying sits in the middle... the spread is trading at 2.50... which is also the intrinsic value... this case will also be indifferent to time to maturity... So it's different from an ATM in any way and you cannot compare it.
Just a question for deep OTM sellers, when you sell ur options, are you getting the mid? or do you have to cross the spread. I've always wondered. Because statistics go out the window if your crossing the spread.