Option Pricing Efficiency

Discussion in 'Options' started by jazzguysoca, Feb 5, 2011.

  1. Question for the option sages who inhabit this part of the ET forums:

    I've been researching options pricing the past few months and based on what I've gleaned from reading Natenberg, Sinclair, and others, it appears that an option buyer with no edge can over time expect to loose the equivalent of the current risk free rate, plus commish/slippage. (And an option seller can expect to make that rate)

    ie: If each day at a random time one were to buy an near month ATM call (or put) and hold it until expiration, one could expect to be down by around the current T-Bill rate (plus commis/slippage) each year, on average.

    Obviously there would be some variation, but after a reasonably large number of trades, the Law of Large Numbers would bring the total losses to their expected loss: T-Bill rate + execution costs.

    Thus over time, you can expect that the actual cost of any option contract to average out to something like 2%/year.

    Is this essentially correct?


    The reason I'm asking is that I'm considering adding options to a stock trading strategy in order to increase my Calmar ratio and protect myself from Black Swans, and am trying to get a handle on how much of my annual returns I'll have to give up for that privilege.

    ie: If adding married puts to my longs will only cost me ~2%/year, then its definitely something I should be doing. But if the costs are more significant, than it might be too prohibitive.

    Anyway, sorry for asking what probably is a stupid question; I'm a long time stock trader with zero options experience, and just want to see if I'm completely out to lunch in my thinking.

    Thanks in advance for any words of wisdom.
     
  2. rosy2

    rosy2

    not sure. but the person on the other side of your trade is probably a market maker hedging his position as he holds it. so you both can "win". you selectively get into positions and the MM takes the other side and hedges.

    My only advice is to look at options with at least 3 months to expiration if you are a buyer.
     
  3. heech

    heech

    Actually, I believe research has shown that selling ATM straddles has significant alpha over the years. Someone must have a link to those numbers. That said, a single 2008-2009 crisis throws those numbers out the door.

    In other words, if you want these as a hedge.... Expect to lose much more than risk free rate in everything but the black swan years.
     

  4. Thanks for the reply, heech. Would the larger losses apply to the more thickly traded options as well?

    I'd assume that calls/puts in SPY/QQQQ/etc or AAPL/GOOG/etc would be pretty efficiently priced and any large premiums would be arbitraged away pretty rapidly.

    ie: If one were to randomly sell ATM calls in SPY and puts in QQQQ on a daily basis and hold until expiration, wouldn't the expected return be in the neighborhood of T-Bill returns?

    Note that my perspective is probably a bit different than that of an option trader as I just want to use puts as insurance policies rather than to try and trade them with any sort of edge (my edge is in the underlying stock positions, rather than the puts)
     
  5. Thanks for the reply, rosy.

    I think in the context of the scenarios I mentioned, the expiration is irrelevant, as the annualized return for any option seller of any price/expiration is more or less the same (assuming my understanding of the Black-Scholes formula is correct).

    In my application, I'm not trying to trade puts with any sort of edge; I just want to use them to hedge my longs and am trying to get a feeling for what sort of premium I'll end up paying.
     
  6. Jazzguy, I think you're taking the whole concept of mkt efficiency to a rather uninteresting extreme. In theory, a randomly chosen portfolio of any instruments, not just options, will return the risk free rate less transaction costs, if sampled over a large enough number of iterations. If you're trying to look into systematically using options to protect your portfolio, that's a subject that has been much studied in academia. The outcome of most such studies is, unsurprisingly, that there's no free lunch.
     
  7. Expectancy is the same for buyer and seller, if it's not already been mentioned.
     
  8. rew

    rew

    It's been a while since I read Natenberg or Sinclair but I don't recall anything about selling options at random giving you the risk free return. The theoretical option price sets the option price to the present value of its expected value at maturity. The ask is set a little higher and the bid is set a little lower, so traders without an edge who buy at the ask and sell at the bid will lose a little bit whether they buy or sell.

    Even if you could earn the risk free rate of return by selling options without an edge you'd be nuts to do so -- you'd make the same money buying a Treasury bond and sleep much better at night.
     
  9. dont

    dont

    the option price assumes that you continuously delta hedge, owning an option and not hedging gives a very wide distribution of outcomes, i am uncertain if over time you will lose the risk free rate , have look at wilmotts stuff I have feeling you get a chi squared distribution of outcomes, the market over prices volatility in an attempt to remove the effect of th black swan, but if you use the options as an insurance that is. judiciously, it can at times work, but I would be skeptical of just assuming the cost without delta hedging would be the risk free rate
     
  10. Where does Natenberg indicate this? It's just my opinion but I don't think that it's true that an option buyer with no edge can expect to only lose the risk free rate plus commish/slippage. If it was, every mutual/hedge/pension fund, investor, etc. would do it in conjunction with equity ownership and never have significant portfolio drawdowns and that's just not happening. In fact, they'd never take equity positions (see below).

    The cost per calendar month (30.5 days) per ATM option would be approximately 3 pct for every 25 BP's of implied volatility (36 pct per year). So for a $100 stk at 50 IV, you'd expect to pay $6 per month for the ATM.

    Analyzing what the return would be on the options is above my pay grade but simplictically, if you were buying puts, you'd do quite nicely in a bear market, quite poorly in a bull and somewhere not too far from neutral in a nowhere year.
     
    #10     Feb 6, 2011