OTM puts with respect to black swan

this is where the MMs have done a poor job. the far OTM stuff is often priced wrong

 

Magnitude notwithstanding, unless you have a fair estimation of when the outlier may occur, there is no way to tell which puts are preferable. With regards to your backspreads, buying dgamma is only preferable if the move comes soon enough before your gammas have bled out. Substituting gamma for dgamma has a cost. The further out you go, the faster your gammas dwindle so you are back to square 1 - knowing when the event will occur.

Since you don't know the magnitude of the decline nor the time frame, i'd make sure i am long enough gamma or vols into the risk hole. The least amount that is necessary to satisfy VaR comfort levels.

 

Care to elaborate ?

 

I understand the problem here, but given the outlier move, we know the results, that is vol explosion and the subsequent effects. And since time is a function of vol, when the outlier happens, am I wrong in saying that the gammas that have bled out will return and then some (depending on time to expiry), due to vols explosion?

Same for dvega/dvol? Long volgas will overwhelm short vegas somewhat in the scenario, due to skew steepness?

As per Derman's sticky tree model puts it and Natenburg shows it, OTM gamma increases faster then ATMs as those get compressed but still increasing in a black swan IV expansion. Since in the backspread both strikes are OTM, but shorts closer, the entire premise is that my shorts will hit ATM peak gamma faster and then fall off a cliff while OTMs remain high but slowing into ATM. Where I hope to be hedged is I have a lot more longs. Hence the reasoning for my line of questioning about dgamma and dvega.

 

Translation: downside volatility kills.

 

The MM’s do a poor job of pricing?

Sorry but no matter what the underlying these days, you name it, any futures contract or any equity product or currency or debt product there is NO mystery in the pricing of the OTM stuff. In fact the pricing comes form years of historical data on that stuff and years of seeing the order flow under all market conditions, and years of seeing pricing vs. the ATM’s.

Gone long ago are the days of “locals” setting the prices in options, especially in options on any equity products? There are few real locals left anywhere in equity based options products and the ones who are left are usually very experienced and know well enough not to set the price and let the big firms who price everything upstairs before they electronically send all their markets to the floor weather streaming them right to the markets like on the ISE, PHLX and BOX or via their own box jockey standing in the pit.

Most every MM these days is part of a bigger firm who’s basically doing one form or another of dispersion trading so they’re pricing the OTM’s exactly how they should be, especially vs. the other stuff in their dispersion matrix. If they were priced wrong the rest of the world would be all over it in a matter of moments hammering the prices to where they should be.

The days of mystery pricing ended a long long time ago.

 

Sure, everything is essentially a grand replication trade where the risk remains in the most liquid asset; whether that be spot, swaps or futures switches.

 

Yup it’s just repackaging of risk and rolling it into liquidity, hopefully and usually for tiny edge and big volume.

It’s a traders dream to find options priced incorrectly and then just slam them back to the correct parameters.

 

Taleb's approach to Black Swan trading was (is?) to take no risk and take extreme risk at the same time. What this means is that he had his funds in T-Bills (no risk) and used the interest to buy OTM options (extreme risk.)

I haven't a clue as to how he determined how far out to buy, and if he routinely bought puts or calls or strangles. Apparently, this was not such a viable trading approach for his fund.

 

i wrote that the MMs price far OTM options wrong. Not so you or anyone can do a simple arbitrage but that those options are either overpriced or underpriced (not correctly priced).