It violates the underlying distribution assumptions under basic option pricing. How would you propose to arbitrage the smile under such useful maths to make "basic option pricing inviolate?" The deep ITM call or put buyer would disagree that options are a bet on vol over direction. The buyer of OTM street volatility[MSFT, INTC, PG...] are betting on gamma/vega. The OTM index call buyer is buying a directional bet, not vol. OTM/ITM options(generically, across classes) are a gamma bet. OTM index puts are a vol or directional bet. <20d options have very little leverage to vega. Ppl trade them as a bet against the distribution and tend to deny the risk. I don't want to get into defining what makes a vega/gamma bet from a numerical basis, obviously there are exceptions and I realize options are priced in vol. I sold some atm GOOG straddles for Sep... they're a vega bet into downside-gamma. Selling the outside 20d wings would make for a poor vega play.
Well, I for one don't buy 90d calls thinking I'm taking-on vegas, nor gammas for that matter. Cheaper to carry as a limited risk proxy for the underlying. Come to think of it, I am not buying any calls for now.
that's why i said it is a weighted average of opinions. if soros believe an asset is worth $10 and has a billion dollars riding on that opinion and i think it's worth $20 and put a thousand dollars on that opinion, if we were the only two players, where do you think that asset would trade? "fair value" is always known; it is the current market price. fair value can be opposed by something like "true value" which might be considered what some future fair value will be discounted to the present.
Off topic a little, but over the years I've noticed something interesting while placing option orders. I may be dreaming, but it seems to happen way more often than not. I will place, for example, a limit order to sell calls at/near the quoted ask. And if it executes right away I will soon see, like in the next 2-5 minutes the stock moving up. So it's like the option floor trader or MM is "plugged in", or otherwise knows the stock specialist's/MM's book/order imbalance. If this is true and not my imagination, you could have a couple minute headstart on a stock move. I guess it would make sense for the option mm's to want to get their hedge on fast, etc, if they know the stock is going someplace very soon. I need to write these instances down and see if they are actionable. I don't daytrade, so I don't look at Level II or order depth, or try to tape read. Could be this info is there for all to see anyway. Or maybe I'm just "remembering" selective events. Good trading to all. C
It does show the higher RISK of the underlying being up or down. Given a risk-neutral expectation E(u), you can find an infinite number of probability distributions that will fit this expectation. Some of them will show immence directional risk, don't you agree?
Yes, and even the first moment plays a role in principal, because the risk-free rate is stochastic, too.
I guess you stumbled on Murphy's Law. It has perceived negative expectancy and an annoying particularity: if you take the other side of the trade, oops! it applies again. It's sort of like Moebius strip: if you remember it from math (http://mathforum.org/sum95/math_and/moebius/moebius.html) both sides of the strip are one.
Guys, can you pick this apart? Or is it solid? Is it that the probability for the two scenarios are not equal? That is to say, there is more of a chance in a change of volatility than a change the same magnitute in the underlying? I'm just guessing this because intuitively I think the chance that the price will go up 30% is much less than the probablity of the vol. going up that much.