interesting question. i'd approach it this way. first, markets are becoming more efficient as greater and greater resources are devoted to the pursuit of finding anomalies. however it's important to remember that market values are a consensus of the spectrum of opinions over what "true value" is. those opinions tend to become realized with large capital to support them. if opinion backed by capital says puts are more valuable then calls, i won't refute what the money is saying. in short, i believe both your reasons explain the skew phenomenon.
How many years are you doing this, if I may ask? Cause I would really love to see how your book fared in 98 and 01. It's easy to boast selling premium in a declining vol environment. I know couple dealers that got caught short call-side gamma in OTC bond options on Sep 11 and posted 10-million loss. There are few big differences between being an insurance company and an option seller. Insurance by definition is a retail business, which drives up the margins. Also, insurance is a sell-only business, in that aspect very similar to structured notes. Now, imagine if every Joe could sell insurance, where do you think their margins would end up. In addition, one of the reason for the hefty premium are the capital requirements to run such a company. Just in case you did not know, insurance companies hedge catastrophic events. They are not net sellers, just re-sellers of risk from wholesale (i.e. CAT-bonds) to retail (i.e. flood insurance). There are other actuarial derivatives being traded in the OTC market. All this said, I'm not claiming that the far wings a fairly priced, I am just saying that being short gamma at ALL times is not nessesarily "the" winning strategy.
Of course - if there is no way to ARB a market of essential goods, the prices will always favor the seller up to the point of subsitutability. Do you think retail gasoline is failry priced, for example?
I think both reasons have some validity also, which means it is possible prices are out of line today, we just don't know it until the future. I can't agree more with your statement on 'true value' more, it is simply what the conglomerate macro view of prices are by all market participants. At this point I'm not convinced the 'rightness' of today's price is not priced more in line with the insurance company analogy, which has a built in profit.
Good point - selling puts is more like selling earthquake insurance, and not like selling car insurance. [edit: I mean puts on an index]
I appreciate your point although I think it is considerably more difficult for a retail client to get approved for selling options.
Mav and others with a good understand of options, thanks for your great posts. I was thinking about your comments concerning about how buying and selling balance in the pricing of options so that there should be no edge and something occured to me that hasn't really been explored (at least in the pages of this thread I've read so far). Sorry if I missed something already stated. If the market is theoretically perfectly balanced then a trader who simply enters a trade blind (flip a coin to buy or sell premium) and does this again and again and again, then in the long run she would be even on the trades but negative the expenses and spread incurred? If that is what you are saying then I will extrapolate a theory from that: If a trader applies successful money management then perhaps the expense and spread can be overcome such that winners run and losers are cut far short of the possible loss. Whether it would be enough to overcome the MM edge I have no idea but the fact that the "game" is stacked against someone beyond the expenses gives a trader a fighting chance right? One doesn't have to overcome expenses AND some theoretical market edge at the same time. He is poised on the tipping point so to speak. In other words, for option writers, the market should be balanced over all the possible points where it could expire ITM (a loss) and OTM. But what if you limit the loss side of the equation through money management and assume IV will increase in making your decisions. Would this then tip the balance? What am I missing? For example, let's take a short strangle. Now let's assume the trader has a way (let's assume this is possible for just a second) to determine that the market will hit one of the strike prices about 30% of the time on average that this trade is made and that she has determined that she will exit that half of the trade at that moment and leave the other to hopefully expire worthless (<1% chance of toching both stikes, let's say). So the gain if both options expire worthless is X and the loss to exit half early is Y. As long as Y - expenses is < 2.33 times the size of X - expenses on average, then the trader should be ahead in the long run, right? So it seems to me that selling options comes down to honing one's skills at knowing the percentage chances of events. It seems that it's a lot easier to tell where an underlying is not likely to be (selling OTM) then where it will be (buying OTM) so that is why selling + money management seems more likely to lead to success than buying (though there is no reason why buying can gain the same edge in the same way) but I look forward to your answer since you guys will likely point out the holes. I just feel that in the end the market may be fair but the spoils go to those with the better management. Saying that a buyer and seller of the same strike have the same chance for that one trade is true but irrelevant to determining the success of each of those two traders in the long run, because one may be be very disciplined about cutting losses and the other not. Is the catch here that the farther OTM the harder it would be to cut risk at a point that is less than the potential profit * chance of profit so that the higher the trader cranks up the % likely win rate (further OTM) the easier it would be for the option to double or triple etc. in value?
This has been a very interesting topic, and thanks to all for your input. My bad on the analogy of insurance companies - clearly it doesn't hold water. I do believe in the effeciency of the market, so it seems I've got more studying to do. Here I was thinking that positive theta gave me an edge (my portfolio performance might suggest it does, but that seems to be a fluke or maybe fortutiously timed trading on my part), but I've been convinced it doesn't, and I definitely need a better grasp of the importance of gamma. I never really pay attention to gamma, although I understand how it works. I'll have to do a search and see if there are any good threads on gamma. I do try to exit short positions of spreads or roll them over 10 to 4 days before expiration, eliminating the growing gamma risk.