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How Volatility Traders Make Money

Are you buying overpriced options?
Jared Dillian is the editor of Bull’s Eye Investor, an investment advisory that uses a top-down approach and macroeconomic analysis to identify profitable investments, with a particular focus on behavioral economics. Bull's Eye Investor is a Mauldin Economic publication. Before joining Mauldin Economics, Jared Dillian had a successful career as one of Wall Street’s preeminent risktakers. He started his financial career as a clerk on the floor of the Pacific Options Exchange, where he fetched lunch and ran risk reports and learned everything there was to know about the derivatives markets. After receiving his MBA from the University of San Francisco, he traveled to New York to become a trader for Lehman Brothers. He worked there from 2001 to 2008, bookended by 9/11 and the bankruptcy, first as an index arbitrage trader and then running the ETF desk for a number of years. Under his leadership, Lehman’s ETF effort grew to be number two on the Street in terms of market share and was routinely trading over $1 billion a day in volume.
Jared Dillian is the editor of Bull’s Eye Investor, an investment advisory that uses a top-down approach and macroeconomic analysis to identify profitable investments, with a particular focus on behavioral economics. Bull's Eye Investor is a Mauldin Economic publication. Before joining Mauldin Economics, Jared Dillian had a successful career as one of Wall Street’s preeminent risktakers. He started his financial career as a clerk on the floor of the Pacific Options Exchange, where he fetched lunch and ran risk reports and learned everything there was to know about the derivatives markets. After receiving his MBA from the University of San Francisco, he traveled to New York to become a trader for Lehman Brothers. He worked there from 2001 to 2008, bookended by 9/11 and the bankruptcy, first as an index arbitrage trader and then running the ETF desk for a number of years. Under his leadership, Lehman’s ETF effort grew to be number two on the Street in terms of market share and was routinely trading over $1 billion a day in volume.

Image via Craig Murphy/Flickr CC

I am old enough that I was trading in the markets before decimalization. If an option was trading for a quarter, we called it a “quack.” If it was trading for a sixteenth, we called it a “teeny” or a “stink.”

Beware the teeny puts.

If you were a market maker on the floor, you generally didn’t want to be short any teeny puts right before earnings. Just spend the money and buy them back. No reason to be short unbounded downside risk for just a couple hundred bucks.

The teeny puts have turned into nickel puts since decimalization, but the mythology is the same: everyone dreams of buying cheap options and falling ass-backwards into money. Problem is… it almost never happens.

Those teeny/nickel puts are almost always overpriced. Experienced option traders call them “wing options.” They are overpriced because nobody wants to be short unbounded downside units.

So the teeny option is a bit of an optical illusion. It is cheap in dollar terms, but in valuation terms, it is very expensive.

Determining the Value of a Stock

Basically, how volatility traders make money is by determining a theoretical value for options. They sell options that trade rich to that theoretical value and buy options that trade cheap to that theoretical value.

The theoretical value is indeed theoretical—it is derived from some estimate of future volatility for the stock. Sometimes, that estimate is wrong.

But as a general rule, if you buy cheap things and sell rich things, you will make money in the long run.

So if you see a put or a call offered at five cents, you can bet that the theoretical value is much less than that. Perhaps less than a penny.

All of trading is knowing the value of something. Many individual investors focus on things other than value when they invest. They focus on the technicals (is it going up?) or sentiment (is everyone bearish?) or macro (what will the Fed do?)—but not the actual value of a stock.

Of course, it isn’t that simple to determine the value of a stock—it’s often a matter of opinion. But having a model is a good starting point.

Don’t Get Slammed

The fixed income investors are usually the first to get caned by big market moves, because they think bonds are mathematical and easily valued, when they actually are not.

They have the illusion of being rational. Nothing could be further from the truth.

Of all things, valuing options is actually pretty straightforward. (It gets more complicated in deals, and really complicated with biotech.)

There is nothing complicated about Black-Scholes. Your estimate of future volatility is probably as good as the robot’s. And the reason options get mispriced is because there are plenty of people who are trading options for reasons other than value—like the covered call writers, or the stupid vol ETFs that just sell volatility in a blob.

Buying call options on something simply because you think it will go up will probably set you up for big disappointment. There are a lot of other considerations.

There has been a lot of discussion about how volatility is so preternaturally low after the inauguration.

Trump is turning out to be plenty volatile, but the market is not. Is volatility cheap? I will have the answer to this in my future issues of The 10th Man (subscribe here for free), but I’ll give you a hint:

Not necessarily. Calls are similarly overpriced, but most stocks don’t gap up as much as they gap down.

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