1000 Vol is a Canard

Vol #27- February 26th, 2021

As if to celebrate some kind of reunion, the Gamestop band got back together. After the congressional hearings and executive mea culpas, there was another run on both the stock and the options this week.

At the end of the day yesterday, it cost $4.50 a share - just under 4% of the stocks premium - to bet that the stock would double by the close today. It cost over $10 a share to profit on a 50% jump. Annualized over the 251 other trading days in the year, the arithmetic says that’s a stock with an implied volatility of 1040% a year.

Four digit volatility over the course of the year, means that every single day the price of something changes by more than 60%. No matter what your risk tolerance is, I’d feel pretty comfortable not recommending that as a good long term holding. But every participant has a different timeline. Markets manage risk across time dimensions.

Two days ago, someone paid $0.87 for the right to buy Gamestop stock at $800, when it was trading at $90. Most participants would call that crazy, but if the objective is to flip it to someone willing to pay $1, they're a time risk arbitrageur.

So where does 1000 vol come from, and what does it mean? The most important determinant of an options price, is the future expected volatility. That equation also goes in reverse. If you want an option to have a certain price, you need to give it a certain volatility.

For options that expire in 6 months, it’s interesting to think about what the distribution of the stock will be over the course of the next 132 trading days. There are enough sample days to make the random movement a statistical question.

When you’re asked how to price an option expiring in 2 days, it’s about a few coin flips and how many dollars you might lose. Long tails have a major impact here. The downside risk is capped at zero, but in 2021, if Gamestop could hit $200, why not $800?

Manias have a way of exhausting themselves quickly, and as you’d expect longer dated options don’t reflect anywhere near this level of continued mania - but they’re still pricing moves over 10% a day.

Only a month ago, we talked about how this kind of action is good for markets - let’s hope the game never stops. Funky price action keeps people interested, and seeking opportunities which drive efficiencies.

When I say 1000 vol is a canard, I don’t mean that traders are pricing fiction into their terminals. They’re just thinking like a trader, and not like an equation. It’s important to take a step back and think “what is this really worth?”