When You Play With Fire

Vol #139: July 27th, 2023

Only you can prevent forest fires.

What Smokey the Bear says about camping, I’ll say about options trading. If you play with fire, you’re going to get burned. There are many good reasons to trade options. But there are so many more reasons not to trade them. 

Options offer tantalizing benefits. The income from being short and the convexity of being long tempts us to count monthly payouts or lump sums. The perfect position to win in up markets and get paid through the bear is but a spread away. 

It’s so tempting to look at the best case scenario.  I don’t know what draws us to the green in a gap risk matrix, just as it is human nature to click the buy button that promises steady returns and explosive upside. We aren’t attracted to what goes wrong in a trade, but prefer to follow the arrows in pretty pictures and see what the number looks like when the position works. And there are so many ways to imagine it working with options. 

The multifaceted potential of these financial scalpels brings traders of all stripes and gowns. Most of them are doing it wrong. 

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Options are volatility instruments. When you trade an option, the prevailing price in the market place is a reflection of the best guess participants have for how and how much the underlying equity is going to move over the contract's lifetime.  Selling a covered call for $1.50 does produce the payout profile you’ve seen drawn in so many textbooks, but as a strategy it’s an absolutist negative delta view that volatility is always overpriced. 

Sometimes it is, sometimes it isn’t. More on that later. To really dig into the logic Moontower has a killer tutorial on why covered calls are just a vol trade.

It’s important to recognize the baked-in positioning here, not because every trader needs to be a volatility expert, but because it needs to factor into your personal trade-off calculation. You’re relying on the market value as being fair, and the risks that come with that. It’s generally a good assumption, but not always. Check the price of flood insurance just before and just after a hurricane.

The other calculation you need to take into account is market friction. Transaction costs, bid/ask spread, or the risk free interest rate are all additional expenses to consider in your trade-off. It’s not free to put on a trade or take it off, and the price of liquidity is usually correlated with the magnitude of your negative PnL. 

If you’re not trading volatility, you need to have a positive expected trade-off from an options strategy. Net of your risk of mispricings and cost of market frictions, does engaging in this options trade make practical sense for me? The answer to that can definitely be yes, but it’s a much higher bar than 95% of what you see on YouTube. It’s more about controlling volatility and bounded expectations than some clever trick that rings the cash register on Easy Street. 

If you peel back the hood on a covered call, what makes it attractive is time decay. Positive carry is sexy. The trade exists in many asset classes, but in options we call it theta. Covered calls, cash secured puts, condors; all of these popular strategies pay the short trader with premium as time passes. 

The problem is there’s no free carry. Risk free rates and stocks both move. The reason someone is willing to pay a nickel with 15 minutes left in the day for far out of the money calls is because when the one in a thousand move happens, hold on tight.  Theta is compensation for risk. 

It’s not just theta gang retail that pollyannas into premium collection strategies - institutional money mollifies their LPs with VRP until the variance bomb drops. They use more slide decks and fewer neon fonted GIFs of J-Pow, but the principle is the same. 

The best guess of the future price might be the current price, however so long as there’s a positive denominator with the square root of remaining time, you must also expect some movement from that spot. Variance adds premium to the option’s value because shit happens. 

Order flow enters the market. Johnny Big Lot wakes up from his meatball sub siesta and smashes buy. The active fund decides to roll their hedges early. Maybe it’s macro related, and a Fed governor has something to say. It could just be technical and some firm deployed a piece of bad code that hits every bid in the marketplace. Or it’s just the clunky market mechanism of discounting future cash flows as new information arrives. 

If your options strategy is to always bet on the predictable and expect nothing to change, the winds of fortune will be devastating when they inevitably switch. Assumptions make an ass out of u and me, and every layer you’ve built your thesis upon that hasn’t been battle tested, will be one to fail. 

More than any other asset class, options also present to the investing public an opportunity to feel a direct face off. Even though futures also have an open interest and matching longs/shorts, they don’t have the same heads-up notion that aspiring options traders feel. You’re long, I’m short, where’s stock going to go?

Dealers sitting behind the curtain are a murky entity. Bestowed with preferential treatment, they are able to circle markets around their shorts and send it through their longs. It’s not enough for these flippers of flow to collect edge, they must extract maximum pain from retail. (So goes the lore.) 

The person on the other side of the trade is playing a different game. They’re pricing implied volatility and trying to scalp edge on both sides. Emulating how they make money or position themselves should be of little interest to a trading strategy - the fact that they are there providing liquidity is far more important. They’re closer to Smokey the Bear’s kid - more scared then you are. 

Effective strategies for retail traders should fall into one of two buckets. The first class is broad overlay strategies for portfolio management. Long put spreads funded by short calls to buffer volatility are attractive because the deficit versus absolute returns is worth having less risk (I call this the GULL strategy). Buying call spreads with interest rate premium (OWL) is also interesting as a trade off between protection and exposure. 

The second class would be active trading strategies that work in regular margin accounts. The edge here is likely to move, so what worked yesterday isn’t going to work tomorrow. This is true for any market participant, and probably one of the best arguments for passive investing - these strategies require constant disciplined work. One example would be finding a structural truth that is not well priced.

In the volatility ETN/ETF space, the cost of managing a fund’s exposure is material, because futures must be rebalanced every day to provide the constant structure. This creates significant drag on the long term price of the note. Using options combos (long put, short call) you can get structurally short the same notional amount of long and short ETF (e.g. SVIX and UVIX) and capture the fee drag with no delta exposure.

This works because it relies on the certainty of the rebalancing as structural to the prospectus. There are execution risks, as well as tracking errors - such as the rounding errors due to contract sizing. The edge could go away as more people squeeze the trade, but there aren’t too many layers of assumptions, it’s literally in funds' operating instructions. 

If that sounds tedious and complicated, you probably belong in the 99% of people that shouldn’t be actively trading options strategies. A simple overlay or no options at all will do you much better. 

The third strategy I’ll allow for, is the play account. Keep a small portfolio where you can shoot your shot, punt spreads and split broken wing butterflies. Read the tea leaves, count the other guy’s gamma, and draw lines on charts. It’s fun to take a calculated risk and see if you’re right or wrong. Size doesn’t actually matter that much. If it turns out you’re consistently making money, scale up slowly. If not, you just paid a very small tuition for what could have been your entire book. The consolation prize is a tax write-offs and the yucks you shared on X.com. You also get a deeper appreciation for the efficiency of markets and grind that is true edge.

With the disclaimers, warnings, and caveats out of the way, if you still decide you need to make a trade, do it somewhere liquid. Not only do you want to trade something that is very well priced in the equity market space, but you want to trade something that has deep options liquidity. (These are usually correlated.) 

Individual names are more fun, but ETFs deserve a special plug first. They have a baked-in diversification plan, provided at a very low cost. They have dozens of the most well capitalized institutions grilling their every mispricing at a billion dollar scale. Top tier ETFs are excellent for the right options strategy because you can lean on their pricing in several dimensions.

These products fit very well with the defined outcome overlay strategies - guardrails for medium and long term investments. Trading strategy number one, where you’re leaning on market efficiency to make relatively well priced trade-offs. 

Liquidity matters so much, because options can be mispriced by a lot.  Volumes and thus liquidity fall off an absolute cliff outside the top names. The top 10 equity names combine to only barely nudge out SPY in total volume over the last ninety days - the top 9 don’t meet that mark. 

An option’s price is derived from the implied variance over an expected duration, so a rough measure for how efficient options markets might be how that pricing converts into reality. VRP is hand waved away as the insurance analogy for selling options to those fancy LPs, and it stands for variance risk premium. It’s the difference between implied volatility and realized volatility, but we can also think of it here as a measure of market efficiency. A small difference - positive or negative - means the weighing machine built on matching engines is doing its job. 

The VRP of SPY over the past three months has been somewhere between 2-9% points¹. Usually it’s positive (see the insurance example) because options also have to price the tail risk. Recently it’s only when implied vol first got crushed in April that we saw the higher differentials for SPY.

Comparing this to even the most liquid of equities, the difference is stark. The #10 individual equity is AMC². I’ll play fair and pick #9 PLTR. Some aggressive stock moves have mispriced realized volatility in both directions. The minimum absolute levels of PLTR are SPY’s maximum. A third of the data points misprice vol by more than 15 points; or over a 20% margin of error on a ~70 vol stock. Interestingly SPY mispricing isn’t much different in percentage terms, but the dollars and cents of 12 vol vs 10 vol is very different than 70 vs 55. 

Is volatility well priced? That’s a subjective question, but anyone dealing with options should know the range of mispricing we’re talking about even in the most liquid of names. If you go much further out the spectrum, liquidity quickly slides into oblivion. 

If you really have an idea about something that’s poorly priced and are confident that you have enough of a directional edge to overcome the vagaries of pricing and execution, go ahead and make that trade. The margin of error is going to work in your favor here. 

Don’t fight the bid ask spread. If you get too cheeky you’re likely to just trip yourself up and broadcast your alpha. The person on the other side knows just as little as you do (maybe less than?)  - that’s why it’s a wide market. They’re hoping your size isn’t too big, to let them reprice, and if they get to do that a dozen times then they’ll be able to cover their costs from the one guy (you?) that actually was informed enough to take money out of their pockets. 

After you’ve crossed out all the reasons why not to trade options, you’re ready for the show. Know your assumptions and likelihood of being wrong. Risk manage your trade sizes to play another day. And don’t you dare ever think you know more than the market. 

Trading options has the power of fire. Well controlled it will cook your food and heat your home. Poorly managed fires are a disaster. A bad trade will blow up in dimensions you never thought possible. Before striking a match, it’s extremely important to know what you’re looking for with options, it might very well be nothing. 

1. This is 30 day implied vol of ATM options, minus the 30 day realized or historical vol using close to close marks.

2. AMC VRP has seen a range from 42% to +189% just over the last three months. With implied vol trading between roughly 80% and 250%, it’s been a choppy ride.