Theta risk
I'm studying some option theory, and I'm wondering if puts + calls have negative theta, then what are the mechanics of it being priced in? So for instance, suppose that I buy a bunch options with -10 theta. Then will the options lose $10 every day? So I'm guessing that's already priced in, but then shouldn't the options be 0 theta?
Thanks!
It's priced in, but theta is not zero because you are long volatility when you're short theta. If theta were zero but vega were positive, you'd be long volatility yet have no downside risk (i.e. arbitrage opportunity).
Btw, options are a zero sum game, but I would argue (and there's some evidence to back this up), that selling options is the positive end, and buying options is the negative end (i.e. expected return for selling options is positive and for buying them it's negative). This is due to the risk averse nature of investors and thus the desire to use options as insurance (for which buying options is more often done).
Options have theta because you have positive delta convexity(gamma). A simple way to think about theta is that it's the rent that you have to pay to be able to receive gamma. I would gain a more full understanding of gamma, since understanding gamma will show you why you will (almost) always have negative theta when you have positive gamma
This is a flawed theoretical argument because you can create positions that are positive theta and positive gamma. They're not common and they involve multiple legs, but they are possible. These are not arbitrage opportunities because you're heavily short volatility. If you think about it your way, then I'm receiving rent to be able to receive even more! Only when you introduce the notion of volatility do you understand why that's not an arbitrage.
To be fair, it's not as simple as my explanation tying it solely to vol either, but your reasoning for why theta exists is technically incorrect (albeit it is very useful from a practical perspective). These are multi-variable instruments, so while there are strong correlations between some of the variables (positive or negative), the interaction between the variables, especially once multi-leg trades are done, can make things much more complicated. Theta exists because time is a variable that drives the price, that's it.
This is an analogy you might find useful. You have two batters in baseball. One has hit .210, .220, and .230 in the past three years. The other has hit .330, .100, and .230 in the past three years. If you had to be on one of these hitting over .300 in one of the next three years, which one would you want to bet on? The second one, obviously, because his volatility is much higher. Because this increase in desire to pay is amortized over the same time frame, the loss in value for each unit time is greater for an investment in the second batter . If the theta were the same, then you would short your bet in the first batter and buy up the second one. This gives you a rough idea of why volatility and time decay are related.
alex-- Arguing that options are overpriced would actually go against most of the research on options over the past 3-5 years that has been aiming for improvements on the BSM model and trying to explain the common observation of 'fat tail' events that happen more frequent than the model and smile imply. There are many that argue they are underpriced over the long term (Nassim Taleb being the most well-known proponent of this argument), and even those that do not believe this to be the case will say that a constant short strategy only works with infinite capital.
BSM is not perfect, that's why we have volatility smiles, fat-tail events, etc. I'm not saying that options are ALWAYS overpriced. Just that they usually are. Look up some tickers and compare historical vol to implied vol.
http://seekingalpha.com/article/255338-do-covered-calls-improve-expecte…
There's more on the topic if you look around, it's actually funny because you can improve returns slightly while at the same time significantly reducing volatility. I'm sure that I could run some "opaque" hedge fund, end up with a sharpe ratio better than the market, even net of fees; all the while doing nothing more than selling cash secured puts on the S&P (or doing covered calls). I'm convinced a lot of hedge funds essentially run this strategy, they just don't realize it. There are some caveats, and some well-founded theoretical rebuttals. But even if we assume perfectly priced options, the expected return stays the same relative to just being long, but volatility goes down. I see mispricings in the options markets all the time. Some are very nuanced, but some are blatant. DId any of you guys notice that put-call parity was not holding in LNKD (hell, it might still not be)? Just that getting sustained access to shorts has been impossible.
Well, you're heavily long vega when you put on such a spread, which is not the same as saying you're long volatility. If you're long a time spread (long vega, collecting theta), you get absolutely killed to a sudden exposure to 'volatility' (ie if there is a five sigma event) because of how your volatility exposure is distributed. Not to mention, you're only long implied vol. If you buy a time spread, you move twice the front month straddle, IV may very well get slaughtered (happens a lot with WASD numbers) on the move and you'll get killed to the gamma.
Like I said in my post, once you start talking multi-leg trades, things can get much more complicated as far as interpreting the greeks. I don't see how you can infer I said anything to the contrary. I was merely correcting an incorrect theoretical statement that "theta is the rent you pay to be able to receive gamma". That is just as incorrect as, how you pointed out, being long vega does not mean that you always make money when volatility goes up, because different expirations/strikes can have different implied vols, etc. You'll also know that, from a purely theoretical perspective, volatility is meant to be constant, so it's not like I said anything wrong in that regard...
Also, who says long/short theta? The terminology is paying/collecting theta, if you talk to anybody on a desk (people will often give you a funny look if you say long/short theta).
I've also said paying/collecting theta, but I also say long/short theta. No one's looked at me funny yet ;)
What the hell are you talking about? You realize put-call parity factors in the cost of carry, right? Hard to borrow stocks often have call/put prices that look off to casual observers when they don't realize that cost to borrow the stock is astronomical (perhaps not even possible).
I'm glad you discovered buy-writes. Awesome. That is about as basic it gets. You're basically saying that you can sell naked puts on the S&P and you'll generally make money since the market is generally higher than it was the year before. The market has already prices in people doing buy-writes and, after transaction costs, it is questionable whether there is any benefit over just being long the S&P outside of having a lower volatility exposure (in which case you should be looking outside of an equity index).
You realize that just selling premium doesn't work, right? That is literally the most simplistic and fail-secured strategy that you can get.
Plus, if you knew anything about the smile, you get practically 0 premium out of selling those near the money calls on equity indexes. That dip portion of the skew is worthless because that's what everybody that owns lots of minis or SPY shares tries to do to capture a tiny bit of edge over being long. Rolling those over each month or having to buy back your shares will inflate the transaction costs for a small investor enough to take away any real edge in the strategy.
Lol talk about refuting points I didn't make. It wasn't that the cost to borrow was too high, it was that there was an inability to short shares, period. That still does not mean that the IV for the puts being about double that for the calls was not a THEORETICAL mispricing. Are you on acid? I'm talking purely theoretical here, and you come back at me with practical shit. I already know the practical caveats to the theoretical stuff. You think you're educating me or something? LOL
My argument was not that you have a higher expected return (you have seen that historically, but I thought it was clear that was not the crux of my argument when I mentioned "perfect options prices", again, THEORY). My argument was that you could make the same return for significantly less volatility. You even mention this in your point.
Yes I realize just selling premium doesn't work. But thanks for the tip!
Yes, I do know about the smile...again, thanks for refuting a point I never made. I never talked about transaction costs, volatility smiles, etc.
I love how you make erroneous negative assumptions about my knowledge of this topic without even knowing me yet I don't make any negative assumptions about you. I manage money for a living, and I trade a lot of options (and I've made some very nice returns doing it). I'm not some newbie. I may not be Robert Merton, but neither are you, and you come across as some smug SOB refuting people's points that they didn't even make! I already know everything you posted!
You really do not know what you're talking about. You're asking me if I'm on acid and you do not know what put-call parity even is, much less think that nobody would have instantly arbed this situation before you read about it on some trading forum.
You said put-call parity was not holding for LNKD, when in fact, you do not understand what put-call parity is! You clearly don't understand what short selling is either since you said "It wasn't that the cost to borrow was too high, it was that there was an inability to short shares, period." Hmmm, what do you think you have to do to short a stock, alex? This has nothing to do with practical vs theoretical--it has to do with understanding what is the equation of p/c parity. You clearly do not understand that the cost of borrowing is to be factored into the price, as are interest rates. That has nothing to do with practicality vs theory.
You don't make the same returns for less volatility because you have higher transaction costs! Not to mention, that strategy has utterly failed in recent years, so unless you believe that the market dynamics will remain constant, you cannot factually say or believe that it will yield better returns with less volatility. Even know, the returns are only comparable because you don't factor in the high transaction costs. You said you could set-up a fund that does this and net of fees/transactions costs/etc. have a better Sharpe. That is absolutely laughable and shows the lack of knowledge and experience with options.
I'm a smug SOB because I'm pointing out facts that refute your absolutely dangerous statements? I don't think you even understand the risks of the strategies you are talking about and trying to pass-off advice to someone that is new to options when you don't understand put-call parity is negligent. Completely negligent. It has nothing to do with smug or having a different opinion--it comes with not spewing bullshit out of the asshole on a topic you don't know much about.
"Yes I realize just selling premium doesn't work. But thanks for the tip!" --alexp
"I'm sure that I could run some "opaque" hedge fund, end up with a sharpe ratio better than the market, even net of fees; all the while doing nothing more than selling cash secured puts on the S&P (or doing covered calls)."
LOL! AWESOME, ALEX.
"it is questionable whether there is any benefit over just being long the S&P outside of having a lower volatility exposure" -Jerome Marrow
Expected return minus rf, the numerator in the Sharpe ratio, stays the same. Volatility, the denominator, decreases. Ergo, the Sharpe ratio increases. That is what I said in my post, and you said the exact same thing.
So, why did I also say it "doesn't work"? Did I contradict myself? Oh no! But you're too stupid to realize the subtle nuance of why.
It "doesn't work" because Sharpe ratio is not a perfect measure of risk-adjusted return (there is no such thing as a "perfect" measure of risk-adjusted return). If you looked at other metrics, you would realize that you are paying fees for a strategy that is not improving your risk-adjusted return (for example, downside volatility remains essentially changed, so the Sortino ratio goes down net of fees). Still, because most investors are not THAT sophisticated and tend to overweight the importance of the Sharpe ratio, you can get away with it. You brush off the significantly higher Sharpe ratio as if it's no big deal, and that tells me you've never had to actually raise money. Metrics such as that mean everything in that regard, and most investors are sophisticated enough to know what a Sharpe ratio is, but not sophisticated enough to understand its pitfalls.
Thus, hedge fund managers are rewarded for higher Sharpe ratios, so it behooves you to have a strategy that sells volatility, because that will improve your risk-adjusted return. Look at LTCM, ridiculously high Sharpe ratio, until they blew up, because yes, there is such a thing as fat-tail risk and the BSM model is not perfect. In theory, their blowing up was almost statistically impossible, yet it happened really suddenly in the span of a month. As you routinely point out in all your posts, theory is not the same as practice/reality. I know all the reasons why, but you seem intent on assuming that I do not even when I think it should be clear that I am aware of everything you have mentioned.
Btw, I just googled it, to smite you and prove to everyone that Alex>Jerome. Some guy wrote his fucking dissertation on this very topic. The abstract's all you need to read. Suck my big...swinging...dick...
http://docs.lib.purdue.edu/dissertations/AAI3210717/
Haha if you see later in my post, I said almost always.
And for a simple single option, it is 100% theoretically correct. Show me any single option with positive theta and positive gamma. He wasn't asking about complex option positions, he was asking about simple options theory. I was trying to clarify something for him, not talk about advanced option theory...
I know, I agree. I was nitpicking for the sake of nitpicking. Imo, it's just a slightly incorrect way of looking at it (that could only be brought to light by showing a multi-legged trade).
lol I'm done trying to show a buffoon the truth. I was hoping that, just maybe, you would have taken this instance to actually go and read Natenberg and understand what you're talking about. In fact, you chose to show yourself to be an even bigger imbecile than I initially believed. I can only hope that no new or aspiring trader reads your comments (and backpedaling) and takes what you say to be true as it will most certainly mean a short end to their career in trading options.
Let's just hope you step back and examine put-call parity before you try and even think anymore about options (or hell, understand what short selling even is!). Without going into the gibberish above, let us not forget that you did say, 'even net of fees', when describing the validity of your strategy, which pretty much ends this thread.
Dude, you're an idiot. Zero facts in your rebuttal. I have cited a dissertation, and shown coherent, well thought out arguments of where I agree and disagree with you. In fact, I would argue that the ONLY reason you took any issue with anything I said, is that you assumed I did not know the caveats to options theory as it pertains to real world practice when in fact I do. In fact, I would argue that any objective reader of this thread could only conclude that, if anything, I understand it better than you (feel free to chime in, fellow monkeys!).
I'm not backpedalling in the slightest. You misunderstood what I said, and claimed victory when in fact a nuanced, sophisticated analysis of what I said clearly shows that you mixed apples and oranges. The dissertation shows that an objective third party agrees with me 100%. The academic (i.e. about the most official thing I could have posted as far as evidence goes) paper shows why you are a retard (it literally reiterates EVERYTHING I said). In response, you come back to me with zero data, rational rebuttals, or anything other than personal insults. (sore loser?)
How does the fact that I said "net of fees" invalidate what I said? I specifically said that to bring emphasis to the fact that the Sharpe ratio goes up so significantly that even after deducting typical HF fees, the Sharpe ratio is still higher. If we looked at a Sortino ratio, they would be the same before fees, but after fees, the covered call strategy would have a lower risk-adjusted return (hence validating my point that "it doesn't work", when you look at a more relevant risk-adjusted return metric). Please tell me how there is anything wrong with this? You're grasping at straws dude, and you're failing at that too...
Bottom line, get the stick out of your ass...you lost. There ARE people out there smarter than you...
And LTCM didn't have a high Sharpe ratio. The inputs to get that calculation were incorrect, making that number invalid to begin with.
http://www.investopedia.com/articles/07/SharpeRatio.asp#axzz1V4HjB2Uc
"For example, according to Hal Lux in his article, "Risk Gets Riskier", which appeared in Institutional Investor in 2002, Long-Term Capital Management (LTCM) had a very high Sharpe ratio of 4.35 before it imploded in 1998."
When you get published in Institutional Investor pointing out the failure in the methodology for how the Sharpe ratio was calculated, especially in the LTCM case, please let me know (like dude, it's three variables, return, risk-free rate, and volatility, all of which are historical, and extremely easy to measure). Obviously, the Sharpe ratio was, ex-post, not a great performance/risk metric to use for LTCM, but it's very easy to calculate. I find it incredibly difficult to believe that you could miscalculate it. What input was wrong? Anyone with monthly return data can calculate it. Do you know how incredibly stupid you're coming across right now? Are you like having a crying fit or something? Stop. Take a breath. Everything will be ok...
lol you cited a piece of shit dissertation that just was a review of older literature and doesn't include the most recent decade.... and obviously no transaction costs are considered.
Your comments on the Sharpe ratio are a joke. If you're using returns of only 1 year (or less!), you cannot comment of the Sharpe ratio of a strategy. You're using incorrect/incomplete information in the equation and receiving an invalid result. If you had run a Monte Carlo of the strategy, you would have assuredly come up with a different Sharpe ratio, hence the inputs being deemed incorrect to begin with.
You don't know put-call parity. You don't know what short selling is.End of discussion.
Whatever dude, you're an idiot. I obviously don't know Sharpe ratios, put-call parity, or short selling. I also don't know how to spell my name, or go to the bathroom by myself. I bow down to the genius that is Jerome Marrow...happy now?
If you want to refute the dissertation, please give me a more recent one contradicting it, or some rational rebuttal of it. I just did a quick google search. I have said absolutely nothing that is incorrect; meanwhile, you have. You also have serious egg on your face per your ridiculous LTCM comments and also blatantly misunderstanding my comments (like when you quoted me as if you had "won" but then I clearly showed why your reasoning was flawed and I was right).
You really don't know jack shit about how to have a proper debate. You keep introducing improper straw men...for example, when did I say 1 year of return data? LTCM was around for a few years and the dissertation used several years of data, so why are you pulling shit out of your ass? No, you add that in there to try to invalidate my argument even though I make no comment about time horizon. Here's another one, where did I talk about Monte Carlo? The dissertation is the only thing that mentioned Monte Carlo, and the results of their analysis confirmed my conclusions. So I guess that, yes, if I had run a Monte Carlo of it, I would magically arrive at a conclusion that supports your analysis, just because you say so. You keep putting words in my mouth, and when I correct you, and CITE outside sources that support what I say, you just come back with even more straw men and personal insults. The fact that you're putting words in my mouth, whereas I'm not doing that to you, speaks volumes about both your character and intellect. Fuck you dude, you're a disgrace and have lost all credibility at this point.
Options are not a zero-sum game friends!
lol awww Alex is mad because he didn't know that the cost of carry is factored into p/c parity..... He thinks that selling puts naked has a positive expected value.... I lost all credibility because I called him out. He cited a random dude who studied at Purdue for his evidence.
Hey Alex, how does my ass taste?
The only person that's gotten monkey shit in this whole thread is you, and it wasn't from me. I say we let people keep voting...
And several years for LTCM? Give me a break, guy. The entire fund was open and shut in about 4. Hardly enough to have any significant data to use for returns in a Sharpe ratio or volatility in those returns. Shit, a decade wouldn't be enough for such strategies.
Lol this comment is funny. I suppose no one ever raises any money until their track record is 4 years long. There were a lot of people that threw money at LTCM, because they fell in love with the Sharpe ratio and believed it wasn't risky because they trusted the pedigrees/names behind the fund. It's very easy ex-post to say that those people were idiots.
I am not advocating that anyone be a consistent premium seller. I made an accurate comment that if you did do that, that your Sharpe ratio would be attractive; because that metric does not capture the risks inherent to such a strategy. Also, it is historically accurate to say that implied tends to be above realized, so you are usually better off selling premium than buying it. I am usually selling premium/volatility, but definitely not when I see outsized risks to the market. For example, I had a ton of VIX futures this month, so I was heavily long vol this month. I've lost no money this month because of that. If all I had was covered calls, they would not have offered adequate protection during this market correction.
If you think I'm BS-ing you, search VXQ11 in the WSO search box. You can see I've been long vol since July (actually, since late June). I bet you think I'm some idiot just blindly selling premium, choke on that piece of evidence, needle dick.
Let me give you some words of wisdom, I've said this to several people today actually. Consistently selling gamma and selling vol will usually work, realized vol generally is below implied. The problem with ALWAYS selling vol is that the strategy works until it doesn't... and when it doesn't it often REALLY doesn't. Does this mean you shouldn't ever be short gamma or sell vol, absolutely not, there are ways to be intelligent about it, but just always selling because implieds are above realized is a disaster waiting to happen.
I totally agree with this and haven't argued otherwise. My only argument was that until you blow up, you have one nice Sharpe ratio you can use to market the fund. That's what all the research would (and does) say. Also, if all you're doing is covered calls, in theory your blow up risk is not any greater than if you just held the underlying long outright. It's when you sell a ton of vol that you dramatically increase your blow up risk (you also make your Sharpe ratio much higher). I.e. LTCM had a Sharpe of 4 before blowing up but if you just did covered calls on the S&P 500, your Sharpe ratio would never be anywhere near 4.
Yes, plainly selling premium 'works until it doesn't' because futures prices have been shown to not be normally distributed and that fat tail events happen at a far greater frequency than would be predicted by the ATM vol and the smile. In fact, there has been a lot of research on how the market has been slowly moving to this where ATM vols are on average lower than they have been historically, with much more extreme skew to price this in, but it is a relatively new phenomena. Being a degenerate short seller is no better than someone who gets degenerately long and would likely result in the same EV. Not to mention, strictly being a premium seller doesn't even require you to actually blow through the strikes to blow out. If you can't continue to cover margin in a big event, you're going to have to puke out of your position and risk.
hahahaha "Choke on a that piece of evidence, needle dick." - Mr. Alexpasch Classic.
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