A thread about directional edge vs carry based on a convo I had with a younger trader.
His strategy was to sell options when IV was in the 100th percentile. What are some problems with this?
The most obvious is that 100th percentile depends on your lookback window and the relevance of that window is I don't know, arbitrary. The historical distribution of IV does not need to have any relevance with respect to qualitative information you have today. (Umm, GME).
Here's another issue.
Any day when vol goes up after a 100th percentile IV day is just another 100th percentile IV day.
The next day given, that you just hit 100th percentile yesterday, just doesn't care that yesterday was a "top" compared to the days that preceded it.
But the biggest issue here is that this selling a high number that you know will go down is just an instance of the "No Easy Trades Principle".
High <> expensive
Let's generalize across asset classes...
Any trade that has directional edge (ie you sell something that you are certain is going down such as extremely high IV) is counterbalanced by carry.
If you sell vol at 150% and that implies a $50 straddle, it won't matter if vol goes down to 25% if the stock gaps down $75.
This is well understood already.
Everyone knows vol comes down after earnings. But the p/l driver is the carry — the size of the earnings move.
This holds in real estate too. Everyone and their grandma can see the low cap rates in the Bay Area for the past decade.
But the cap rates are so low because the carry is high...the annual appreciation.
(One of my suspicions is that low cap rate properties are actually relatively underpriced. Any donkey can pull up mashvisor.com and see what screens as value. It takes more effort to find reliable drivers of growth to earn carry in "expensive" markets)
This logic holds for stocks too.
Earnings are the carry and the P/E is the directional trade. Yes, a 100 P/E stock is going to eventually have a lower P/E. Yay, directional edge!
Except what matters is the growth. The low p/e example is already well branded — "value traps".
Going back to the options example. if you sell high IV remember IV will rarely get higher than the range of RV bc point spreads imply mean reversion.
So if you are short high IV expect negative carry.
Vet option traders expect to choke when they buy IV in the zero percentile.
The big question is the speed of convergence.
If you are short that $50 straddle at 150% vol and the next day the stock is down $25, but vol halves you can hedge your negative gamma, cover some short options and win. But if you gap down $75 you lose no matter what vol does.
Profitability depend on how the speed and shape of the implied parameters (IV, P/E, cap rate) cross the carry parameters (RV, earnings, rent).
If IV got so high as to exceed any point on a vol cone maybe then you'd have an easy trade. Your directional tailwind (IV will probably decline) and your carry can both win.
Good luck finding that.
Here's a half-joke rule I've had with traders I've worked with.
When you do your vol sorts, you sell the second highest vol on the board. You always buy the highest.
This is not advice.
If the directional tailwind vs carry frontier sounds familiar it's because I've talked about it before. It's my version of EMH.
An example of thinking about wanting to be long options where the stock ain't going.
In my PA I might consider stock replacement. Not ITM calls though. OTM calls.
Why?
The first thing most might think is "steep upside slope"
That's not exactly what I'm thinking.
US large cap is expensive by every measure. Fine. Well Meb Faber said Japan went to 90 p/e. The market could 2 to 3x from here on flat earnings. Falling behind on that would suck. Not acceptable. Wealth effect would mean I could never afford a house in that world.
Still...
That's not really the driver of the trade expression. It's that given the valuation I'm ok missing a 10% rally say but if the market rolls over there's my actual win condition.
Not being overly exposed to the sell-off (I know stonks only go up)
Watching finance/tech moguls who have ridden govt-sponsored near zero cost of capital to multi-gen wealth not answer the door when the govt comes back around looking for a wealth tax rebate
Don't get me wrong it's a bad idea...but strictly for practicality reasons. Not for some ethical or other made up incentive theory. We haven't cared about sht like that since GS was made whole on AIG CDS, entrenching TBTF, and favoring monetary over fiscal until a pandemic hit.
Next time the govt buys assets to stimulate the economy it should also buy a lookback option from the asset sellers. Then we can say "look you knew the rules before you took the money". They still would have signed up bc people love to sell options too cheap...
Publishing an option post today that emerged from writing Moontower this week. It's about a qualitative intuition for option behavior esp spot/vol correlations.
Option greeks esp as you get into 2nd order ones like gamma, vanna and volga often cause a listener to slow down...
They say "ok, wait what's gamma again...[start recalling some if...then scenarios]"
I have 2 quick heuristics that can make the effect of a vol change more clear especially if you imagine an extreme change in vol (so if your scenario is "vol down", mentally crank it down to 0)
Heuristic
1. "Further away heuristic"
If vol goes down, all OTM options become "further away". The effect on greeks is obvious. Just imagine the extreme as vol goes to zero. All the greeks go to 0. Deltas and second order greeks.
Position sizing and enabling leverage are too big relative to the presumed liquidity.
A question I don't see being asked is what factors are contributing to the presumption of liquidity?
(Same thing as underestimating risk, and WSB stumbled on a soft spot in assumptions).
Another way to think about it is perhaps how much is reasonable to short should not be a function of days to cover type metric but how much liquidity you could have gotten to cap the potential loss by buying OTM calls (or how many deep puts could you have bot instead)
In other words, the price of hard optionality instead of a risk mitigation strategy that looks like portfolio insurance in the opposite direction.
Underestimating gap risk. It always come back to this. It's always there even if you couldn't predict the tendie form it would take