You buy a call option in a heavily pumped meme stock you think is going to keep going up.
You were right, it keeps going up!
But your call is losing value. Why?
π§΅for those who shouldn't be trading options but are going to anyway!
1/n
Without a good mental model, then the price of an option contract may appear to change in confusing and magical ways.
With a good model, you will understand the most important dynamics intuitively - without needing any complex maths.
This is the 101 before the 101.
2/n
[A quick administrative note so I don't confuse anyone:
To keep it simple we're going to inhabit a world where:
- options are European style
- interest rates, risk-premia, dividends, and other carrying costs don't exist.
i.e. we're gonna inhabit a risk-neutral world]
3/n
Random disorganized thoughts on "rebalancing" πππ
Why do we rebalance?
Cos market movements change asset prices, which causes our actual exposures to deviate from the ones we want.
Also, our views on asset returns and (co)risk might change and need to be updated.
1/n
The trading problem (ignoring txn cost) is to:
- forecast expected returns (alpha) over some forward horizon
- model risk (including the relationship between assets)
- find a set of asset weights we think maximizes our objective (risk-adjusted returns) subject to some stuff
2/n
Rebalancing is really just shunting weights back in line when the market moves them away from where we want them.
In practice, rebalancing can look a bit more complicated because your alphas and risk estimates are changing too.
In the original thread we noted:
- you can't trade VIX
- so there's no market mechanism to stop it from being predictable
- but VIX futures do trade and their price incorporates where the market thinks VIX is likely to go
2/n
If the market thinks VIX is going to go up, the futures will likely already be trading at a premium.
Sellers won't sell low if it's likely to go up.
Buyers will be happy to buy higher if it's likely to go up.