the easiest win in options is for stock traders
how to NOT incinerate money
Friends,
Most people who get into options are seduced by levered returns, but for the relationship to go from a fling to the real thing, they commit to learning about “vol”: implied vol, realized vol, vol surfaces. I’ve declared that options are ALWAYS about vol.
This is snobbery to the same degree as reserving “champagne” for sparkling wine that originates from a particular region of France. I resort to such snobbery on options to make the distinction between an option trade working for directional reasons vs vol reasons (if it works for the former and not the latter you were probably better to just trade the stock). But as all strong pronouncements go, they obscure truth. Sometimes to deceive, but other times, like in my example, it’s to move the emphasis to what matters without heat loss from caveats and equivocations.
In this post, we discuss the full truth. Options are always about vol unless they are about funding.
Funding is boring, bean-counting stuff. We want sexy. Think about it — what do you hear more about, rho or vanna? The opposite of love is not hate, it’s apathy. I get it, so many things vying for our attention, the investor neglect of “cost of carry” seems like a weird thing to wear a ribbon for — except for the fact that understanding cost of carry is both the easiest and most widely applicable “win-win” in the options world. Its neglect is quite tragic.
We will fix this over the next 2 posts. These are foundational posts that might well represent the largest gap between what people know and what they should know. It’s the basic blocking and tackling of options that every professional training program starts with whether you are going near options as a trader, quant, stock loan, ops or broker.
I’ll add that given the rise of heavily borrowed, speculative “meme” stocks, in a landscape where interest rates are not pinned to zero, this topic has never been so timely.
Today, we:
Start with a puzzle
Show how the solution informs arbitrage theory
Next week, we go from theory to practice:
We’ll show just how much money you could be leaving on the table in both longs or shorts by not letting the options market finance your position. This is relevant to any investor.
For those who are more vol-inclined we see how this work forms the foundation of modeling option surfaces. We’ll conclude with related considerations that are out of scope.
Onwards…