Using Options Better
including practical tips
Friends,
While a successful volatility trader’s edge is in discerning relative value between options, they are agnostic on the direction of the underlying. This is a niche symbiosis in the ecosystem of markets. The Egyptian plover that cleans the gluttonous gator’s teeth.
The wider, active marketplace, with deeper pools of alpha, sets the price of underlying assets. Fundamental and macro traders have opinion on direction but are agnostic about the price of the options. Just as the vol trader assumes the underlying is “fair”, the directional trader assumes the options are “fair”.
(moontower.ai achievement is bringing a vol trader’s discernment about the relative value of options to the directional trader)
So it doesn’t surprise me that most option users just think of calls and puts as levered directional bets. But an option’s contract is a bundle that prices financing costs, volatility and time. To think of them as firstly as directional tools is to not fully internalize how deep an insight the put-call parity identity is.
The price of an option is primarily about volatility.
[Just look at the decomposition of their p/l equation in A Visual Primer For Understanding Options]
Trading the stock is blunt 2-D expression of a trade. Whether trading the stock directly or an option to express a thesis depends on 2 prerequisites:
The investor’s perception of the stock’s distribution over some period of time.
This is embedded in any decision to click “buy” or “sell”. How explicit any investor’s targets are and what rules they keep for changing their minds spans the gamut from “vibes” to code.How that perception differs from the option market
To satisfy #2, you need to be able to interpret the what a vol surface is saying.
What does the straddle price mean?
What does a high or low skew mean?
How do I know if the skew is high or low?
What does the vol differential between months mean?
There are so many expiries and strikes, how do I discern which actions on which contracts at what size is the best expression of #1?
Or is the option surface saying that my view is “consensus”? In which case, the only reason to use the options is to sculpt your payoff profile for various scenarios. This exercise makes the trade-offs easily apparent.
[This sounds like a lot but on almost a daily basis I step people through questions like this in the time it takes to have coffee. Half the battle is the options are a second-language problem — and I don’t mean in the jargony sense — I mean it in the I-already-know-the-words-but-I-still-translate-them-instead-of-thinking-in-option-language-natively.
Which is probably why I have a habit of explaining option ideas with my hands automatically. Option sign-language is hockey sticks paths through time embodied.]
Over the years of talking to non-vol traders I have found that option users fall in 2 categories:
Levered directional players who do not understand that options price volatility and distributions (This discovery peaked during WSB/Reddit heyday and inspired How Options Confuse Directional Traders)
Investors with an intuitive understanding of options as distributional bets
My grand treatise for group #1 is: Celibacy Vs Condoms: The Answer To Whether You Should Trade Options
For group #2, sit up tall!
You don’t need to have a view that sounds like “this option is priced at 24% vol and I think vol is going to realize 28%”. It’s enough to understand:
“I’m buying this call because if the stock is up 10% it’s up 20%” (conditional probability of discontinuity)
The distribution is more bimodal than the option’s market seems to think. One of my favorite examples of this was in The Big Short when the Cornwall guys bought far OTM calls on Capital One because they understood that when the bank was cleared by regulators the stock would be much higher. These were not option guys, but they recognized that the option’s prices didn’t agree with their expected value in what was a discontinuous scenario.
Practical tips
The following ideas are shareable parts of conversations I had with a family office that uses options.