Vol drag is misunderstood...until now
Friends,
Yesterday, we (yet again) discussed the topic of how vol drag affects the skewness of a return distribution. In particular it shifts the median return lower.
The thread I wrote bounced all around the internet but like a nerdy game of telephone the message is suffering from major info loss as it gets passed on.
Vol drag does NOT change the mean or expected return. It affects the return you are most likely to experience.
Imagine 2 lotto tickets — let’s call them WGMI and NGMI.
WGMI has a 50% chance of paying off $20k
NGMI has a 1% chance of paying off $1mm.
They have the same expectancy. But NGMI is far more volatile — your most likely result is a zero.
Those meme stock put spreads look expensive because they are bets on distribution not expectancy! Spreads are bets on pure probability NOT the magnitude where as outright options are about probability x distance just like expected value is about probability x outcome.
If I have an asset with an expected return of 10% the 2x version of it (without fees) has an expected return of 20%. Full stop.
However, the 2x version is more volatile, therefore its median expected return is less than 2x the median expected return of the asset itself. That’s vol drag. It impacts the median. The skewness. The distribution. NOT THE EXPECTANCY.
If that clarification was a lightbulb moment, feel free to stop right there. It’s already a good day. But if you want euphoria bursting from your skin, know that it gets better.
The following discussion includes:
“vol bonus” the alter-ego of the drag
the worst return I ever had in options
a simulator you can use right now to see vol drag and vol bonus
This work will become pat of a lineage including:
Let’s continue.