Recently I had the epiphany that an investor’s real budget constraint isn’t how much money they have (with portfolio margin you can get 6x or even 12x leverage) but how much risk-taking capacity they have. So another way of making what I think is your main point is that the market pays you to take (certain kinds of) risks, so don’t waste your risk-taking capacity by taking too little risk. But one should be smart and try to figure out where the market is paying the most per unit of risk.
Standard finance theory says the market should pay you the most for taking “market risk”, i.e., holding the total market portfolio. But the total market portfolio includes no options, because short and long options cancel each other out giving a sum of 0. So the only way that it makes sense for someone to hold an options position is if they differ from the average investor in some way, and figuring out how they differ should be the starting point for deciding what kind of options positions to hold, right?
In this case, it seems that you’re saying the average investor manages someone else’s money, which makes them want to buy puts. They have to pay extra for this because most assets are managed by investors like this, so there’s a lot of demand and little supply of puts. If you’re not like this, you can therefore make above-market risk-adjusted returns by selling puts to meet this demand. (I’m not totally sure this is true empirically, but wanted to spell out the reasoning I think you’re using more.)
Empirically, option implied volatility tends to exceed realized volatility for most stocks most of the time. This is plainly visible if you plot both implied and historical volatility on the same chart, and even more obvious if you use moving averages for each to smooth the noise. This is the well-known “option seller’s edge”, an effect that has been quite persistent historically.
And not just for puts, due to put-call parity, this applies to calls as well.
Empirically, this strategy of selling a naked 30-day at-the-money SPY option (randomly a call or put) shows a positive expectancy, while the reverse strategy of buying the option shows the opposite. I’m not actually recommending you do this (because it’s easy to accidentally Bet the Farm by selling naked options), but it illustrates the edge.
As for why this should happen, yeah, the market is risk-averse, so there’s a risk premium for taking that risk off their hands. How big that premium is depends not just on the amount of risk, but the demand for insurance and the competition between insurers. If there were too many competing insurers to supply the puts (or if they were too big), then the margins would be too thin (but not negative!) for retail traders to profit from. But that’s not what we see happening. I wouldn’t say differing from “the average investor” is what matters, but from the investors who control the most money.
Recently I had the epiphany that an investor’s real budget constraint isn’t how much money they have (with portfolio margin you can get 6x or even 12x leverage) but how much risk-taking capacity they have. So another way of making what I think is your main point is that the market pays you to take (certain kinds of) risks, so don’t waste your risk-taking capacity by taking too little risk. But one should be smart and try to figure out where the market is paying the most per unit of risk.
Standard finance theory says the market should pay you the most for taking “market risk”, i.e., holding the total market portfolio. But the total market portfolio includes no options, because short and long options cancel each other out giving a sum of 0. So the only way that it makes sense for someone to hold an options position is if they differ from the average investor in some way, and figuring out how they differ should be the starting point for deciding what kind of options positions to hold, right?
In this case, it seems that you’re saying the average investor manages someone else’s money, which makes them want to buy puts. They have to pay extra for this because most assets are managed by investors like this, so there’s a lot of demand and little supply of puts. If you’re not like this, you can therefore make above-market risk-adjusted returns by selling puts to meet this demand. (I’m not totally sure this is true empirically, but wanted to spell out the reasoning I think you’re using more.)
Empirically, option implied volatility tends to exceed realized volatility for most stocks most of the time. This is plainly visible if you plot both implied and historical volatility on the same chart, and even more obvious if you use moving averages for each to smooth the noise. This is the well-known “option seller’s edge”, an effect that has been quite persistent historically.
And not just for puts, due to put-call parity, this applies to calls as well.
Empirically, a covered short strangle portfolio not only beat the index, it had performance comparable to a hedge fund.
Empirically, this strategy of selling a naked 30-day at-the-money
SPYoption (randomly a call or put) shows a positive expectancy, while the reverse strategy of buying the option shows the opposite. I’m not actually recommending you do this (because it’s easy to accidentally Bet the Farm by selling naked options), but it illustrates the edge.As for why this should happen, yeah, the market is risk-averse, so there’s a risk premium for taking that risk off their hands. How big that premium is depends not just on the amount of risk, but the demand for insurance and the competition between insurers. If there were too many competing insurers to supply the puts (or if they were too big), then the margins would be too thin (but not negative!) for retail traders to profit from. But that’s not what we see happening. I wouldn’t say differing from “the average investor” is what matters, but from the investors who control the most money.