Trading Options: A thesis
In borrowing money on securities, the federal reserve of the US government decided many decades ago that society had an interest in limiting the degree to which people could use borrowed money in buying securities. They had the example of the 1920s with what was 10 percent margin. That was regarded as contributing to the great crash.
So the government through the fed established margin requirements that said, "I don't care if you're John D. Rockefeller; you're going to have to put up 50 percent of the cost of buying your General Motor stock or whatever it may be." And they said that maybe Mr. Rockefeller doesn't need that, but society needs that. We don't want a bunch of people on thin margins gambling, essentially, in shares where the ripple effects can cause all sorts of problems for society. And that's still a law, but it means nothing anymore, because various derivative instruments have made 10 percent margins of the 1920s look like what a small town banker in Nebraska would regard as conservative compared to what goes on.
- Warren Buffett (1995)
The thesis for index fund investing, as well as diversified buy-and-hold strategies, is that on average, companies succeed in generating profits.
Options investing has a somewhat more complicated thesis. I can think of three reasons to sell stock options:
- To exploit psychological inefficiencies (rare-event overestimation and risk non-neutrality),
- To exploit inefficiencies in accepted market regulations (margin requirements and short-inaccessibility),
- To tangibly monetize diversification.
This post inaugurates a series discussing our intended options trading strategies.
Psychological inefficiencies
In principle, options contracts should be priced at their expected value. However, they are often priced higher due to psychological inefficiencies.
One often-cited metaphor is that the options market is a casino, where sellers collectively form the house, while buyers form the gamblers. This is what I refer to as rare-event overestimation: Gamblers typically overestimate the likelihood of hitting jackpots, and will overpay for options contracts.
A second often-cited metaphor is that the options market is an insurance market, which exists due to risk non-neutrality. Since most investors are presumed to be risk-averse, they likely are willing to overpay for options contracts which reduce their risk, independent of the expected value of the contract.
Market inefficiences
In an ideal market, money would be lent freely: Traders would be able to access as much capital as they wish. However, this is not the reality.
For instance, margin regulations prevent brokers from offering more than 2x leverage. As a result, traders are pushed toward options markets as the only means to leverage beyond a certain level. This crowds the options market and raises contract prices.
Similarly, retail investors typically do not have easy access to short trades. The demand for put options is thus artificially inflated.
On the flip side, traders wishing to capitalize on the inefficiences pointed out so far cannot do so freely: Regulations require that short options be backed by large amounts of capital, which most investors do not have and are prevented from borrowing. This artificially suppresses the supply of options contracts.
Monetizing diversification
You might be a typical investor with a typical risk-averse profile. In that case, you would be just as willing to buy an option as to sell one, and so you may as well do neither: The premium over expected value, as decided by the market, should be a fair valuation of the risk carried by the contract. However, there are other ways to reduce risk that don’t involve paying someone a premium - namely, diversification.
The options market may be viewed as a way to monetize excess de-risking, for those who have the necessary capital and are willing to expend the effort. (The fact that effective diversification requires large amounts of capital is another manifestation of a market inefficiency, though this is less pronounced as brokerages begin to offer fractional shares.)
Note that diversification is part of the thesis for index fund investing as well: Stocks are fairly valued relative to their risk-adjusted returns, but a diversified portfolio reduces that risk without reducing returns. However, options facilitate a more pure conversion between risk and value, since options generate no other value.