Monday, November 10, 2008

Why buying out of the money options make sense in a market making perspective and volatility trading perspective

I was initially intrigued when I heard that Taleb was trading on out of the money option. In a way this makes sense since he has exposure to market making. I shall discuss below why this is a sensible strategy from two perspectives.

Market making perspective

In out of the money option pose lesser risk to a market maker than option this are either in or near the money. Since their delta is small, the market maker need not bring down his ask on a small unfavourable price move, but if the price move is large then the liquidity might dry up and might not be able to sell the out of the money option. Also due to liquidity of the options the market maker can lower his bid on them thus gaining a larger spread. Though a market maker need not lower his ask on a downward move he is in a position to increase the ask on a by a greater margin on an upward move. In extreme events the option inventory may end up in the money. The time decay of the options is also less or negligible when considering the market makers holding time.

Also the market maker can scalp using his inventory of out of the money option to make an additional amount of money. (If a trader has DMA then also he is in the position to make money by “juggling” an out of the money option portfolio.) All these do not require any predictive power in the market, which in deed is very difficult to do consistently.

If out of the money options are bought

Reference: http://www.cs.cmu.edu/~softagents/papers/CR_nevmyvaka_sycara_seppi.pdf

http://www.investorschronicle.co.uk/InvestmentGuides/Shares/article/20080423/eaf42688-f417-11dc-96a0-0015171400aa/Shares-Understanding-Level-2-market-makers--DMA.jsp

http://www.investorschronicle.co.uk/InvestmentGuides/default/article/20061124/443df720-e8ff-11db-9f1b-00144f2af8e8/Which-DMA-platform.jsp


Volatility Trading Perspective

dV / V = 1 / V * (∂V/∂S * dS + ∂V/∂σ * dσ + ∂V/∂T * dT + ∂V/∂r * dr)

E(ΔV / V) = 1 / V * Delta * E(ΔS) + 1 / V * Vega * E(Δσ) + 1 / V * Theta * ΔT + 1 / V * Rho * E(Δr)

E(ΔV / V) = Lambda * E(ΔS) + 1 / V * Vega * E(Δσ) + 1 / V * Theta * ΔT + 1 / V * Rho * E(Δr)

Returns can be maximized by buying the Option Greeks at the cheapest weighted by the expected change in the factor.

When trying to maximize the return by buying the Greeks cheap would mean that you end up buying somewhat out of the money.

Thing to watchout here is trasaction cost. This can eat all your profits.

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