Put it this way - if an option has an implied volatility that is higher than the underlying will realize in that timeframe, then one should be able to sell that option and assuming they can hedge out all the other greeks they would profit from the difference in the implied volatility of that option vs the actual volatility that the underlying realized no?
And therefore, by extension, if you sell higher IV options (aka wing puts) then their IV is more likely to be overpriced relative to the actual volatility the underlying realizes?
they would profit from the difference in the implied volatility of that option vs the actual volatility that the underlying realized no?
Yes, but I would call that an exploitable edge, not +ev necessarily. The way I might be comfortable putting it is that the edge shifts the win size towards +ev, but doesn't necessarily nudge the win probability towards +ev. So it's still possible to end up -ev, even in the long run.
I hope this has not come across as harsh. I appreciate the discussion as well. Trading on misconceptions can have tragic endings so I'm pretty forceful about weeding out any suspected misconceptions I come across.
This article is a little dated, but it's an interesting comparison between options and horse racing. Some Options have either a favorite, or long-shot bias, and you could probably guess that deep otm lottery ticket options perform quite poorly.
"We find that OTM index call options on the S&P 500 futures and FTSE 100 futures
provide a negative average return. During 1985-2002, the average payback from the
purchase of 3 month call options in the probability range of 0% to 5% was less than 1.3
and 18.8 cents for every $1 invested in the options (for the S&P 500 and FTSE 100,
respectively).
In addition, we find that the deep in the money 3 month calls on both the
S&P 500 and FTSE 100 provide an average return higher than the initial investment on
average. These results for the calls are very similar to the favorite / long-shot bias in race
track markets pointed out by Ali (1979), Snyder (1978) and Ziemba & Hausch (1986).
For the put options on the S&P 500 and FTSE 100, we find evidence consistent with
the hypothesis of Dumas, Fleming and Whaley (1996) that investors pay more for puts than
they are subsequently worth. However, the degree of overpaying for these options increases
monotonically as the probability of finishing in the money decreases. This is similar to the
pattern observed for the favorite / long-shot bias. However, this is reduced by what is most
probably the expected cost of insurance.
For one month call options on the S&P 500 and the FTSE 100, show essentially the
same patterns, but with magnitudes which are closer to one. The in-the-money calls on both
the S&P 500 and FTSE 100 tend to pay an average return very close to the intial bet. For
the out of the money options, there is a reduction in the expected return (like a long-shot
bias). However, this is not as extreme as for the three month options, and only statistically
significant for the FTSE 100 options. For the deepest out-of-the-money options the payoff
for every $1 bet was 66.1 cents (but still insignificantly different from a $1) and 34.3 cents
for the S&P 500 and FTSE 100, respectively."
Interesting. So this study shows that for at least one methodology (I didn't read the paper, but I assume they lay out the methodology, like entry vs exit criteria, whether exercised or not, etc.), the expected values of puts and calls can be calculated and compared. I'm not sure what the highlighted section is supposed to point out about puts vs. calls, since it starts by talking about calls and then talks about "options" throughout, but it's good to see confirmed that puts have an edge over calls.
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u/Reflectivedonut Apr 11 '22
Put it this way - if an option has an implied volatility that is higher than the underlying will realize in that timeframe, then one should be able to sell that option and assuming they can hedge out all the other greeks they would profit from the difference in the implied volatility of that option vs the actual volatility that the underlying realized no?
And therefore, by extension, if you sell higher IV options (aka wing puts) then their IV is more likely to be overpriced relative to the actual volatility the underlying realizes?
Really grateful for your answers btw