Option trader and founder of Convexitas Devin Anderson drops some terrific insights in his interview with Bill Brewster on the Business Brew Podcast. I found them deeply resonant.
I added my comments to the following excerpts which were taken from minutes 20-30 in the episode.
“Risk Over Rules”
Risk vs rules-based approach
Risk-based limits are set for every mandate that we monitor throughout the day, every day. For each mandate, we agree on a size and determine the risk limits for the product. We manage within these risk bands for the handful of different products we have. This approach is different from a rules-based approach, which would dictate specific actions based on market conditions or other factors. Instead, we exercise discretion within the risk-based framework.
- The market exposure cannot be greater than the notional amount you have hired us for, and it must be negative.
- We cannot take a leveraged short.
- There are minimum amounts of convexity that we must maintain at all times
- [Our size is constrained by] shock scenarios.
There is a set of rules that determines the band of market exposure and the minimum amount of shock and spot convexity we must have, but it is up to us to decide how to implement those rules. We determine which part of the surface looks the most interesting, what the relative value is, and how much of it we should have on at any one point in time. This is a completely different way of thinking than simply investing a set amount and waiting to see what happens in the future.
“All good option trading has to start from biases in the market”
To draw a parallel to value investing. If you don’t believe that you have an edge in some stock, and you don’t believe that there’s a discount, then why should you own this thing? We can apply that same general framework to options trading, thinking about it as one level up. So there’s still the stock or the market or whatever the underlying equity is, that can have value in it. But then the options themselves have their own market, microstructure, flows, and biases. It’s not enough to say, “Well, I have a view on a stock, therefore, I’m going to trade some options.” If you’re going to trade some options, you have to say, “I have a view on the stock. And there’s this interesting thing in the options that makes trading the options worthwhile relative to just trading the stock.”
So in everything that we do, it starts from some biases in the option market. Those biases in the options market take the shape of flows and imbalances that result from forced trading, yield-seeking, or bank hedging. There are actually a bunch of sources of these.
[Kris: this is what Benn Eifert means when he says “disturbances in the force”. If there were no flows all the point spreads would be fairly priced. No “willing losers”, no opportunity.]
In our case, we buy short-dated options that we believe are inexpensive because there’s an avalanche of people selling them, ranging from private banks to other managers that look like us to even big institutions. There’s a depression in a certain part of the short-dated volatility surface, particularly S&P, that we think offers very good value. That’s solely because there are yield-generating programs out there that are pushing the prices down. Then we can go out on the long end of the curve and find really good values there in certain conditions when the market sells off because of the particular dynamics of the way structured products have to be re-hedged. So we look for certain flows after a market sell-off that tells us that that’s happening and we go out and trade those options. But the point is, a good options trading program needs to start from value in the options themselves, not a statement about the underlying. Ultimately, you have to be able to make a statement about the options and a statement about the underlying together.
“Beware of hockey players”
Inevitably you come across a private bank “options expert”, right? And he’s like, “I have my strategy and it works on all underlyings because I’m going to come in and trade my call or whatever it is, right?” But really, what he’s saying is:
“I’m trading options for their payout at expiry, without a lot of regard to whether there is any relative value in the options themselves.”
Just because you can buy a put and reshape the terminal payout of the terminal distribution out that options expiry doesn’t mean that that option is underpriced. It could be overpriced, and in fact, they often are. If I buy hurricane insurance after the rates have already gone up, like Yeah, I guess I’ve mitigated my downside, but what did I pay to buy the insurance?
[Kris: see It’s Not The Merit It’s The Price]
As a general rule, whenever you hear someone giving you a pitch about derivatives that are based on its terminal payoff, and they’re drawing hockey sticks for you, your radar needs to go up.
So we have a joke: “beware of hockey players.”
[Kris: think buffered ETFs or structured products]
On breakeven arguments
The only place where I have consistently seen breakeven arguments work is in biotech or pharma, where there are very specific events. If you have knowledge about the likely outcome of an event, you can look at the breakevens and determine whether it’s a good value. I have seen this strategy work in those industries.
[Kris: I’ve seen this in nat gas as well — what’s the common link? These are all special sits types of scenarios where the distributions vary greatly from lognormal or bell-curve shapes, often having 2 more modal outcomes.]
However, during my time on an institutional dealing desk for over a decade, I only met two people who could consistently trade options for direction without paying attention to biases and make money. Even then, I’m not convinced they were making that much money trading the options.
[Kris: See my discussion of path vs destination]
Options or re-size the position?
And then you need to ask the question: why these options? What is the mispricing or value in the derivative itself? if someone comes to you and is like, well, I you know, you should get long whatever sector in the option space they need to have a really good reason for why those sector options are mispriced.
What is special about the option pricing itself that makes doing this an option better than just re-sizing the position?
Kris: this is an absolute money question!
It relates back to how options are priced with specificity:
You are paying for specificity via options because they are priced with a particular vol to a specified expiry. The offsetting benefit is you are highly levered to being right.
From If You Make Money Every Day, You’re Not Maximizing:
The beauty of options is how they allow you to make extremely narrow bets about timing, the size of possible moves, and the shape of a distribution. A stock price is a blunt summary of a proposition, collapsing the expected value of changing distributions into a single number. A boring utility stock might trade for $100. Now imagine a biotech stock that is 90% to be worth 0 and 10% to be worth $1000. Both of these stocks will trade for $100, but the option prices will be vastly different.If you have a differentiated opinion about a catalyst, the most efficient way to express it will be through options. They have the most urgent function to a reaction. If you think a $100 stock can move $10, but the straddle implies $5 you can make 100% on your money in a short window of time. Annualize that! Go a step further. Suppose you have an even finer view — you can handicap the direction. Now you can score a 5 or 10 bagger allocating the same capital to call options only. Conversely, if you do not have a specific view, then options can be an expensive, low-resolution solution. You pay for specificity just like parlay bets. The timing and distance of a stock’s move must collaborate to pay you off.
Since you pay for specificity, you need a well-formed understanding of your edge. If you’re going to trade options directionally I would want to see the specificity in your fundamental analysis that suggests these particular options are the right options to buy or sell.
It’s so easy to lose on timing or changes in vol even if you get the direction right. See: