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Trading Overpriced and Underpriced Options

We often read books were options 'guru' and ex-market makers teach that we should look for underpriced options and buy them and overpriced
options and sell them. I am assuming they are looking at the implied
volatility and comparing it with historical volatility. 

As an ex-market
maker I was wondering if you felt there was an edge in this that could consistently be exploited, or would this be difficult  for a
retail trader with limited tools etc.

Dave

***

Thanks Dave.  This is one of those really good questions that somehow gets overlooked.

Any time you can gain an edge, that's to your advantage.  And yes, most
people who refer to trading over-and under-priced options are referring
to making implied volatility comparisons. Yes, MM can take advantage,
but I seldom try as a retail investor.

It's going to seem as if I have a negative comment about everything,
but the truth is that edge is difficult to define, and the bottom line
is that I make little effort to take advantage.  One philosophy of trading is that if you have no edge, you have no reason to anticipate earning any money from the trade.  I accept that idea as reasonable, but the difficulty is knowing when you have an edge vs. when you think you have an edge.

The best hedge is to find overvalued/undervalued
options in a
single security, and produce a spread.  However, that once simple idea
has been overshadowed by the simple fact that option volatility is known
to be
skewed and that lower strikes appear to be overvalued – when
they are
not.  In the early days, we sold naked OTM puts.  But with a better
understanding of option skew and the explosiveness of OTM puts on a
market decline, those who survived no longer consider selling a bunch of OTM puts as trading with edge.  [Selling naked puts as a precursor to acquiring stock for a portfolio is okay – when the risk is understood]

So yes, you can compare current IV with historical. However, the
time period for 'historical' is open to question.  Should we care how
the stock traded over the past few years, or only the past month or
two?  That's a difficult question to answer.  The very nature of some stocks
changes over time.  Big growth stocks become stable companies and grow
at a slower rate.  Surely we recognize that IV is going to be lower
than it used to be for those stocks.  We never know how stocks will behave in the future, and with which historical period to make comparisons.  That's just one of the difficulties encountered when comparing current IV levels with those of the past. I don't know which historical data to use.

I'm taking a long time to say that yes, take an edge when you can get
it, but it's next to impossible to know whether you truly have an
edge.  Those playing in the market right now have priced options in
such a manner that tells you that you would be wrong to bet against
current IV.  I once ignored current IV, depending on
historical measures instead.  Years ago I became convinced that this was
the wrong approach and that current IV represents the best estimate for future volatility.

Pre-earnings and pre-FDA announcements are special situations, because the very life of the company may be at
stake.  Thus, huge price changes are possible upon release of the news.  It's may be tempting to refer to these options overpriced and sell a limited number to gain an edge, but risk of loss is real and the best approach is to control risk by paying careful attention to a worst cast scenario.

But, day in and day out, current IV is a decent measure of fair
pricing.  Again, if we are in an unusual environment, such as 2008 when
IV was steadily rising, we all knew there was going to be a great
time to sell volatility.  The huge problem was: when is that time? 
Sell too early and risk a disaster.  Wait, and you may miss a big
opportunity.

As a market maker, we get to make a lot of trades and can built a
substantial pile of edge over time.  Buying near or at the bid price is far more efficient that buying at or near the ask price.  That's the best way to get edge. Our task was to hedge various risk (most often vega, but it can be gamma
as well) factors, giving up as little edge as possible.

As a retail trader, that's a difficult task.  Yet, you can sell premium
when prices feel overvalued (higher IV) and buy premium when you feel
options are cheap.  However, you will have vega risk.  If IV does not
return to 'normal' levels you may not be happy with the position. 
That's the problem. 

The big trader – market maker or otherwise – can
easily and relatively inexpensively build a  position that reduces much of the
much risk.  As retail, if we own a position, it takes too
many additional trades to get neutral everything.  So I just accept the
fact that I cannot do that.  It's not limited tools – it's limited
capital and limited margin room.  If you want to trade a 20-lot spread,
you don't really want to be trading another 20 contracts (or more) just
to hedge all risk.  By being unable to buy bids and/or sell offers,
your trades would not be made at prices that are good enough to justify
the effort to completely hedge.  The main reason to buy edge, is to
lock in that edge and collect the profits when the options revert to fair value. 

As retail customers, we seldom lock it in.  We wait for
the edge to work (become cash) – and then collect if we are correct, or
pay if we are not.  The professional adds edge and then hedges risk and
then adds more edge.

When conditions are favorable, or when I perceive more edge (higher IV), I
can (and do) increase position size.  Not by too much.  That's being
greedy and taking too much risk.  But I can add 10 to 20% more
contracts. 

Similarly if IV is low and I don't like the idea of buying
premium (and I don't), I must change my style when selling
premium.  I accomplish that by selling options with less vega.  Alternative: reduce position
size.  That's one way to capture a little extra edge.

766



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