A Real Option Strategy (Patreon)

So what isn't priced in??

You guys probably all watched the most recent video where I talked about the bad TikTok investment strategies.

The unfortunate conclusion of that video is that despite the TikTok strategy being "bad", our strategy isn't necessarily any better from a long term statistical perspective. 

Being that the options market is priced efficiently, both strategies should have an expected value of 0. While you might see temporary ups and downs, in theory you never have any statistical edge. When considering trading commissions and market maker spread it's actually a negative expected value game.

Gambling.

Which is still fun! Ideally we'd like to have fun and make money doing this though.  

I wanted to write about a real option strategy that I think could be implemented with positive expectancy. 

That way we're the casino and not the degenerate. 

I'm going to assume most of you have a decent understanding of how implied volatility affects option prices + how options work. If you don't, I have some older posts talking about it. There are also plenty of videos on Youtube explaining it.

Now let's recap the theory behind this strategy. 

IV tends to increase in the weeks before earnings. An earnings report is a big catalyst that can have a huge impact on the share price. 

Anticipation of a volatile share price = higher likelihood options will expire ITM = more expensive option premium to compensate. 

Looking at the chart below, we can see how the market tends to overestimate future volatility going into earnings. 

(Each of the red "E"s representing earnings - View chart here)

"Tends" is the key word here. 

It's easy to look at the above chart and think shorting implied volatility through earnings is free money. After all, LEVI's implied volatility has tanked consistently after earnings the last 4 times. 

Just keep in mind that there is of course a good reason why IV increases in the weeks leading up to earnings. 9/10 times you make 10% after IV drops, 1/10 times your spread hits max loss after IV rockets up. 

This is part of the reason why it's so important to thoroughly determine if your strategy does in fact have a positive expected value and your results can't just be attributed to luck. 

Let's say you have a 10 sided dice. If you roll a 1-9, you win. If you roll a 10, you lose. What is the likelihood that you roll 15 times without ever losing?

Around 20%

Those 15 consecutive wins in the stock market could translate to huge temporary returns, however, they aren't the product of any systemic edge. They're the product of luck. You were simply in the 20% of people that won 15 times in a row without losing. 

Gambling

So what does work?

Strap in because this is probably gonna get dense as fuck. 

We know volatility has mean reverting properties. It goes up and down but usually tends to revert back to a central point. 

If we want to develop a real trading edge, we need to understand when option premium is "rich" relative to the market's anticipated future volatility. 

By the way I found this interesting thing from Lehman Brothers on "Identifying Rich and Cheap Implied Volatility" if you want to read it. 

Just because IV is at it's 99th percentile rank (it's higher than 99% of the time last year - very very fucking high)  doesn't necessarily mean options are overpriced.

Think about $GME options during the big rally - 

That initial spike in IV on January 14th probably seemed like a great opportunity to sell options. They seemed overpriced at the time. 

We can see how it worked out....

Does that make any sense? I know we're getting deep into the nuances of this. We just need to recognize that despite IV's mean reverting properties, we need to dig deeper if we want to find truly overpriced options to sell. 

Here's where we get into uncharted territories.

I don't know a systematic method of finding truly overpriced options with any degree of consistency. 

I have a bunch of ideas. A lot of which seem to have worked for other people. However, there's really no definitive answer as to how you consistently do this. If there was, the strategy would have already been arbitraged away by quants on Wall Street. 

This is one of my favorite ideas

Selling cash secured puts on small cap, optionable, stocks that have recently spiked upwards. Sell puts at the floor at which the stock spiked up from. 

$XYZ announces big news and jumps 20% from $10 to $12 in a few hours. $XYZ's implied volatility increases drastically within this time. You sell the 10 strike put and collect a premium. 

We're short volatility and long on the underlying. Logically, this should be a great strategy. The only way we lose money is if the underlying drops below our short put.

This is where your own due diligence comes into play. A big spike in the share price might be the effect of news that represents a critical change in business fundamentals. What's the likelihood the stock drops below your short put if it's future has changed from a strict valuation perspective?  

Hopefully unlikely.

From there, we probably want to start analyzing the increase in implied volatility. What future volatility is the market anticipating? Is it too high?

I'm still trying to figure out a way to quantify the answer to that question. For now, there are a few things you can do -

1. Look at correlated assets to see if their implied volatility has increased equivalently. If it hasn't increased as much as $XYZ, that might be indicative of overstated IV (This is of course assuming the news that caused the spike is sector wide instead of business specific).

2. Look at $XYZ's historical moves in implied volatility and try to fabricate some kind of trend. This is.... less than ideal. Past performance is no indicator of future results; HOWEVER, there may be scenarios when you can look to the past to gauge the relative impact of whatever caused the spike. Is that impact greater than a previous event? If so, how is that impact reflected in implied volatility? 

3. Please leave better ideas in the comments. 

Tie this all together and you might have a half decent trading strategy. 

- Use Finviz to setup a screener for small cap optionable stocks.

-Look for big spikes premarket/throughout the day. 

-When you see a big spike, figure out what caused it. 

-Ask yourself two questions: 

1. Is that cause truly a justification for a higher share price?  

2. Is the market overstating the stock's future volatility? 

-Say fuck it, sell cash secured puts at the pre-spike price floor (with a proper position size), drink 5 beers, and go to bed.

I like this strategy because it involves analysis that couldn't be easily programmed into an algorithm. It requires you to gauge whether both the spike in the share price and implied volatility are justified. 

Those are two ideas that aren't easily quantifiable. There are thousands of reasons a stock might spike, and thousands of reasons the options market may be pricing future volatility inefficiently. 

Portfolio Update 

We have a ton of cash. It's worked out well with how the S&P has been returning over the past few months; however, I don't want to be sitting on it too long. 

I haven't seen any intriguing opportunities on openinsider recently. Might start selling some options on here to keep things interesting. I'm still checking the insider transactions every day though. 

Apparently TD makes you do an options course before you get level 3 approval. 

TD - To sell covered calls you're going to need a masters in finance, at least 25 years of derivatives trading experience, a liquid net worth of $5,000,000+ with no dependents, and an 800+ credit score. 

Robinhood - You're 14 right? Sell these naked Tesla calls on margin and shut the fuck up.

We can sell cash secured puts though so maybe I'll start testing the strategy above.