Minyan Mailbag: What's the Best Way to Trade Options?
Each situation is different, so blanket statements don't add value here.
I have been trading options almost excusively for the past six months with varying degrees of success. One theme I have been hearning that the best risk/reward is to buy undervalued, sell overvalued, then hedge.
What would be the best way to go about this? Would it be relevant to do a search looking for options with implied volatility in the 10%ile and historic vols below IV levels, which presents an 'overvalued' condition?
To me this looks like an attractive calendar spread candidate. Also, if I started to incorporate buying 'undervalued' selling 'overvalued,' does this tie up a lot of capital compared to traditional options strategies (calendar, diagonal, fly, condor, etc.)? Thanks for your insight.
My firm takes a more bottom up approach on individual stock options. First, we will analyze a company's financials, primarily the balance sheet. Then we will look at the options of the stock to see if in general we think options are fairly priced. Then we will look at how the options are relatively priced between each other. Then we will look at the price of the options relative to an appropriate index (in this way we can tell if the option mis-pricing is due more to systematic or unsystematic risk).
So we can trade options that we believe are mis-priced in three ways: absolute price (very subjective), relative price to other underlying options (the most objective, but highest tail risk), and finally relative to an index (fairly objective, but high correlation risk).
Normal people use options to hedge or lever a situation. Various levels of general volatility lead those people to mis-price options (they tend to mis-price options mostly in high volatility environments, although we believe this period is exceptional in under-pricing options relative to overall systemic risk).
What we do must be repeated over and over using moderate leverage. Our platform is set up to margin those options relative to risk and not Reg-T, which normal people are subject to.
Each situation is different, so blanket statements don't add value here. The best suggestion I can give is to know each situation well and how each fits into a controlled risk environment.
Options in general tie up way less capital than stocks. And no particular strategy that involves both buying and selling them will necessarily use up more capital than another one. It will depend on the specifics.
As to buying undervalued and selling overvalued, in terms of implied volatility relative to historical, I would not recommend that play. There can be very misleading relationships.
For example, take a stock with a big "news" gap somewhere within the last 30 days. The historical volatility will read relatively high until the gap day works out of the system, while the implied will look very cheap in comparison. The gap will narrow, but there is no "play" there, the historical will simply revert to normal.
On the flip side, if the IV is higher than the historical volatility, it does not mean it is necessarily correct to game it with short options, or long calenders. It could just be that news is anticipated, and the near month options get relatively bid up in advance.
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