Minyan Mailbag: Zero Volatility
I sense you are getting a bit tired of having me around
Editor's Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next discussion with that very intent.
OK, overwriters are short cheap calls. They sell the calls and that's mostly it. They don't trade around.
If the market breaks lower the call buyers will make money on the short stock. The original call seller may sell stock because of market conditions. But how is cheap gamma exacerbating this?
I get selling puts / selling stock will snowball.
First of all, being long stock and short call is the same exact risk profile as being short a put. So when a fund buys stock and sells an at-the-money call as a strategy, it is the same thing as being short a portfolio of puts.
When a fund is created with a strategic objective of "income and capital preservation," which is how these funds are presented to potential investors, the expectation for losses of capital is minimal. But inherent in this strategy are large potential losses if stocks decline precipitously. The short call will only protect the portfolio from losses by the amount of premium sold; the cheaper that premium the less protection.
If the fund is selling over-priced calls, the risk for reward of the portfolio can be favorable: the amount of possible return is relatively high as is the protection of the portfolio from losses. If the fund is selling under-priced calls, the risk for reward will be relatively unfavorable.
So when the fund is selling cheap calls it is implicitly accepting a poor reward for risk that the investors might not be willing to accept. Of course those investors will never realize the risk unless the market begins to fall. But if the market does fall and the fund begins to show unexpected losses the investors will begin to redeem. As they redeem it will force the fund to liquidate (sell stock and buy back the now out-of-the-money calls) in order to raise cash. This will cause further selling in the market.
So the fact that the fund sold cheap calls (high gamma) puts the market in the position of unexpected losses if certain things occur.
It is all about expectations and sizing of risk, a main determinant of forward volatility.
Are you assuming that the funds are picking the options first and then the stock? Or are there managers (good or bad) who buy stock and hedge with calls? So, isn't it possible that just poor stock picking, not hedging, will cause redemptions which causes selling and not the options themselves ?
These two risks are mutually exclusive.
A "buy-write" fund (as I have described) normally picks a stock it is "fundamentally comfortable" with, whatever that means. How different funds value stocks is of course widely varied. No matter how high the option price is that they sell then against that stock will not save the fund from poor stock picking.
But the fund can pick a good stock, but that stock can go down just because the market goes down. If in that case the manager has sold too cheap of a call, even though that stock has gone down less than the market (because the manager picked a good stock), it still can create larger losses than expected by the investor.
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