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Options Trading: Like 1987?



Editor's note: The following exchange between Prof. Succo and Toddo occurred on this morning's buzz. We wanted to share it with those who are not Buzzin.

Once again yesterday we saw heavy option selling.

The source is of course the new funds set up to generate "income" through strategic selling of options.

From this over-supply of options we are seeing index options, specifically QQQQ options, priced at implied volatilities below the actual volatility that the index is trading at.

This has not been the norm for as long as I can remember. Normally, index options trade at higher implied volatilities than actual reflecting demand from hedgers who "worry" about the market.

Obviously no one is worrying.

Quick question for Professor Succo

John, as many people know, you and I worked together on Morgan Stanley's option desk in 1991. Prior to that, you traded through the '87 crash and saw the "groundwork" being laid via "cheapie teenie" (1/16th of a dollar) puts being sold.

Would you draw any similarities between that period and what we're seeing now via the compression in the marketplace (as per your last Buzz)?

Thanks cookie.



I have written about 1987 and the influence of portfolio insurance, a failed attempt to replicate option protection synthetically. Portfolio insurance interrupted the supply/demand mechanism that prices options. Options became extremely cheap. And of course, the cheap option prices greatly exacerbated the decline when it unfolded (cheap options equals high gamma and high gamma acts like leverage).

If I compare option prices today to those in 1987 I would say two things. First at the money options were a little cheaper right before the crash in 1987, but not by much. We are splitting hairs.

But secondly, the skew (out of the money puts relative to at the money puts) was non-existent then (very flat). The market was more aggressive in selling out of the money options than it is today. The lessons of 1987 are still "somewhat" with us in this case.

So in a nutshell the option market is levered, but not to the extent that it was in 1987.

But I must add that the macro environment, one in which I believe correlations can rise significantly (a main variable in volatility), is more fragile now than then.

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