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Just Who Controls Options Prices, Anyway?

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Prof. Succo -

It's unclear who wrote the opening comments, but quickly glancing at Bloomberg it seems that the at-the-money QQQQ options trade at an implied volatility just about equal to the volatility of the underlying. Also, the point that nobody is "worrying" seems to imply that options prices are controlled by natural hedgers. While I have no empirical evidence to back this up, it seems that options prices are actually controlled by quant guys and vol traders. Perhaps the natural hedgers are using other methods to hedge (i.e. simply being less invested in stocks).

One question about your main point: If you feel that macro problems exist thus raising the probability of increased correlation, is it time to put on the reverse arb (buy index vol and sell vol within the indices)?

Minyan NW



MNW-

If we look at one or two day volatilities you are almost right: the implied volatilities of the options are just about realized. But this is like saying we are in a new bull market if the market is up one or two days.

We really have to look at rolling average volatility. If we look at 60 day and even 30 day rolling volatilities, option prices are cheaper than realized volatility.

This is almost certainly due to tremendous supply from funds that sell options as a matter of course and respond to higher option prices by selling more. Statistically, this will cause option prices to drop faster than rolling volatilities.

Which leads me to your next point - I really disagree with the premise that volatility traders (quants) control option prices. They simply don't. They "respond" to option prices. At the margin these quants will affect option prices "marginally" within a range only.

Volatility traders come in only a couple of flavors: broker dealers, hedge funds, and floor traders. Broker dealers and floor traders respond predominately to flow, generating business and spreads. Hedge funds that trade volatility do not have a fraction of the capital (even levered) that large directional funds have.

For example, when I notice an over-write fund selling options in JPM, and doing it every day, I know that fund has 1) an agenda, 2) a lot more money than I do, and 3) a different time horizon (which will cause that fund to re-adjust their exposure only on very large moves; these moves likely become panics. I can go in and buy options in large size only for that fund to then say, "You liked that? O.K., have another."

When I notice a credit hedge fund buying puts to hedge their bonds I know that they are 1) price insensitive and 2) huge.

And that is a very important point. Volatility traders are extremely price sensitive. I miss trades all the time for 2 cents. I am not going to affect an option price significantly before I walk away.

Large funds that sell options for income or buy options to hedge their exposure are not that price sensitive. When they want / need to hedge, they are not going to let price get in the way to any great degree. When they sell options they are using other people's money and doing a lot of hoping.

Directional funds provide the supply and demand dynamics that cause the large and trending moves in relative option prices.


Prof. Succo

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