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Minyan Mailbag: Volatility Trading



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Prof. Succo,

Does the proliferation of option selling strategists fundamentally change the dynamic of volatility trading or is it likely to be a unique opportunity before some 'corrective' or catastrophic adjustment occurs.


Minyan Ron


If we assume that the supply of options is abnormally high and that option prices are fundamentally cheap, this has a structural effect on the market.

The buyers of options are certainly traders; volatility funds/floor traders/broker dealers who are professionally set up to trade volatility. As a result of the heavy supply, we can assume that they are generally long options and therefore long gamma.

The sellers are funds set up to systematically sell options as a strategy (in my opinion, they are also generally disingenuous in their description to investors as to the risks involved). Other sellers are pensions and mutual funds who more opportunistically sell options. It is a great statement when I say that the latter are more intelligent in their approach.

We can assume that the buyers of volatility (options) are aggressively trading their long gamma (it probably doesn't surprise you that I have decided to take a somewhat different approach). The sellers on the other hand are not trading their short gamma, preferring to not re-hedge and "earn their income." Remember, re-hedging when long gamma takes profits, albeit smaller than they normally would be if the volatility were higher, while re-hedging short gamma takes losses. The sellers of options do not want to take losses to control risk, so they kind of just hope the stocks don't move.

The end-all of this is the actual volatility within a range is dampened because the long gamma traders are much more aggressive in re-hedging than the short gamma traders. As long as the market (stocks) does not break one way or another, the selling of options is a reinforcing strategy.

But when the market (stocks) does break, the break is more violent than it otherwise would be (if options were less cheap) as the long gamma traders have already re-hedged but the short gamma traders find themselves very exposed and have to re-hedge with a gun to their head.
Option sellers will cry foul to this description as they will say, "we will never re-hedge; we will just take the delta exposure and sell more options. But this argument is just a matter of degree. It opens the picture to even more exposure the farther things move.

This is exactly what happened in 1987. I remember when the market began to break down the week before the crash and all those who had sold options held tight.

That is until Monday and Tuesday when they were forced to unwind either through redemptions or margin calls.

So it is just a matter of degree. As options become cheaper and cheaper and gamma climbs higher and higher, all may look calm, but the compression builds to a tipping point. The tipping point may never be reached, but the risk is there nevertheless.

So back to my first statement. I believe options are cheaper than they deserve to be and that compression is therefore quite significant. Unlike most gamma traders (and I am sure I will get a few negative responses for this), I am actually under trading our gamma. This leaves me longer tails than those who over trade it trying to capture every little profit. What I give away by under trading it I have more than captured when a name like AMGN, SPW, CL with cheap options moves significantly.

Position in AMGN, SPW

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