On Options

• Posted by Adam Warner
• on October 22nd, 2009

Jared at Condor Options examines an academic study entitled Options and Expectations by Hayne E. Leland and has this takeaway.

For all its apparent complexity, options trading ultimately reduces to two possible views. For any option position p, p is either net long or net short options, and as Leland explains, an option short (or seller) must expect markets to be more mean-reverting than average, while an option long (buyer) must expect markets to exhibit mean-aversion or momentum. In a relatively arbitrage-free world, speculation on mean reversion or momentum are really the only two strategies that there are.

I would totally agree.

Options trades have two components to them, direction and volatility. But the directional bet can obviously be accomplished by simply buying or selling the underlying. So by choosing to use options as an alternative, you are necessarily making a bet on volatility. Consider wanting to go long XYZ and choosing calls over stock itself. For every 100 shares you intended to buy, you instead purchase 2 ATM calls. If XYZ moves beyond the range implied by the volatiltiy of the calls, you are better off owning the calls either by the extra profits on the upside, or the stopped out loss on the downside.

By the same token, consider someone who I will call “me”. I don’t go straight long stock all the often, especially now after the big run up. I do play most everything on the bullish side though via puts or put spread sales. I may win nominally if they all close OTM, but I did not make a good decision if the volatility and/or momentum of the underlying is greater than the volatility I sold.

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