How to Find Cheap Options to Buy and Expensive Options to Sell

Posted on May 11, 2020 by Robot James
5 comments
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If you want to make money trading, you’re going to need a way to identify when an asset is likely to be cheap and when it is likely to be expensive.

You want to be a net buyer of the cheap stuff and a net seller of the expensive stuff.

Thanks, Capitain Obvious.

You’re welcome.

How does this relate to equity options?

If we take the (liquid) US Equity options market as an example then there are an absolute ton of options contracts you could be trading.

95% of them are sufficiently fairly valued that you won’t make much money trading them once you’ve paid all the costs to buy and sell them and hedge your risk.

The remaining 5% are worth looking for.

Options have a positive dependency on volatility. In looking for “cheap” or “expensive” options, we’re really looking for cheap or expensive “volatility”.

So we ask the following questions:

  • When does the forward volatility “implied” by options prices tend to be lower than the volatility that realises in the subsequent stock price process? We would look to buy these options.
  • When does the forward volatility “implied” by options prices tends to be higher than the volatility that realises in the subsequent stock price process?  We would look to sell these options.

james cordier option sellers

We want a quantitative way to our very large universe of potential stock options by criteria that have historically been predictive of under/over-pricing of volatility in options prices.

One good starting place is the many academic papers entitled “X and the cross-section of options returns”. 

This family of papers look at the extent to which historic under/over-pricing of volatility in options prices can be explained by causal factors such as size and momentum.

Here’s a summary of the key results:

  • Value Factor – Options on value stocks tend to be overpriced relative to growth stocks
  • Size Factor – Small-cap options tend to have overpriced volatility
  • Idiosyncratic Vol Factor – Options on stocks with high idiosyncratic volatility tend to be overpriced. Options on stocks with low idiosyncratic volatility tend to be underpriced
  • Beta Convexity Factor – Options on stocks with convex betas to the index tend to be underpriced (high downside beta / low upside beta)
  • IV Term Structure Factor – Options for which shorter-term implied volatility (IV) is greater than longer-term IV tend to be underpriced. Options, where shorter-term IV is lower than longer-term IV, tend to be overpriced
  • IV Premium Factor – Options with the lowest difference between historical realised and implied volatility tend to be underpriced. Options with a large difference tend to be overpriced.
  • Momentum Volatility Factor – Options on stocks with high absolute momentum tend to be underpriced. Options on stocks with low absolute momentum tend to be overpriced.

Source Papers

A Word of Caution

Be aware that the “cross-section of options returns” literature tends to make these effects look juicier than they really are because:

  • they don’t tend to model the opportunity cost of the margin you’d need to hold on your shorts
  • they tend to assume midpoint execution, which is optimistic for less liquid options.
We’ll be doing large scale factor analysis on these (and similar) effects,  building a screener and long/short trading strategy as part of our Options Trading Bootcamp later in the year…

(5) Comments

Derek Wong
May 12, 2020 at 1:39 pm

IV Premium Factor – Options with the lowest difference between historical realized and implied volatility tend to be underpriced. Options with a large difference tend to be overpriced.

Based on my reading I took the inverse idea.. Referencing Goyal and Saretto. Portfolios 1-10 are sorted by decile wrt. RV- IV. Table 2 shows the descriptive statistics for these values with RV_t – IV_t where portfolio 1 =-0.16 & portfolio 10 = 0.212. This means IV_t > RV_t for portfolio 1 and IV_t long dated ATM VOL) tend to be overpriced vs contango term structured (short dated < long dated ATM VOL). I don't have sources on hand right now but can look them up later.

I was very interested in this article as I truly believe that there is an opportunity in volatility. I just want to clarify my thinking. I would love to continue this conversation, and learn how you guys are implementing this into a system.

May 13, 2020 at 9:30 pm

“We find that a zero-cost trading strategy, involving a long position in a portfolio of options with a large positive difference between RV and IV and a short position portfolio of options with a large negative difference is very profitable. A long-short portfolio of straddles, for example, has a monthly average return of 21.9% and a Sharpe ratio of 0.626.” Goyal and Saretto

I interpret that:
If HV > IV (large + diff.) => IV low => cheap option (underpriced) => good for Long Straddles
If HV IV high => expensive option (overpriced) => good for Short Straddles

Am I wrong?

May 13, 2020 at 9:53 pm

The seconf if again (breaks down when post)
If HV grater than IV (large – diff.) , implies IV high , implies expensive option (overpriced) , implies good for Short Straddles

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