Let me just check I was understanding your point. I was thinking that you were giving something like the following argument
(a) (arbitrage constraints tell us that) we can think of selling a covered call as selling the replication of the underlying
(b) normally if X can make more money M than Y from the use of R then it can make sense for Y to sell R to X for some sum less than M. For example if I am really bad at collecting overdue sums owed to me but you are good at collecting ones owed to you it can make sense for me to sell my outstanding overdue receivables to you at a discount. That helps us both, and is accretive to what I would have brought in if I hadn’t sold.
(c) market makers can make more money than I can via being able to buy and sell the underlying so as to replicate the option
Therefore
(d) Unless trading costs are too high to make it worthwhile, we should expect that there is a price between the value of the option to me and the value to the market makers such that if I sell it to them we can both do better than if there was no sale. Efficient market forces should lead us to expect that that kind of price should be offered.
So far so good for theory, but we don’t observe that. Question is, why?”
Does that roughly capture the way you were thinking about it, or did I misunderstand something?
yes and very well said. i like that. you may have just written next week's post. haha.
the reason may be that TSLA trends rather than mean reverts. so that its vol tends to be in the same direction. in other words, the walk that TSLA stock is making is not so random. In that case, selling calls is a bad idea.
idk if you can tell that a priori, but that is a possible explanation.
Really interesting way to think about it via market maker advantage on replication. Could their discussion of the comparatively short numbers of DTE for hedged options, and how much of the return was driven by residual/unexplained P&L as compared with realized+vega have something to do with that? Like, the market makers demanding a huge premium to take on the risks related to that return profile over a short term (average) run in to expiry? Thinking about the stuff from like 1:07 in the video
I'd like to do some experiments on this myself -- comparing the probability of going in the money vs value of the option. i mean the binomial model kind of implies that it is based on the end result.
if anything, this is such a good reminder that it pays back in spades to do experiments.
Mark & Kris said that the unexplained pnl was due to higher order greeks and that sounds reasonable to me. This is not so much that the pnl is "unexplained" as it is merely addressing the shortcoming of their methodology of attributing pnl. Gamma is 2nd derivative and has curvature -- it matters more when you are close (close in time and close in strike). As you move away it matters less. That means that if you just use a static gamma measure to estimate the pnl due to gamma, then you are going to be close for small moves in the underlying and increasingly wrong for large moves. If they did a Taylor expansion including accounting for changes in gamma then it would be more accurate.
Let me just check I was understanding your point. I was thinking that you were giving something like the following argument
(a) (arbitrage constraints tell us that) we can think of selling a covered call as selling the replication of the underlying
(b) normally if X can make more money M than Y from the use of R then it can make sense for Y to sell R to X for some sum less than M. For example if I am really bad at collecting overdue sums owed to me but you are good at collecting ones owed to you it can make sense for me to sell my outstanding overdue receivables to you at a discount. That helps us both, and is accretive to what I would have brought in if I hadn’t sold.
(c) market makers can make more money than I can via being able to buy and sell the underlying so as to replicate the option
Therefore
(d) Unless trading costs are too high to make it worthwhile, we should expect that there is a price between the value of the option to me and the value to the market makers such that if I sell it to them we can both do better than if there was no sale. Efficient market forces should lead us to expect that that kind of price should be offered.
So far so good for theory, but we don’t observe that. Question is, why?”
Does that roughly capture the way you were thinking about it, or did I misunderstand something?
yes and very well said. i like that. you may have just written next week's post. haha.
the reason may be that TSLA trends rather than mean reverts. so that its vol tends to be in the same direction. in other words, the walk that TSLA stock is making is not so random. In that case, selling calls is a bad idea.
idk if you can tell that a priori, but that is a possible explanation.
Really interesting way to think about it via market maker advantage on replication. Could their discussion of the comparatively short numbers of DTE for hedged options, and how much of the return was driven by residual/unexplained P&L as compared with realized+vega have something to do with that? Like, the market makers demanding a huge premium to take on the risks related to that return profile over a short term (average) run in to expiry? Thinking about the stuff from like 1:07 in the video
I'd like to do some experiments on this myself -- comparing the probability of going in the money vs value of the option. i mean the binomial model kind of implies that it is based on the end result.
if anything, this is such a good reminder that it pays back in spades to do experiments.
Mark & Kris said that the unexplained pnl was due to higher order greeks and that sounds reasonable to me. This is not so much that the pnl is "unexplained" as it is merely addressing the shortcoming of their methodology of attributing pnl. Gamma is 2nd derivative and has curvature -- it matters more when you are close (close in time and close in strike). As you move away it matters less. That means that if you just use a static gamma measure to estimate the pnl due to gamma, then you are going to be close for small moves in the underlying and increasingly wrong for large moves. If they did a Taylor expansion including accounting for changes in gamma then it would be more accurate.