In the long run, the direction of most equity markets is always up. That’s the best reason one can think of for long term buy and hold style of investing. However, there are downsides in the short term. The efficient market hypothesis indicates that investors (or fund managers) can’t do much about these temporary downsides. Does that mean the market is efficient? Yes. But…..whoever said investors are rational? Irrational investors can create market inefficiencies. We all know that insurance is a negative NPV (net present value) proposition for consumers as a whole (unless they have asymmetric information about their own situation). But, as individuals, we still buy insurance because we are risk averse and we are okay with negative NPV to offload some risk. If you can take on this risk and diversify it away, you get to collect the risk premium.
The options market is a great university of (behavioral ) economics of investors. I will list a few. There are many more though. The question is if these are known inefficiencies, doesn’t everyone know them? If they do, wouldn’t they have picked up the hundred dollar bills lying on the pavement already? Some get picked up; some are hidden in the muck of risk.
Here are some of the well known inefficiencies in the option market.
- Volatility smile: This is a well known inefficiency. Out of the money options tend to be more expensive than at the money or in the money options in general. This happens because out of the money options tend to offer more bang for the buck if the underlying were to move big. Hence speculators and hedgers are willing to cough up more for them.
But is it really easy to profit from this inefficiency. Let’s try. The simplest way to attempt this is to sell OTM options (puts and calls) and buy ATM options on the same underlying. But this can lead to exposure toward unintended Greeks. Such a position, unintentionally leads to being net long or net short on the underlying. We didn’t plan this but it happened. In the process, we also probably got exposed to big and rapid moves in the underlying (gamma)and to time value decay (theta) when the only exposure we wanted was to volatility (vega), if we paid more time value for the ATM options than we got by selling the OTM option. Apparently, picking up hundred dollar bills on the street can’t be so easy.
- Call options are equal, put options are more equal: Due credits to George Orwell. Data reveals that calls whose strike is about 3% OTM (relative to current market prices) with 1 month to expiration are available at roughly 40% to 50% of the price of equivalent puts. Here’s the option chain as of today – http://www.marketwatch.com/investing/index/spx/options
The fact is most of the investors’ money (especially in equity markets) is long only money managed by long only (or buy and hold) funds. Given this, most investors are more risk averse than what is called for. That doesn’t mean they make great returns either. Most of the fund managers fail to beat the benchmark indices consistently. This combination of risk aversion and return starvation leads to something interesting – buying of OTM puts (to hedge downside risks in the underlying) and selling of OTM calls (to supplement limited upsides in the underlying). Guess what? This make puts pricey relative to calls. A cursory look at the prices of OTM calls on the SPX or SPY or ES reveals this.
Can we really profit from this? Depends on how you look at it. If you just bought the OTM call, sold the OTM put and did nothing else, you will have a position which would somewhat resemble a synthetic long position in the underlying (but not exactly the same as a long position). Based on the options listed above, I can roughly draw the payoff curve like below.
What this means is unless the SPX crashes below X by the time of expiry, you will make some money. If the market is above Y by the time of expiry, you will make a healthy return on the call you bought and you get to keep the entire put premium that you collected. With Z days to expiry and the general long bias of the SPY, this is not exactly bad. You do get badly burnt when the market crashes big. But you are not worse off than the typical buy and hold investor. If the underlying enters correction territory but holds above X you may continue to make money equivalent to (or less than) the difference between the premium of the put and the premium of the call. Same if the market stays flat.
If you are more of a trader and less of an investor, you may like to hedge this position which looks like a synthetic long (but is not exactly the same). So you can’t exactly take a short position in the futures market.
Ultimately these phenomena are statistical and are not pure arbitrages. Kindly keep in mind that they don’t have to work all the time. Always know your appetite for risk and never exceed it. And do make the effort to hold risk management (diversification, cutting losses) and money management (allocations to strategies and asset classes) principles sacred.
When I set out to find the holy grail, I was disappointed to realize that there wasn’t one! There were many! Small, different from one another and not supremely holy (but finely crafted nonetheless) grails! The key to holiness was drinking a little from each grail, every night for a lifetime, growing the collection of grails and occasionally trashing the broken ones.