Expected Option Returns

[Matias]

Hopefully this thread is appropriate although it is meant to be generalized Expected Option Returns discussion.

I'm not looking for anecdotal evidence but academic research.

I'm interested if there is scientific evidence to suggest that writing options could have higher risk adjusted return than buying stocks.

 

[Matias]

This was interesting to read. Unfortunately the mathematics goes over my head, but the observed results seem understandable.

https://www.jstor.org/stable/222539

The key take away to me is, that Put options have returns that are negative. Also put returns are also too low to be consistent with the Black-Scholes/CAPM model (when taking into account their betas).

 

[Matias]

This paper

Why are Put Options so Expensive?

This paper studies the "overpriced puts puzzle'' -- the finding that historical prices of the S&P 500 put options have been too high and incompatible with

deliverypdf.ssrn.com

also discusses what is called "overpriced puts puzzle" and writes

The Jensen’s alpha for ATM puts is -23% per month and highly significant. Other popular performance measures, such as the Sharpe ratio and others, also indicate that put prices have been very high.
• For ATM puts to break even (i.e., to have the average excess return of zero), crashes of the magnitude experienced in October 1987 would have to occur 1.3 times per year.
• The economic impact of the put mispricing appears to be substantial. We estimate the cumulative wealth transfer from buyers to sellers of the S&P 500 futures options and find it to be $18 bln over the studied period.

 

[saniflash]

cf. CBOE S&P 500 BuyWrite Index - Wikipedia

 

[Max Plaid]

This paper

Why are Put Options so Expensive?

This paper studies the "overpriced puts puzzle'' -- the finding that historical prices of the S&P 500 put options have been too high and incompatible with

deliverypdf.ssrn.com

also discusses what is called "overpriced puts puzzle" and writes

The Jensen’s alpha for ATM puts is -23% per month and highly significant. Other popular performance measures, such as the Sharpe ratio and others, also indicate that put prices have been very high.
• For ATM puts to break even (i.e., to have the average excess return of zero), crashes of the magnitude experienced in October 1987 would have to occur 1.3 times per year.
• The economic impact of the put mispricing appears to be substantial. We estimate the cumulative wealth transfer from buyers to sellers of the S&P 500 futures options and find it to be $18 bln over the studied period.

This is referring to the buying of puts... I view the buying of short-term options as pure gambling and very, very rarely do it, almost never...

 

[Knightshade]

This was interesting to read. Unfortunately the mathematics goes over my head, but the observed results seem understandable.

https://www.jstor.org/stable/222539

The key take away to me is, that Put options have returns that are negative. Also put returns are also too low to be consistent with the Black-Scholes/CAPM model (when taking into account their betas).

This and the other link you post both seem to say that BUYING puts has negative return.

And supports the idea SELLING them has a positive one.


That said, there's so many different strategies available in trading options-- and behavior can differ from one underlying to another so much based on varied IV (and same with share behavior) I think you're not gonna get quite the crystal clear picture you seem to be after for the GENERAL and BROAD question of "are options better than shares"

 

[Matias]

I'm aware that the studies that I presented show that buying puts has negative value. Of course that would suggest that writing puts has positive value

So this data seems to suggest that what you're doing in the "be the house" thread has legs.

 

[Matias]

That said, there's so many different strategies available in trading options-- and behavior can differ from one underlying to another so much based on varied IV (and same with share behavior) I think you're not gonna get quite the crystal clear picture you seem to be after for the GENERAL and BROAD question of "are options better than shares"

I've been firm believer on the

Efficient-market hypothesis - Wikipedia

en.wikipedia.org

and because of that i've believed that it is not possible to constantly get risk corrected excess return.

This data seems to contradict that. This data suggest that writing options is more profitable than it should be.

 

[BornToFly]

The bottom line is that writing options can be profitable, but you have to know what you are doing and not take on too much risk....

For a growth stock like TSLA, I believe in the next 5 years it is more profitable to own shares than use the cash for options. Therefore own shares and use available margin, just not too much....

 

[Knightshade]

I've been firm believer on the

Efficient-market hypothesis - Wikipedia

en.wikipedia.org

and because of that i've believed that it is not possible to constantly get risk corrected excess return.

This data seems to contradict that. This data suggest that writing options is more profitable than it should be.

From your own link:

Empirical evidence has been mixed, but has generally not supported strong forms of the efficient-market hypothesis

No shortage of folks like Warren Buffett and Peter Lynch who don't buy into EMH either.

 

[MikeC]

I've been firm believer on the

Efficient-market hypothesis - Wikipedia

en.wikipedia.org

and because of that i've believed that it is not possible to constantly get risk corrected excess return.

This data seems to contradict that. This data suggest that writing options is more profitable than it should be.

How can you still believe in efficient markets when you've watched TSLA over the last 8+ years? It's been pretty clear that the stock price is disconnected from reality from time to time (for whatever reason). There was no new revelation that came out in 2019-2020 that suddenly revealed TSLA was worth 10x what it was the prior year - the company just continued to execute and the market finally woke up to what was clear to us all along.

It just doesn't make sense that the share price will only reflect the sum of all current information when there is billions of dollars at stake every week in the options market that also depends on the share price. Any true theory of efficiency would have to include the effect of the options market to account for the full scope of transactions.

 

[Matias]

How can you still believe in efficient markets when you've watched TSLA over the last 8+ years? It's been pretty clear that the stock price is disconnected from reality from time to time (for whatever reason). There was no new revelation that came out in 2019-2020 that suddenly revealed TSLA was worth 10x what it was the prior year - the company just continued to execute and the market finally woke up to what was clear to us all along.

It just doesn't make sense that the share price will only reflect the sum of all current information when there is billions of dollars at stake every week in the options market that also depends on the share price. Any true theory of efficiency would have to include the effect of the options market to account for the full scope of transactions.

Efficient market hypothesis doesn't mean that the stock price is right every day. It only means, that it is with the same probability too high or too low. According to the hypothesis TSLA might now with the same probability be too expensive or too cheap.

 

[MikeC]

Efficient market hypothesis doesn't mean that the stock price is right every day. It only means, that it is with the same probability too high or too low. According to the hypothesis TSLA might now with the same probability be too expensive or too cheap.

Without knowing the actual “probabilities”, that’s not a testable or falsifiable statement.

TSLA in June 2019 did not have an equal probability of going up or down. Easy to say in hindsight, of course, but this was blindingly clear to all of us on this forum at that time.

It just seems naive to think that stock prices aren’t affected by market forces other than current knowledge of the performance of the company. Options market, whales buying or selling for whatever reason, dark pools, manipulation, etc.

The book “Misbehaving” by the behavioral economist Richard Thaler has a lot of examples of non-efficient markets, if you’re interested.

 

[EVEnergy]

In the short term, pricing can be driven by momentum and other factors but in the long-run, EMH (I think) holds true. As for options, the only way I know to make some "extra" return is writing covered calls. You will always pocket the option premium regardless of share price movement and can also partake in some (but not all) of positive price movements. I've done OK doing this but the downside is that you need a lot shares to cover the option contract.

 

[adiggs]

risk corrected excess return

One observation about this - the only measure of risk that I know of is volatility. The idea is that volatility is directly and concretely measurable where risk is not, so we can use volatility as a proxy for risk.

I accept that volatility is a good proxy for risk over the short term; certainly days, and probably up into weeks and months.


As you get further out in time than that, such as time horizons used by buy and hold investors, volatility stops being a good proxy for risk. It becomes outright bad in fact. On a long timeline actual risk are things like the company going bankrupt, losing its way on product development, being overtaken by a competitor that does things better / faster / cheaper, etc.. Company strategy and execution against the strategy.

Unmeasurable stuff, but able to be researched.

 

[Matias]

The book “Misbehaving” by the behavioral economist Richard Thaler has a lot of examples of non-efficient markets, if you’re interested.

Thanks!

 

[Matias]

In the short term, pricing can be driven by momentum and other factors but in the long-run, EMH (I think) holds true. As for options, the only way I know to make some "extra" return is writing covered calls. You will always pocket the option premium regardless of share price movement and can also partake in some (but not all) of positive price movements. I've done OK doing this but the downside is that you need a lot shares to cover the option contract.

With writing covered calls you give up the fat tail positive risk of the stock skyrocketing, but still have the fat tail risk of the stock crashing. So the probability distribution is skewed negatively.