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Mark Twain Might Have Been a Great Option Trader



November 17, 2017

Mark Twain is attributed to having said, “I’ve known a great many worries, but most of them never happened.”  Ever since the market crash of 1987, option markets have been more inclined to price in the possibility of a severe downside sell-off by pushing up the relative prices for out-of-the money puts. 

That year, when the Dow dropped 22.6% in one day, market participants felt the pain of a multi-standard deviation move to the downside. Look at your probability bell curves and they’ll show a 68% chance of no more than a one standard deviation move, or a 99.7% chance of no more than a three standard deviation move. On Black Monday (October 19, 1987), the Dow fell by a jaw-dropping 22 standard deviations! The option trading world experienced a ‘light-bulb-over-the-head’ moment and realized that a crash down is more likely than a crash up. Hence the emergence of option skew, a pronounced elevation in out-of-the-money put values sometimes known as ‘volatility smile’ – although it’s more of a volatility smirk since the puts are more bid-up than the calls.  

But is this fear warranted? Well, as Twain alluded, most of the things that we fear may never come true. However, option markets price-in fear and it can therefore be monetized. What an amazing thing to be able to monetize event risk that in a sense doesn’t materialize most of the time! This has led to a consistent profitability in selling downside skew. From 1988 to 2014, the CBOE’s PUT Index (which actually sells closer to the money strikes on a monthly basis) had outperformed the S&P 500 Total Return Index by about 0.4% annualized but has experienced less volatility (roughly 12% daily realized volatility versus 18% for the S&P 500, or 30% lower than the underlying market’s volatility). In the observed 26 years, the Dow was up 860% – selling fear properly can indeed pay. Right now, S&P 500 skew is as high as we’ve seen it for some time. Smile at the opportunity.


Source: LivevolCore, as at October 25, 2017.

The views/opinions expressed herein may not necessarily be the views of Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.

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