Traditionally, professional options traders choose to utilize options because of the advantage provided by volatility. Volatility traders (“vol traders”), those who are always selling options to take advantage of the convergence of volatility and Theta (time) decay, are seen as the smartest guys in the room.
They capitalize on the complex pricing of options, essentially making a bet that whoever is on the opposite side of the trade doesn’t understand the effect of the aforementioned convergence. There are many strategies for volatility trading but most fall under one umbrella: capturing edge via mis-pricings created by volatility and Theta.
The story goes that the professionals sell the options when volatility pushes the prices up, and then they sit back, put their feet on their desk, and let time decay take the option to zero.
These strategies have existed since options were first introduced, and the view that “long only” traders are uninformed amateurs has grown alongside them. Those employing long only strategies, almost always assumed to be in the retail space, were looked at as unaware of the true drivers of an option’s price.
But, as we hit all-time highs across indices and lifetime low levels of volatility, where do those assumptions stand now? In March 2009, the VIX peaked at $79.13. Since then it’s been a downward cascade to where it now trades in the range of $13.00-$21.00. The five-year chart says it all.
In our opinion, the drop in volatility has created a more level playing field. Enormous capital investment into market structure and volatility based strategies have sky rocketed operating costs for professional firms and significantly minimized the coveted edge. Alpha has become exponentially harder in an environment with ever shrinking volatility and smaller spreads.
As such, many of the professionals are leaving the space or trading with significantly less volume until they can make more profitable adjustments. Naturally, as options have less and less “exogenous” pricing elements, the prices of these options take on stronger and stronger correlations with the underlying securities. With this in mind, the so-called “broken markets” may have a savior within the weekly options space, or as it has been commonly now called, the “Delta 1″ trader’s space.
A Delta 1 trader that understands the underlying stock can essentially spend 100x less money for the same exposure and trade in and out of options, just like in a stock. And due to the shrinking volatility factor, the risk that a long options trader is buying an “artificially inflated” option has been significantly reduced.
For once, the intimidating Black-Scholes and binomial pricing models can be set aside, and a trader can finally trade options with confidence know that factors that once played such a large role in options pricing models are quickly losing their importance.
The less edge the big boys have, the more edge retail and Delta traders will regain. Now more than ever, stock traders can transition to a strategy that buys at the money weekly options, with reduced need to alter their strategies that work well in stock.
Of course, as always, mind the risk.