I don’t understand why anybody would go short if they can buy a put option. I know, if you can’t find the needed terms or the contract itself, then you only have the shorting option. Are there any other reasons one would short when a proper put contract is available?
You may be hedging with your short in order to eliminate a specific type of risk and you don’t want the hedge ratio to change as dramatically as it would with an option.
You may not want to pay for time-decay (theta).
You may not want to have levered exposure to volatility changes (vega).
You may not have an account or policy that allows options.
You may find shorts simpler to manage than options.
You may not trust your counterparty.
It may not be clear what strike price is appropriate to your strategy.
Transaction costs may be significantly higher (bid-ask spread).
Do you buy calls instead of going long shares?
I feel personally it depends how long my long is going to be. I know what you’re saying.
I just felt, being level 1 newbie, like the leverage opportunity and minimized downside of a put contract (as oppose to bottomless losses from a short position) outweighs any benefit a short position may have. I now see some of the other considerations-- thanks for detailed answer bchad.
Aw, shucks. Blake woulda done the same for you, I’m sure, font of utility that he is. 
honestly, surprised blake isn’t on this thread shitting all over me for asking
Good post from bchad. I will also add that oftentimes people like to short companies that are facing presumably massive secular headwinds, but sometimes it can be difficult to time the inflection point I.e. when the story is going to take a turn for the worst (e.g. major miss on earnings for whatever reason). In this case a short could be more desirable than a put because the worst thing that could happen is the stock blowing up after your put has expired.
Numi - I thought you were supposed to be smart, all those words to say you think delta1 is better because options have an expiration date, surely even you can see how dumb that is, no?
This also ignores the inconsistent logic btwn your two scenarios (i.e. why would you hold shares past expiry date, but not be willing to rebuy options).
Lol, can’t wait for the inevitable justification and qualifying.
Moremoneypleas - bottom line is this, if you have a view on price, trade shares, view on implied vol, trade options - that simple.
I see, in regards to trading options, where the view on implied vol would lead to options over shorts. But if you’re planning on executing the put contract, then does implied vol really matter?
Why is that inconsistent? Given the frequent upward bias of markets, shares can move against a short position – for a long time – even if your longer-term bearish thesis is correct. Presuming that you would want to cover a short and then re-enter the short later after the stock continues to run would be predicated on the dubious scenario where you could time the market and somehow “know” that the stock could continue to appreciate “irrationally” against your short thesis, and that you could somehow time re-entry of your short at a higher price. If I understand what you’re saying, then that’s exactly why you would hold shares past the “expiry date” – i.e. downside catalyst happens later than you expect, but you still need that to drive convergence of price towards your short valuation.
If the underlying stock price doesn’t move below the exercise price of a put option before expiration date, your puts expire worthless. That doesn’t preclude you from having the proclivity to “re-buy options,” but that would only be after the loss of premium on your puts had already been realized. In contrast, you wouldn’t bail from a short position prematurely if you felt your thesis was still intact.
Yea, it’s the price, it matters very much, just like the price of the underlying is key in your decision to go long or short. All you’re doing by using options to trade a delta view is introducing unnecessary volatility into your p/l. Sure, sometimes you win on both - if the market opens down 5% on monday you’d rather hold four 25delta puts than short 100 shares, but over the long run the expectation is zero.
You’re just describing premium decay, we know, thanks.
Normally mild-mannered LPoulin seems a bit testy today. My guess is that he’s climbed the options knowledge tree high enough that he has forgotten that you can be an intelligent financial professional without being fully conversant in day to day options jargon (e.g. “delta1” instead of long (or short), etc. ). My understanding is that LPoulin trades options nearly full time, whereas a lot of us are primarily about the underlying and occasionally use an option as an instrument.
Basically, the big issues with options are that you have to pay a time premium, you have to have a view on volatility, the bid-ask spread can be high compared to the outright stock. If you don’t like these, you might consider shorting the underlying instead.
Expiration can be an annoyance, but you can get around that by holding long-dated options, or by rolling them forward. Rolling forward involves more transaction costs because you have another purchase, commission, and bid-ask spread to pay for every month. Also, if you are buying short dated options, the premium decays quickly, so usually it doesn’t make a lot of sense to roll those options forward (if you are buying them) unless you’ve expected something imminent to happen and for whatever reason it just hasn’t yet. If you don’t know when something will happen, it’s probably better to use a long-dated option.
There’s also the question of choosing your strike prices. If you are holding long-dated options, they aren’t going to move as much as the underlying unless they are deep ITM, but if you are deep ITM you are also paying up for a lot of intrinsic value, so you don’t get the leverage that you wanted. If you are just doing risk control, that’s not such a problem, bcause you will be thinking in terms of nominal exposure rather than option price, and it will seem cheap. If you are trying to use options for leverage, then that can make levering up more difficult because you have to buy (1/deta)x more options in order to get the same exposure as a long or a short. That will simultaneously make you more sensitive to changes in volatility, which is why you need to have a view.
In L2, you’ll also learn that you seldom want to exercise options - you’ll sell them if you want to lock in a profit or let them expire if you think they’ll keep their value and you want to save on transactions costs. The one condition where it makes sense to exercise early I think had to do with exercising a call in order to get a dividend that was more valuable than the remaining time premium. I forget exactly that case, since I’ve never done that.
I seldom use options because there are so many things to keep track of and they typically require frequent adjustments to keep them in balance as delta changes. I find my brain cycles and time are best used for other things, although I would like to learn to do them better, particularly applying options spreads, and lower-risk kinds of options strategies.
Options are extra tricky because you have to get the issue, the price, and the timing right, or constantly bleed premium. If you are selling options you get to earn premium, which is nice but you are then more vulnerable to extremely expensive tail risks (though you can trim those risks by buying countervailing options and sacrificing some premium). Even if you are buying, the chance of losing 100% of the money paid for them is quite high, so you can’t think of options as if they were “cheap versions of the underlying” because that line of thinking will lead you to put on enormous quantities of risk if you are not extremely careful.
If you have a view on volatility, however, options are the main tool available to express that view, particularly since the VIX ETF products don’t don’t seem to track all that well and lose a lot of money on the embedded costs of rolling contracts forward.
bchad’s initial post addressed the main points and I think everything that has been added after that is just restating the same stuff. One thing I should add that might be important from an investing perspective: options trade using arbitrage free risk neutral pricing assumptions, i.e. no risk premium in the market. So essentially the future world envisioned by option prices is different from the future world envisioned by a risk adverse investor.
There are some ways to take advantage of this. For instance, the risk neutral world of options shows a ridiculously high probability that SPX will be under 70% of today’s level in 10 years. This is counter to the world where investors must be compensated for risk. So guys like Warren Buffet sell a bunch of put options at these maturities.
If you have access to a long dated vol surface (like 7-10 years) for something like SPX, I encourage you to plot out digital option prices across a broad range of strikes. The results might surprise you.
What does this mean! You can’t profit by exploiting perceived “differences” between the unobservable real world probability and the risk-neutral probability, which is just a measure-theoretic mathematical abstraction - that’s ridiculous. Option prices are not driven by the laws of some parallel state of the world governed by risk-neutral probabilities, they are the capital needed to finance a no-arbitrage replication strategy that involves trading the underlying (and the replication argument doesn’t need to invoke the concept of risk-neutral probabilities at all).
Maybe I completely misunderstood what you’re saying cause it makes no sense to me at all. So, uncle Warren sells a bunch of long-dated puts and what happens then?
I never fully understood the risk-neutral probabilities. My sense was that since you could create a replicating portfolio to hedge the option using a combination of cash and the underlying, there was effectively zero risk, and therefore the option seller was not entitlted to a risk premium for taking on the contingent liability. In practice, there is some risk that you won’t be able to rebalance the replicating portfolio fast enough and that doing so would create extra transaction costs, so there is some kind of cushion that market makers give themselves, and that is why implied volatility tends to be higher than realized or even expected volatility.
It always seemed to me that if you did have a model that predicted that the expected value of the underlying at expiration was something other than your typical brownian motion with drift and your model was good enough, then you might be able to make some money by buying options with positive expected returns after paying premiums. However, I know that the option math is more complicated than that and so I figured that this might be too dumb a question.
A better example is covered interest arbitrage. The forward currency contract is basically determined by todays spot rate and the interest rate differential, and there’s an arbitrage relationship that basically locks the forward price to the no-arbitrage value, other than transaction costs. It seemed to me that if you had a model of spot rates that did a decent job of predicting future spot rates, and that those rates somehow differed from the covered interest arbitrage prices, that there was a profit potential from exploiting that difference.
Numi just bothers me, always has. Didn’t mean to offend anyone else, apologies if I did. Will chill it out, my bad.
Bchad - You’re getting at the heart of the matter. There’s no arbitrage at inception (outside of structural, technological, or informational advantages), just like any other position you take with any other instrument. You need to predict something and edge is only determined in hindsight. Same problem as trying to say a stock is over/undervalued, or interest rates are high/low, or making a market in the SP.
Most of the time, if you think you’ve found an arbitrage, you’re probably just looking at things incorrectly. That’s why I was trying to make the point that that there’s no advantage in using options over shares, unless you think you can predict the options price along with the underlying’s price - which imo seems difficult.
We’re all allowed to be grumpy now and then.
Today is Easter, even Jesus had a right to be grumpy on Easter. At least after he is risen and before he had coffee.
From what I’ve seen out there, the most intuitive and easy to understand derivation for the price of a derivative (with any payoff, not just vanilla option) is using the one step binomial lattice. With just a few lines of simple algebra it arrives at the no-aribtrage price of the replicating portfolio of stocks and bonds, showing that it is independent of the expected return for the underlying.
I think most textbooks should really pause here and allow this to sink it, because it is powerful and somewhat unexpected result. The problem is that they immediately jump to the next step and transform the expression through algebraic manipulation - so from a replicating portfolio with clearly shown positions in the stock and bond, it becomes a discounted weighted average of the option payoffs under some abstract probability measure. You gain a lot of mathematical elegance and ease of computation at the expense of lost intuition.
To think about derivative prices as expectation under risk-neutral measure is a mathematical abstraction that allows you to compute these derivative prices easily. But option prices themselves are not driven by risk-neutral expectations - that would be like the tail wagging the dog. Option prices reside in the same world of real-world probability measures as their underlying, they are just the no-arbitrage price of the replicating portfolio in that same physical world.
I almost never just ‘buy puts’ directly. If I want to get short, I usually ‘sell calls’ or call spreads. Unless IV is substantially cheap atm, then maybe I’ll buy ‘some puts’.
Also, if I want to get short at the money, where the stock is, and IV is cheaper for the put, I’ll buy the closest atm put and sell the equivalent call to get a delta close to 100, instead of buying twice as many puts for the same rate of change and paying more for the overall ‘bearish’ position. I like to collect credit over debits.
Also, I only get exercised when the assignments costs are cheaper than closing out my entire position at a loss.