The Right Tail, The Right Question
With the eye-popping short squeeze and subsequent collapse in Gamestop (GME) pointing to increasing speculation, if not, outright mania, investors are right to ask whether they are focused on the wrong side of the return distribution.
As investors who usually hedge the first-order directionality of options, we think the focus on buying puts versus calls, though, is misleading.
The right question is not whether a stock is going to go up or down but how quickly. Both questions are tough to answer but if you are going to actively trade options, the second question is, in many ways, more important than the first.
Anybody who taken a first-year class in options can tell you that an option payoff can be nearly replicated by a combination of borrowing and lending of cash and trading in the underlying stock…assuming the volatility is constant. This last point is critical and, we think, sometimes forgotten by infrequent users of options.
Sure, it’s nice knowing that you can lose a limited amount by owning options. But if either the volatility of the underlying finishes well below the volatility that you paid for the option or the market’s prediction of future volatility drops after purchasing the option, then it can be very difficult to make money and, over time, paying too much for options can be a meaningful drag on returns.
Just ask anybody who bought GME January 2022 50 strike put options on the day that it closed at $347. The puts were trading around $25. As of February 4th, the stock has dropped a whopping 80%+ and those same put options are trading around…$25. In the case of GME, it’s not that the actual volatility has been so low but that the option market’s expectation of subsequent volatility has cratered. The effect is similar: the owners of the puts got the direction right (in a big way) and have still not profited from it.
GME is obviously an extreme example but we wanted to use this concept on something more relevant to most investors. Specifically, we wanted to know what history indicates about whether investors should replace their US large cap equity exposure with call options.
To answer the question, we ran the following analysis in which we measured the historical outperformance based on current premiums of owning calls relative to an outright stock position. For example, each data point compared the current price of a call with the market-adjusted outcome of some historical path.
Here’s a summary table of the average of outperformance based on one month overlapping weekly returns since 1971.
Figure 1: Summary table of the average of outperformance based on one month overlapping weekly returns since 1971
Source: Capstone
At first glance, it appears that owning calls at current levels looks quite reasonable. An average loss of only 10 bps and even an “expected” gain for the further out-of-the-money calls? Hard to argue, given the environment, that replacing some equity exposure with calls is likely to be a loser.
Before investors reach that conclusion though, we would suggest slicing the data in two different ways. Both attempt to better account for some of the biggest markets moves over the past few decades.
The first method looks only at the median result for each strike.
Figure 2: First Method - Median result for each strike
Source: Capstone
The second method groups the results for each strike by volatility bucket.
Figure 3: Second Method - Grouped results for each strike by volatility bucket
Source: Capstone
Both techniques, we think, reveal something rather important that a simple look at averages might miss. The volatility regime really matters to users of options.
Sure, if one is going to replace a slug of their equity exposure call one time because they have a hunch the market might take a dive but still want to be invested in case they are wrong, then looking at averages and medians might be overkill.
But, essentially, what the bucketed data shows (and the median hints at) is that owners of options at current levels are swimming against a pretty strong tide, if delivered volatility is going to be below 15% over the life of the option.
What will deliver volatility be over the next month? We have no idea. Predicting delivered volatility over such a short time frame is as useful as predicting short-term market direction. What we can say is that for the last month, the S&P 500 has delivered 16% volatility and for the last three months, it has been 14%.
Here are the results of the 14% to 16% bucket.
Figure 4: Results of the 14% to 16% Bucket
Source: Capstone
In other words, if one thinks the volatility regime of the last few months is likely to persist, then short-dated at-the-money calls are slightly rich while further out-of-the-money calls look closer to “fair value”. Not exactly an exciting result but maybe the buyers of GME puts might have found the framework useful a few weeks ago.
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