By Steve Papale
I used to hate hockey. The game seemed boring to me – not enough scoring. Just guys chasing the puck around. I admit the fights were interesting. Now however I must admit I have become a fan. Partly due to the success of the Chicago Blackhawks and partly due to one of my kids playing. So I watch. And lately I have been watching late into the night. Blackhawks and Ducks have had several overtime games and one that went past 1 am. So for the rest of the season I’ll be operating on hockey time. Potential late nights and short naps during the day. Normal scheduling will resume when Blackhawks win the Cup or get eliminated.
The last few weeks we have been discussing edge and how to capture it. As traders, or business people in general, that is the name of the game. Last week we ended up talking about the relationship between implied volatility and the underlying or statistical volatility. Generally these will track each other. In fact if the options are fairly priced the options volatility and the statistical will be the same. The gamma of an option will exactly offset the theta.
Think of gamma as the movement factor and theta as the time decay factor. If we sell an option, movement is the risk and theta is the reward. For the buyer it is flipped, the gamma is the reward and the theta is the risk. Therefore, if IV is higher than statistical for example, than the options are priced higher than movement in the underlying is suggesting. In this case the option seller is getting paid more than he should based on the statistics. This is edge.
Now does this mean we can capture this once the trade is placed and take it to the bank? Unfortunately no. That would be something called riskless arbitrage. The edge is the economic reason to get into a trade. The profit or loss on the trade depends on the normal factors in the market such as movement in underlying and changes in IV. But we the edge we captured allows in this case the options seller to collect a bit more premium than he should have gotten based on the underlying which allows him to achieve profitability sooner or buffer adverse market moves. So identifying markets that that have a long term mispricing relationship between the options and underlying is one way to capture edge in a trade.