translating to “option surface” language

This is a useful practice:

Translate your sentiment into “option surface” language

For example, a reasonable posture right now is to be bullish…it’s also an uneasy one because it feels consensus.

Of course, consensus can be and often is right. It just won’t have a great risk/reward if it’s indeed consensus.

But that’s a bit fuzzy.

Instead, let’s reframe:

1. A rally is expected therefore as it happens it’s “stabilizing”. Doesn’t catch anyone off guard, frog slowly boils. Vol dampening.
2. A small pullback in the interim also not too crazy given how much we’ve rallied (broad indices up 1.5 standard devs in past 3 months)

In sum, the coin feels biased upward but left tail holds extra surprise (highly “destabilizing”) because its even more unexpected.

Translating this bullish distribution and vibe into options…

You’d want to own something like an ATM/OTM call spread and a tail put as an alternative to owning outright deltas.

[You could do enough of these option structures to maintain a long 100% position if you want.]

The question the advantage gambler would ask:

“Is the option market offering an attractive price for this posture OR is the structure more expensive than usual?”

You can get an approximate idea from looking at things like scatterplots of normalized skew vs vol.

[There’s a bit of push and pull. If the price for such a structure is historically cheap then you’d also be inclined to revise your impression of how consensus this posture actually is. By triangulating it with other measures of risk appetite (say credit spreads, bond yields) you can try to divine what the contradictions mean. For example, on Thursday, stocks and bond yields were up but gold, homebuilders, and REITs were down. That feels like a bullish economy outlook where bond yields are yelling “growth” while the reality of higher yields is weighing on both gold and real estate. But the fact that gold is weak says it’s not a reckless inflation story. BTC went up but that the deregulation energy muddies the water. Caveat: I wouldn’t conclude anything from 1 day’s price action. This is really just a demonstration of how you can look for contradictions to infer what the crowd is focused on.]

As I’m thinking about it, it makes me want to construct some canned structures that map to narrative postures like the one I described above. You can imagine a dashboard of such postures and the price for them over time.

“Long call spread, and long OTM tail puts” is my option translation of the natural language sentiment.

[See the unlocked post a deeper understanding of vertical spreads to review why a long call spread which is a bullish position is also “long skew” — when call spreads are expensive think to yourself “market thinks we’re probably going higher but this is counterbalanced by a further left magnitude in the event it goes lower”]

All this said, I haven’t “looked up the price” which means wrangling data to see what the option market says about the full package but with SPY skews are all at middle of the road percentiles it’s probably average which means somewhat attractive if you think the distribution is more tilted than average.

On the role of options and investing

The nice thing about option expressions is the flexibility. The ability to customize the structure to fit your thesis. You can adjust the strikes to taste based on what you feel the distribution might be. You can select tradeoffs (perhaps you sell less OTM calls because you think “blow off top” is an underpriced scenario so you are willing to pay more up front premium). If you find the structure is cheap, expensive, or fair you can also decompose the legs to see what is driving the overall price.

To throw a bucket of ice water on people who want to have it both ways:

If you’re a passive investor and you sweat the shape and moves along the way, you’re not really cut out for what buy and hold requires (it’s a compensation for patience not labor).

The solution is most cases is simple — size down until you are comfortable not looking. You can expect a 25% drawdown once a decade at least.

If you spend more time thinking about the nearer term shape of returns…then options are more surgical. The outright stock price is a blunt compression of an idiosyncratic distribution into a flat 2-D number. Options are the 3-D version. Most people shouldn’t care about the 3-D but if you do options are the weapon of choice.

By getting better at options thinking and “having a vol lens” you can parse what the surface says and compare that to what you think. The tighter your thinking the easier it is to map it to the options surface. Since it’s professional’s job to think tightly I they have more to gain from adopting a vol lens. (If you want to make a stronger statement you could say that not understanding the best way to express their views is at best an invitation to be outcompeted, at worst negligent.)

For the retail investor, fuzzy “I’m just along for the passive ride, I’ve outsourced my pricing to the market, and just have to decide my size” is fine. But if you want to take more control, options offer granularity which steer you to sharper thinking.