An option room with a view

Let’s say I want a burger. The easiest way to have a burger in a restaurant is to order one, right? Alternatively, we could order the whole menu, which happens to have a burger in it. We’ll end up eating a lot more, but I suppose we’ll still get to the same objective.


In financial markets, if we have a view, there are lots of ways to express it. Let’s say we think EURUSD will go lower, perhaps motivated by the move higher in UST 10Y yields. The simplest way to express this is to simply sell EURUSD spot. What’s the downside (if you’ll excuse the pun)? If EURUSD goes higher, we’ll lose money. Given it’s a spot position, even if we have a stop loss, there could be slippage, in particular if there are moves when the market is closed over the weekend, and also for example during periods of unexpected news, coupled with poor liquidity. Hence, there could be occasions where our loss exceeds a specific cap.


Using options to express this view, for example by purchasing a put option, means that we can effectively cap our loss to the price of the option. As a result, options are often seen as attractive because the downside is limited when we’re expressing a view. However, does this mean we should always use options? Not really. There are many factors which impact the price of an option, and volatility of the underlying is key. If the volatility of the asset is very high, the price we pay will also be high.


Furthermore typically the implied volatility of the option, will often be higher than the realised volatility, so there is usually a risk premium we pay when buying options. There is also a wider spread associated with options compared to spot, especially if we are trading very exotic options (although your market maker will probably be happier if you end up being a quanto double knock out range accural etc.) We also bleed P&L through the passing of time if we are long options. Whilst selling volatility is generally profitable because of this factor, here, clearly we can be exposed to unlimited downside in many circumstances.


In recent months, the whole GameStop saga has shown that retail are also active in option space. Implied volatility for GameStop did at times go to figures which were absolutely bananas, over 1000%! Trying to express directional views with a limited downside such as buying a call, would appear to be very expensive. However, one point which was flagged by @mark_dow a while back (successfully), was that selling puts, could be one way of taking advantage of the high volatility. His key point was that whilst you could be exposed to losses, it was limited, because spot can’t go below zero. By contrast selling calls, can open you up to an unlimited loss, given spot can keep on going up and up.


Options give us another way to express directional views, and there can be some advantages. However, we need to also understand the downsides. Ultimately if you have got the right view, using options might end up costing you more than expressing it through spot, especially when volatility is high. If you want to order a burger, just order that, rather than the whole menu. Obviously, options allow you trade other views about moves in volatility rather than directional views.