Options

AI & Machine learning
1

Hi,



Why it is said that Options are always expensive and hence option writting is more profitable. Certainly there is unlimited risk in option writting.





Thanks & Regards,                                                                                                                                                                    

Jigar.

2

Hello Jigar,

 

Whether options are expensive or not depends on the relative comparison with other similar assets and strikes for the same asset. It's not true that options writing is always profitable. As you mentioned correctly, writing options have a probability of unlimited loss.
 
However, writing an option allows to pocket the premium earned in case your view on the underlying turns out to be true or the underlying stays where it is. In this sense, profit writing an option has got more probability as compared to buying an option where you profit only when your view turns out to be true.
3

This is based theoretical expectation and empirical evidences in almost all asset classes. Selling options (and delta-hedging) involves potential blow-up risks as you mentioned. A fair market therefore must price in this occassioanl blow-up risk. This gives rise to a profit-and-loss (pnls) profile of short options where the strategy makes small amount of money most of the time to compensate for those occassional large losses. On top of this (until recently and still in some asset classes), options selling is usually done by sophisticated market players (with delta-hedging) and buyers (usually unhedged) are usually risk-averse insurance seekers. The expected pnls of short options strategies are therefore positive (even compensating for the blow-up losses to incentivise the option sellers). This is what is known as volatility risk premium.



This has distilled in to this "street wisdom" that "options are always expensive". They are definitely not "always expensive", but usually expensive on the average - depending on the particular markets dynamics. Also, note that this crucially assumes option selling strategy is delta hedged (i.e. your effective risk is mostly gap risk, any other risk premia should be priced away in an efficient market).



This kind of behaviour (small profits most of the time with chances of occassional large losses) are observed in many other strategies - e.g. scalping, mean-reversion trading, credit default swap writing, loans underwriting, general insurance among other things.