Thursday, December 20, 2012

The High Price of Low Delta Options

Antti Ilmanen and Frazzini and Pedersen have papers highlighting the poor returns to low delta options. This highlights the power of prediction markets, in that since Alpert and Raiffa (the working paper is dated 1969) we have know that people over estimate their confidence for 1 and 99% probabilities:  these are more like 10 and 90%, respectively. Yet, these are surveys. When people put money down on these improbably (or highly probable) events, the estimates are actually too timid.

Consider the imminent apocalypse.  The End of the World is given a meager 1000:1 odds:
Paddy Power is also offering a fairly skimpy 1/1000 that the sun will rise on the 22nd.
Other betting sites offer only 500:1 odds. So, when someone says 'everyone thought' or 'no one thought', don't think this implies there was easy money. Even if the odds are as great as the absence of an apocalypse, you'll get something more like 500:1 with real money. Needless to say, this materially affects the expected value.


Jeremy Norton said...

Hi, thank you for yet another informative post. I agree that sometimes we place a bet on things and over estimate our chance. This is the reason why I always lose on these kind of things. Oh well, never again..

Anonymous said...

Read this helpfull article:

Mercury said...

I am happy to write any amount of end-of-the-world puts if anyone would care to bid me.

Anonymous said...

I thought low delta options were a great way to profit from disordered black swans? When a giant meteor blows up the earth some option seller will become a very wealthy man overnight. Just imagine how VIX futures will skyrocket!!

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