Thoughts
1 min

Puts are valuable beyond their payoffs

Every loss comes with loss of opportunity. This makes insurance valuable beyond its expected payoffs. Applied to options, this helps us understand why market makers buy out-of-the-money puts and how buying puts can be part of expressing a bullish view.

Thalex X
Published on
Aug 18, 2024
Written by
Hendrik Ghys

Loss comes with loss of opportunity

For the business of options market making to be viable, options have to be sold on average above their cost of hedging. Hence, the volatility risk premium. This means options on average are sold above their expected payoffs. This is no different than a manufacturer charging a price above cost of goods sold.

What's in it then for the buyers?

In short, continued access to optionality. Options are insurance. It's valuable beyond expected payoffs because when you lose, you actually lose twice. Whenever you lose money, you also lose access to the opportunity set of the money you lost.

A real world example can be found in option market making.

Market makers buy out-of-the-money puts, knowing full well they're expensive in terms of volatility risk premium. But volatility risk premium doesn't tell the full story. It's an objective metric. It ignores the subjective value for the market maker to continue doing business during the times where these puts pay off.

When volatility picks up, the profitability of market making increases exponentially: higher volume, wider spreads, and market share concentration. A market maker can't afford to be constrained by losses or elevated margin utilization during these windows of opportunity and should be willing to pay for options that allow monetizing a fast market.

In other words, they pay premium to operate in prime market conditions.

Puts if you're bullish?

The same duality between the objective value of payoffs compared to the subjective value of optionality takes center stage when debating the simple question of whether it's worth hedging a long position with puts.

As a starting point, if you systematically buy puts, you should expect to lose money. The puts stand-alone will cost more in premium than they give back in payoff, especially for an asset like Bitcoin, which drifts upwards over time.

The merit of tail hedging could be dismissed on these grounds. The puts lose money so you're better off not hedging?

This misses the optionality of reinvesting the payoffs from puts.

If you buy and hold Bitcoin and protect downside with puts, the cash you get during drawdowns can be used to buy more Bitcoin.

Think of the puts as midfield defence. Their job is to intercept the ball and start a counter-attack. At a portfolio level, the puts 'intercept' losses and allow to counter-attack by buying the underlying during dips.

While the puts may be a losing trade in isolation, their effect at the level of your portfolio, if rebalanced, is to increase your Bitcoin exposure over time.

By reducing risk, the hedge pays itself back by allowing you to take more risk over time.

Implementation questions

While the concept of a tail-hedged long portfolio is straightforward, there are many implementation details to consider. For instance:

  • Which strikes and maturities do you select for the puts?
  • Do you delta-hedge the puts?
  • What is your rolling strategy over time?
  • How do you monetize the puts?
  • How to adjust for cheap versus expensive IV?

For further reading on this topic, we recommend Common Hedging Discussions part one & two by Benn Eifert, which can be found under QVR's research section on their website: Research — QVR Advisors.




Disclaimer

The information, content, opinions and other entries published on this website represent the views, opinions and understanding of Thalex. They are not trading advice, and don’t constitute, nor do they intend to be understood as, an invitation or induction to trade, invest, engage with, or otherwise take part on, any activities carried by Thalex and its associated companies. Please be aware that, when trading, you are exposed to a risk of loss, which can be heighted by the leverage effect of derivatives, and your account can be subject to steep and variable balance swings. Please make yourself familiar with any local guidance and regulations, as well as the permissibility to trade crypto and crypto derivatives. Thalex disclaims any responsibility for the fair use of any of the information and content in this website, and accepts no liability for any losses derived from the use of these materials. Thalex strongly encourages you to fully understand the nature, risks and potential rewards of trading derivatives, taking external advise if necessary.

This information and content should not be understood as advice, or a call to action, trading or investing. When investing, you are exposed to risk of loss, and you may end up with a lower account balance than your initial account balance. Derivatives are leveraged products subject to high price fluctuations, and this may have a negative impact on your investments, holdings and strategies. Please make sure you understand trading activities, crypto assets, futures, forwards and other derivatives fully, seeking independent guidance if necessary. Trading carries a high degree of risk – the value of your investments can go up or down – please invest only what you can afford to lose.

From the blog

The latest industry news, interviews, technologies, and resources.
View all posts