I first learned what an option was in 1997 when I picked up "A Random Walk Down Wall Street" at a used bookstore in Washington state. In one of the later chapters, it had the hockey stick diagram for a call option, which showed you that you could lose a little and make a lot. My thought was why doesn't everyone do this?
After some time on an options exchange, I learned about volatility pricing and why everyone doesn't do that. It's because options can be expensive and they can be expensive even when they optically look cheap -- because you have to be right on the timing, not just the direction. I can count on one hand in my entire career the number of times I bought naked calls and made money, but it seems to be happening more lately.
The fact is that in the equity markets, there is natural demand for downside puts and lots of supply for upside calls. People like buying downside for protection and selling upside for income. Covered call strategies have been popular for years. There is even an index for the strategy: the buy-write index. Most of the time, the buy-write strategy -- buying stock and overwriting it -- will outperform the broad market. Except in times like these.
The buy-write strategy will underperform when the market races higher. If you're long stock and sell calls against it, if it goes up a lot, your stock gets called away. And you've left a lot of money on the table. The irony is that over writers are giving away that upside for next to nothing, since implied volatility is at very low levels.
Downside puts are usually expensive and upside calls are usually cheap, since everyone wants puts and nobody wants calls. This phenomenon is called skew by option traders. You can plot out implied volatility levels by strike and get a sense of how steep the skew is. In other markets, especially commodities, it is the calls that are more expensive since the sharp moves are usually to the upside.
Equity investors have been conditioned, however, to protect themselves against crashes and steep declines. Plus, there is a concept known as spot-dependent volatility, in which realized volatility will be higher at lower levels in the market and lower at higher levels.
This is a long-winded introduction into the radical investment strategy I am presenting, which is that investors would be better served buying, rather than selling upside calls. They are cheap. But that's not the best or only reason.
The better reason is that it looks like stocks are getting frothy, and my gut tells me that stocks are going to get more volatile rather than less volatile on the way up. I think that the options market is massively underpricing the upside. Really powerful bull markets have a habit of leaving people in the dust.
For the record, I am the proud owner of the SPX Dec15 2500 calls -- I paid very little for them about eight or nine months ago and they are worth slightly more today. But I have no intention of whacking them out. This trade is either going to be worth zero or it is going to be a life-changing amount of money. If the market is up a little over 20 percent two years in a row, I win. If the market is up more than that, it could be the trade of a lifetime.
I know people who are putting this on. With a bubbly stock market and an inflation-loving Fed chairman, I'll take my chances. Years from now, Michael Lewis might be coming out with a book called "The Big Long."
At the time of publication, Dillian was long SPX calls.