Tales of a Technician: Of Airplanes, Anxiety, and Options Overpricing | Tackle Trading
I recently returned from back-to-back trips that required a handful of plane flights. Planes and I don’t really get along. Granted, I don’t get as wigged out as Peter in the movie Hook, but anxiety accompanies me nonetheless. Unlike Peter, my fear isn’t one of crashing, but rather of getting sick.
There are few places to become sick at that are worse than a 138-foot long aluminum cylinder flying 30,000 feet above the Earth at 400 mph.
So why all the anxiety? Is it because I get sick every time? Nope. Matter of fact, my recent travels went great. Most of the time I’m just fine. Every once in a while, though, when I’m least expecting it, sickness strikes. These unwelcome experiences leave scars on my psyche that are slow to fade. They become etched in my brain and cause me to fret over future flights.
You would think that over time the fear would fade provided I don’t have any additional episodes. Inevitably, though, once I’ve convinced myself such panic attacks have forever been eradicated, another will arise in true sneak attack fashion.
I don’t share this to garner sympathy. It instead illustrates a few interesting facets of human nature that have important implications in the world of investing.
We don’t need a rigorous medical/scientific study of humans (though there are many) to understand the fear of pain is often worse than the pain itself. Such a fact is borne out by firsthand experience. The worst parts of my occasional anxiety come before I even get on the plane.
One more example, then we’ll turn to trading.
The other day my three-year-old stuck some toilet paper up his nose just for kicks. (Must have got that instinct from his mom). It went up pretty high so we wanted to lay him down and use a flashlight and tweezers to pull it out. My boy went ballistic. Like ape crazy. Before we even did anything. By the time he settled down he had snorted the thing so high we had to take him to the doctor.
Both stories illustrate the part of human nature that lies at the core of why option contracts tend to be overpriced. We could modify the phrase “fear of pain is often worse than the pain itself” to make it more applicable to investing.
How about, fear of a selloff is often worse than the selloff itself; or even fear of loss is often worse than the loss itself.
…and finally, fear of volatility is often worse than the volatility itself.
An acquaintance of mine used to run a newsletter for selling iron condors and other delta neutral strategies. The slogan for his firm was “Fearful investors: making options overpriced since 1987.”
In options speak, implied volatility is consistently higher than realized volatility. This is what option sellers rely on, at least in part, to profit. This is their edge.
Why won’t this perpetual overpricing go away? Because every time a market correction comes along, it fans the flames of fear anew. It reignites investors’ willingness to pay up for protection. This explains why option sellers should welcome the occasional market correction. It re-inflates option premiums which had become too cheap, and thus less attractive to sell, due to the lack of volatility and anxiety permeating the market before the crash.
Financial freedom is a journey
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Originally published at tackletrading.com on October 21, 2015.
