From Theory To Practice

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Option Alpha

From Theory To Practice

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

Today’s segment is compliments of the brain power that our summer intern, Ben Latz, possesses. He developed the intellectual basis for this piece, and it was our conversations afterwards that filled in the details. The basis of those talks, and of this piece, was as follows. Ben took a look at how selling premium stacks up against buying an index fund. He found that selling premium, either with a straddle or a naked put, outperforms a passively invested index fund (something that we’ve shown in various contexts before). This was puzzling to him because the Efficient Markets Hypothesis suggests that we shouldn’t observe any systematic outperformances over time. Nevertheless, even after we control for delta and buying power reduction, there exists an alpha when selling premium.

So, Ben and I worked through several possible reasons for this discovery, in everything from theta to volatility to tail risk. In this segment, we work through those discussions.

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