Options, Mean Reversion and Momentum

TheStreet.com

For all its apparent complexity, options trading ultimately reduces to two possible views: one favors momentum and the other mean reversion. For any given option position p, p is either net long or net short option premium: whether you buy puts and calls outright or trade iron condors and ratio spreads, your positions will always have been opened for a net credit or net debit. An option short (or seller) must expect markets to be more mean-reverting than average, while an option long (buyer) must expect markets to exhibit mean-aversion or momentum.

In "Options and Expectations," Hayne Leland explains this relationship between option buyers and sellers and the price tendencies of momentum and mean reversion. By "reverse engineering" optimal portfolios containing options, Leland uses a simple model to infer what an investor's market expectations must be for him to hold that portfolio.

An option seller, he argues, must believe that the market is likely to revert around some local mean; otherwise the expected return of the option sales would be negative. An option buyer, conversely, must believe that the market is likely to exhibit more momentum than is currently reflected in the consensus estimate, since he will recoup his costs from buying option premium only if the underlying assets move sufficiently far from their initial price.

This mapping from option selling to mean reversion and from option buying to momentum provides a good opportunity to test whether your positions and trading approach are in line with your own psychology and preferences, but also to round out your portfolio.

If you like to invest in stocks to capture big trends, then, on the one hand, an option selling strategy predicated on mean reversion might seem counterintuitive or even unattractive. However, note that premium selling spreads like calendars, iron condors, and straddles will perform best precisely in those situations when momentum-based strategies tend to struggle. Conversely, if you prefer investing in value stocks - stocks that you expect will return to a mean (their true value) over time - a momentum-based approach using options could round out your portfolio.

A smart portfolio should include exposure to both momentum and mean reversion, for example by buying stocks that exhibit one factor for the long term and trading options predicated on the other factor with a short- or intermediate-term duration.

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