Insurance is a means of protecting against the risk of financial loss.
Regarding financial markets, products exist to reduce risk or express opinions more efficiently. One such product is an option, a derivative that acts like an insurance contract.
Options are the right to buy or sell an asset at a later date and agreed upon price.
Option buyers purchase put and call options to speculate on the direction or insure against loss.
If the option buyer were short stock, he or she would buy a call to hedge upside exposure.
If the option buyer were long stock, he or she would buy a put to hedge downside exposure.
The counterparty in this transaction writes options in exchange for a premium derived from factors such as the spot and strike price, time to maturity, volatility, and interest rate.
In some sense, option buyers pay sellers to cover their losses past a certain level and time.
Nothing is free. When selling options, similar to insurance, returns are obtained through the calculation of expected probabilities and attempts at writing overpriced contracts. Volatility, the magnitude of potential change, is a key input in pricing formulas.
Volatility, a derivative of fear, compels option demand.
When the demand for an option rises, volatility and option premia rise with it. Demand for an option does not necessarily mean an underlying security will move. It just means that fear has compelled a market to increase its demand for protection.
As is true for most other aspects of life, fear is blown out of proportion, and hence, this is what happens in the derivatives market: fear often overstates the magnitude of potential change.
So, when purchasing protection, one must be correct in their direction, time, and volatility assumption to make money on an option. When selling, one must hedge against the risks associated with direction and volatility, among other things.
An option seller must not necessarily be directional to make money. Instead, they can leverage the dynamics of time and volatility to gain more efficient (i.e., lower risk and/or cost) exposure.
In light of these market dynamics, Physik Invest harnesses the trade of ratioed, multi-leg structures, which combine short and long options positions to better express its edge, often reducing risk and improving returns. Though direction is frequently a factor in positions netting a positive return, it is not a requisite.
About Physik Invest
Physik Invest provides actionable insights into credit and positioning, the economy and geopolitics, as well as trade theory and structuring. Founded by Renato Leonard Capelj in 2020, the business began as a personal portfolio for him to share his methods, research, and market performance. After establishing the appropriate business structures, Physik Invest may expand its services to include paid research, consulting, and trading solutions.
As a disclaimer, Physik Invest and Capelj are not in the business of providing advice. They won’t solicit the public for capital or collect fees. Accordingly, their comments should not be construed as recommendations.