Are Options the Best Way to Understand Asset Value?

AI isn't the only major evolutionary technology in markets these days. Cem Karsan, founder and CIO of Kai Volatility Advisors, breaks down why options are the better way to map asset value, and why there's been such a proliferation in options strategies in the last five years in a recent Excess Returns episode. 

Opening: Why You're Missing Out When Excluding Options

Karsan: That's what's happening to options. They are dramatically better. You're playing three dimensions instead of two. We're going from flat world to a three-dimensional world. Why in the world would you still play in flatland?

You May Be Misunderstanding Options

Nadig: If liquidity is sort of the fuel here, then the market's structure, which is how the liquidity is pocketed, moved, changed, transmogrified, has to matter a lot. That's been my whole career, is focused on that. We've seen this huge change in how that structure is working, specifically this massive movement into options over the last four or five years, right?

I mean, zero-date expiration options are now 60% of the volume in the S&P 500 complex, right? We've got a whole new raft of players showing up with new liquidity or taking that liquidity from maybe they were just in stocks and now they're trading the options market. How does that change of venue for the liquidity help us understand what's going on or create opportunities or create risks we might be missing?

Karsan: Yeah, that is a huge question and a huge trend that's so important. So, first, you guys have probably heard me talk about this, but this is again, another critical, important thing. Options are not the tail wagging the dog. I've been saying this for years, and I think people are finally catching on to it. When I first said it, people like, "You're insane, right? What do you mean it's not a derivative? It's literally called a derivative."

We look at options as a derivative because we started with the asset price. Everything started as our understanding of, "Oh, this is a thing, and it has a value, a single value that we are going to put on it." But what most people don't realize is options model the full distribution of the outcome of every asset. They are incredibly more precise in terms of being able to model aspects, or risks, or different types of movements of any asset.

A Three-Dimensional View of Assets

Karsan: I can give you two stocks, same market cap, same exact industry, no name, white label, and you would be like, “Well, those must be very similar stocks. They must be the same stock essentially.” But you could peel back the option chain and you could look under the hood, and one could be right distributed with a fat left tail. Another one could be left distributed with a fat right tail. One of them could have earnings and growth potential that is way down the road, with very little earnings now, and one could have all of its earnings front-loaded with a probability of a decline and a loss on the back end.

The three-dimensional distribution of the outcomes and the projected characteristics of "the dog" – the asset – is what options give you in three dimensions. And, ironically, the expected value of that whole rich distribution, just the average of it all, is the stock price or the asset price. And so, the reality is, it's always been the dog. It just wasn't liquid enough. There weren't enough network effects for it to be traded and used fully.

It is a better technology. We talk about technologies all the time. Often, new technologies, new ideas that are dramatically better, do not get adopted for quite a time. But then once they do, they hit that they get all the network effects, they hit a tipping point, and then it explodes and it takes over.

Nadig: And that’s options right now?

Karsan: That's what's happening to options. They are dramatically better. You're playing three dimensions instead of two. We're going from flat world to a three-dimensional world. Why in the world would you still play in flatland? It makes no sense. And the reason you would before was because it wasn't liquid enough, because there wasn't enough understanding and education, because there wasn't access, because of regulatory issues, because of size constraints. All of those things have broken down. We've gone from when I started in the business, which was 27 years ago, we only had quarterly options in the S&P 500. Every strike was 25 points, and we were trading 4 or 500 in S&P. Now it's every 5 points with 10 times the size of the underlying.

Don’t miss the rest of this in-depth conversation on options, liquidity, and AI risk. To see the full discussion, go here.