The High Price of Low Delta Options

Antti Ilmanen and Frazzini and Pedersen have papers highlighting the poor returns to low delta options. This highlights the power of prediction markets, in that since Alpert and Raiffa (the working paper is dated 1969) we have know that people over estimate their confidence for 1 and 99% probabilities:  these are more like 10 and 90%, respectively. Yet, these are surveys. When people put money down on these improbably (or highly probable) events, the estimates are actually too timid.

Consider the imminent apocalypse.  The End of the World is given a meager 1000:1 odds:

Paddy Power is also offering a fairly skimpy 1/1000 that the sun will rise on the 22nd.

Other betting sites offer only 500:1 odds. So, when someone says 'everyone thought' or 'no one thought', don't think this implies there was easy money. Even if the odds are as great as the absence of an apocalypse, you'll get something more like 500:1 with real money. Needless to say, this materially affects the expected value.

Share this post