Ilya Feygin from WallachBeth Capital and Stacey Gilbert from Susquehanna split duties for a well-attended session at today’s CBOE Risk Management Conference titled Determining Edge in Options Trading – an Application of the Kelly Criterion.  The topic was fresh in everyone’s minds as Ed Thorp, a pioneer of using the Kelly Criterion, was our keynote speaker the day before. 

Feygin began the session explaining at a very high level the Kelly Criterion.  In very simple terms it is a method for determining what fraction of a bankroll or capital should be used to bet on each trade.  He notes this is simple in theory, but in the real world things are not quite so straight forward.  For instance, probability is often uncertain and varies, there are infinite outcomes but finite bets, and drawdowns to actually impact a trader’s ability to step up and trade again. 

Stacey Gilbert took over and demonstrated how cheap showing 5% out of the money puts are as historically low levels when measured as a cost of the underlying.  VIX is at the low end of historical ranges so we know SPX options are cheap, but as many market participants have been focused on high SKEW it may have taken some people in the audience as a surprise.  She followed this discussion talking about implied moves around events, specifically earnings, relative to history and then the subsequent move.  She finished with noting how option pricing can be used to determine the market’s expectations of certain outcomes.