My thinking is this:


Suppose, based on correlation to other things they own, there are people willing to pay you cash to sell them bond options - and you just swallow the volatility yourself.


Sklansky asks, will not enough people compete for this free money that it should disappear? I mean, even if there were only one guy on Earth who could stomach the volatility, he would quickly get rich enough to sell all the options you wanted, and he'd have to hold some back like OPEC.


More likely, in my opinion, there would also be natural counter-parties on the other side, who based on some natural need would be willing to pay you cash to buy options from them - covered call writers, in effect.


Any one of these people could get free money from the other, even though he would have been willing to pay. As such, whichever side is smaller, it gets made up by cash traders, the theoretical guy with no external utility or correlation.


Ultimately, the only way you can get free money, relative to other opportunities, would seem to be if you are unique. Because, let's be honest, nobody is volatility-indifferent, everybody has a different utility for some payout scheme, and everybody is correlated to something, even if only by being a waitress in the financial district.


I think the last guy who is going to A) get free money, and B) expect it, is the cash guy. And remember, future money which you can't count on today is not as useful as money which you can count on. So either A) somebody is using a bad model, which causes free money to keep popping up over and over "unexpectedly," or B) somebody is missing a cost or utility somewhere when he measures cash payout.


Aren't you glad to know my thinking?


Seriously, this phenomenon of free money...


I give up,


Wait, we can fall back on the laws of evolution! If free money is favoring the survival of people who sell bond straddles, or need them as natural counter-parties, and yet their population doesn't grow to where the nourishment runs thin, there must be some unseen factor killing them off. Who knows, it could be a world of bottomless abundance, bad math, or even disbelief!


elroy


P.S. A quick tutorial in "beta" for anyone bored enough to read this far, and who doesn't know what we're talking about:


Suppose a dollar is worth $1.00, a 50/50 chance of $1.50 or .50 is worth 98 cents to you, and a 50/50 chance of $2.00 vs. 0 is worth 95 cents.


If there are two .50/1.50 investments, and they are perfectly correlated, you will be willing to pay 98 cents for either one. But once you already own one or the other, the second one is now worth less than 98 cents to you. Or, if they are perfectly inversely correlated, you will be willing to pay MORE THAN $1.00 for one, assuming you already own the other! Right?


Buying the beta -1 instrument brings the value of the other instrument from 98 cents to a $1.00, or something, you do the math. So what does this have to do with option prices?


Well, suppose there is somebody who has a use for stock, so he is willign to submit a high-friction limit order to an exchange - and give someone else the opportunity to lean on him - just to get some stock. Notice, a buy-limit order is identical to a put to a market-maker over the time it takes the customer to cancel it!


So, with enough of these high-friction limit orders to lean on, an options market-maker can sell puts, and then sell short stock into limit orders as the market collapses to hedge himself the whole way. And sellers can then sell to the option hedger on the way back up, they all make money, and everyone is happy [img]/images/smile.gif[/img]


Positive-sum game...