Yes Virginia, Options Are Risky
Equity options can be risky. At least that’s what we are obligated to tell little Virginia when she asks. But we would be doing her a terrible disservice if we left it at that. We owe it to her and to ourselves a little better explanation.
The concept of risk is one that very few people in this world understand. Take this guy, we’ll call him Bill, that says he doesn’t smoke because smoking can potentially lead to lung cancer. Instead of smoking, he prefers to drink, and quite heavily at that. Occasionally he will even get behind the wheel of a car after some heavy drinking. But he doesn’t smoke. Nope, that would be too risky.
Or what about Tom, who refuses to put money in the stock market. You know, because the stock market is risky and it could crash, and you could lose all your money. Tom of course has no inhibitions about buying a house that recently tripled in the last 5 years. No, much safer investment.
What about Susan, who is afraid of flying. You know, the plane could crash. It could be hijacked. Midair collisions happen from time to time. No, she feels much safer driving on the highway long distances on icy roads where she could potentially run into our friend Bill, from above.
Why bother going through all these examples? Because it helps explain why we have very little understanding of what risk is, and how we lack the ability for the most part to measure risk on any kind of an objective basis. This brings us back to equity options.
How many times have you heard someone tell you that selling naked options is risky? Or that calendar traders are almost risk free? Or how it’s much safer to be long gamma versus short gamma. Or how some friend of theirs has discovered this wonderful strategy that just can’t lose. They probably just got back from one of those seminars.
The problem we have here is in how we define risk. Let’s look at a few examples. Let’s take two people, Peggy and Bob. Peggy has just been taught a very low risk strategy, the calendar spread, or as commonly referred to as a long time spread or a horizontal spread. She learned this strategy at a seminar called, “How To Trade Calendar Spreads With Very Little Risk”. Peggy was taught that this trade had very little risk and it was very safe. Peggy has 100k in her brokerage account.
Bob is more of a gunslinger. Bob also has 100k in his account but he likes to sell naked straddles. Let’s say Peggy finds a wonderful calendar spread she wants to put on, and she can buy the spread for a dollar or in other words, a point. Let’s say Peggy decides to buy this spread 500 times. Her total cost is 50k on her 100k account. Now the good news is, Peggy can only lose the debit on this trade which is just one point. The bad news is, that’s $50,000!!!!!
Now Bob is going to sell a straddle on the QQQQ’s. But Bob is only going to sell it one time for a credit of 2 pts, or two hundred dollars. Now in theory, Bob is the more risky trader being that he is selling naked straddles and Peggy is the more conservative trader. But who is really taking more risk here. If Peggy is wrong and her time spread does not work out, she stands to lose $50,000 or half her entire account! How much money could Bob lose? Well in theory, the QQQQ’s could go to zero on the downside or as high as infinity to the upside, whatever level that is. But assuming Armageddon is not going to happen this month and assuming that this market cannot mathematically reach infinity as it is a never-ending number, how much could he really lose?
Let’s say the QQQQ’s are trading at 40 and let’s say we have the largest drop in the market’s history in a one month period, say 50%? That would equate to a 20 pt move in the QQQQ’s. How much would Bob stand to lose on this trade? Well, if he sold the 40 straddle one time for 2 pts, he would lose a total of $1,800 or 1.8% of his account. Not bad for Armageddon eh? What about Peggy? Peggy could lose $50,000 or 50% of her entire account on one trade. So the question now becomes, who is really taking more risk here, Peggy or Bob.
Well, I’m sure it’s obvious to most here that Peggy has taken substantially more risk then Bob, even though she has a textbook safer strategy. This leads us to question again how we define risk. Do we define it by strategy, or by dollar exposure? I hope it’s obvious to everyone here that risk must be looked at from the big picture. Saying you have a safe strategy means nothing. The infamous now defunct hedge fund, “Long Term Capital”, had a very safe arbitrage strategy that they employed. The problem was that they risked 100 times more money then they actually had so that just a 1% move, yes a full one percent move would wipe them completely out, and the entire US banking system with it. They had the same problem that Peggy currently has, that is a terrible misunderstanding of risk. And a terribly subjective definition of what they call a safe strategy.
In the end, it was Bob that was taking the least amount of risk selling his naked straddle on the QQQQ index. You see Bob knew very well that the key to risk management was not in the strategy, but rather the capital employed in the strategy. Peggy meanwhile has contacted her attorney to go after the person that told her how safe calendar spreads were. Maybe when this guy said safe, he meant she could only lose 100% of her capital on the trade. Clearly the word safe can be a very ambiguous term.
So in the end, Peggy has filed a lawsuit against the folks at, “How To Trade Calendar Spreads With Very Little Risk”. Of course her instructor from that seminar was injured in a terrible accident on an icy highway in Illinois involving our friend Susan who was afraid to fly, and some drunk on the road who turned out to be Bill. But Bill has other problems. The house he told Tom to buy in Evanston as an investment, rather then put it in the stock market, has taken a 20% hit due to an unexpectedly large increase in interest rates. Needless to say Tom is angry. Especially seeing how the stock market had yet another up year. And our friend Bob the gunslinger, well, the market really didn’t crash 50%. The QQQQ’s traded up a full point to 41 over the month. Bob made a $100 on the trade. I think he just made an offer for Tom’s home in Evanston seeing how the home took a 20% hit over the last year. Good work Bob! I hear Bob also attends the Chicago Options Traders Group. And his little daughter Virginia is the only student in her school who truly understands risk.
John
The concept of risk is one that very few people in this world understand. Take this guy, we’ll call him Bill, that says he doesn’t smoke because smoking can potentially lead to lung cancer. Instead of smoking, he prefers to drink, and quite heavily at that. Occasionally he will even get behind the wheel of a car after some heavy drinking. But he doesn’t smoke. Nope, that would be too risky.
Or what about Tom, who refuses to put money in the stock market. You know, because the stock market is risky and it could crash, and you could lose all your money. Tom of course has no inhibitions about buying a house that recently tripled in the last 5 years. No, much safer investment.
What about Susan, who is afraid of flying. You know, the plane could crash. It could be hijacked. Midair collisions happen from time to time. No, she feels much safer driving on the highway long distances on icy roads where she could potentially run into our friend Bill, from above.
Why bother going through all these examples? Because it helps explain why we have very little understanding of what risk is, and how we lack the ability for the most part to measure risk on any kind of an objective basis. This brings us back to equity options.
How many times have you heard someone tell you that selling naked options is risky? Or that calendar traders are almost risk free? Or how it’s much safer to be long gamma versus short gamma. Or how some friend of theirs has discovered this wonderful strategy that just can’t lose. They probably just got back from one of those seminars.
The problem we have here is in how we define risk. Let’s look at a few examples. Let’s take two people, Peggy and Bob. Peggy has just been taught a very low risk strategy, the calendar spread, or as commonly referred to as a long time spread or a horizontal spread. She learned this strategy at a seminar called, “How To Trade Calendar Spreads With Very Little Risk”. Peggy was taught that this trade had very little risk and it was very safe. Peggy has 100k in her brokerage account.
Bob is more of a gunslinger. Bob also has 100k in his account but he likes to sell naked straddles. Let’s say Peggy finds a wonderful calendar spread she wants to put on, and she can buy the spread for a dollar or in other words, a point. Let’s say Peggy decides to buy this spread 500 times. Her total cost is 50k on her 100k account. Now the good news is, Peggy can only lose the debit on this trade which is just one point. The bad news is, that’s $50,000!!!!!
Now Bob is going to sell a straddle on the QQQQ’s. But Bob is only going to sell it one time for a credit of 2 pts, or two hundred dollars. Now in theory, Bob is the more risky trader being that he is selling naked straddles and Peggy is the more conservative trader. But who is really taking more risk here. If Peggy is wrong and her time spread does not work out, she stands to lose $50,000 or half her entire account! How much money could Bob lose? Well in theory, the QQQQ’s could go to zero on the downside or as high as infinity to the upside, whatever level that is. But assuming Armageddon is not going to happen this month and assuming that this market cannot mathematically reach infinity as it is a never-ending number, how much could he really lose?
Let’s say the QQQQ’s are trading at 40 and let’s say we have the largest drop in the market’s history in a one month period, say 50%? That would equate to a 20 pt move in the QQQQ’s. How much would Bob stand to lose on this trade? Well, if he sold the 40 straddle one time for 2 pts, he would lose a total of $1,800 or 1.8% of his account. Not bad for Armageddon eh? What about Peggy? Peggy could lose $50,000 or 50% of her entire account on one trade. So the question now becomes, who is really taking more risk here, Peggy or Bob.
Well, I’m sure it’s obvious to most here that Peggy has taken substantially more risk then Bob, even though she has a textbook safer strategy. This leads us to question again how we define risk. Do we define it by strategy, or by dollar exposure? I hope it’s obvious to everyone here that risk must be looked at from the big picture. Saying you have a safe strategy means nothing. The infamous now defunct hedge fund, “Long Term Capital”, had a very safe arbitrage strategy that they employed. The problem was that they risked 100 times more money then they actually had so that just a 1% move, yes a full one percent move would wipe them completely out, and the entire US banking system with it. They had the same problem that Peggy currently has, that is a terrible misunderstanding of risk. And a terribly subjective definition of what they call a safe strategy.
In the end, it was Bob that was taking the least amount of risk selling his naked straddle on the QQQQ index. You see Bob knew very well that the key to risk management was not in the strategy, but rather the capital employed in the strategy. Peggy meanwhile has contacted her attorney to go after the person that told her how safe calendar spreads were. Maybe when this guy said safe, he meant she could only lose 100% of her capital on the trade. Clearly the word safe can be a very ambiguous term.
So in the end, Peggy has filed a lawsuit against the folks at, “How To Trade Calendar Spreads With Very Little Risk”. Of course her instructor from that seminar was injured in a terrible accident on an icy highway in Illinois involving our friend Susan who was afraid to fly, and some drunk on the road who turned out to be Bill. But Bill has other problems. The house he told Tom to buy in Evanston as an investment, rather then put it in the stock market, has taken a 20% hit due to an unexpectedly large increase in interest rates. Needless to say Tom is angry. Especially seeing how the stock market had yet another up year. And our friend Bob the gunslinger, well, the market really didn’t crash 50%. The QQQQ’s traded up a full point to 41 over the month. Bob made a $100 on the trade. I think he just made an offer for Tom’s home in Evanston seeing how the home took a 20% hit over the last year. Good work Bob! I hear Bob also attends the Chicago Options Traders Group. And his little daughter Virginia is the only student in her school who truly understands risk.
John
posted by John at 3:17 PM
1 Comments:
Hi John,
it is briliant description of risk for the common people. Thanks.
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