OK - so now you know that not only are you trading WMDs, but you are playing in an extremely dangerous environment. Lions, Hippos, Crocs, Sharks, Snakes… they are all there and they want to rip your face off. Grind you to a pulp. Take everything you have. But we have a simple, yet bullet proof way to protect ourselves from this risk.
Options on Futures.
Just like insurance on home, auto, or self – It costs you, it’s annoying to pay, but you absolutely need it to ensure you avoid catastrophic loss.
Nothing More need be said
Options are one of the most misunderstood instruments out there. So let me take some time to explain to you what they really are and how we use them.
1) A Futures Option contains all of the attributes of the underlying Future it is an option on. (Contract Size, Fixed duration, Exchange Traded, Minimum Px move etc.)
2) A Option is a Contractual obligation to buy or sell a given Future at a specified price, by some specified point in time.
3) A “Call” option is a right to buy a Future at a specified price, up to a specified date.
4) A “Put” option is a right to sell a Future at a specified price, up to a specified date.
5) When you buy a Call or Put, your maximum loss is the purchase price of the option, however your maximum gain is practically unlimited.
6) When you sell a Call or Put, your maximum gain is the sale price of the option, however your maximum loss is practically unlimited.
I’d like to spend some time on these last 2 bullet points. Remember, Options are like insurance policies. If you buy an insurance policy on your spouse, you will pay a fixed premium on that policy each year. The price will be determined by the underwriter of the policy who will factor in A) Size of the policy B) Duration C) Statistical likelihood of a person “maturing” and therefore having to pay up.
So if your spouse is 30years old, healthy, and a non-smoker, then the statistical likelihood of them dying in the next 10 years is very low. Your insurance costs will be cheap. If they are 45, and a smoker, you can still buy the insurance but it is going to cost you more.
Let’s say your policy is for $2m, and you are quoted at $400 a year for the healthy individual. The maximum you lose here is the annual premium payment. Now if something happens, like they slip on a banana peel you left on the edge of a cliff, and accidentally fall off of it, then you collect the full $2m.
From a Risk/Reward perspective, that’s a great setup for you. You pay very little, and in the event of catastrophe you make a bundle – your gain is many multiples of your cost.
But now, let’s put the shoe on the other foot – Lets make us the seller of the insurance policy. You agree to pay someone off $2m if they die, and in return you earn $400 a year. Does that sound like a good proposition to you? Hopefully you are nodding no?
Nobody in their right mind would do this on a one off basis. It only works if you underwrite 1,000s of policies, in which you received a massive float that you invest to generate returns, which are then used to pay off the statistically insignificant instances of the healthy 30 year old dying.
As you are not an insurance company, and would only underwrite these policies on a one off basis, it simply doesn’t pay for you to sell insurance. Your risk/reward profile is completely screwed up. You are collecting a little, but risking a lot.
Let’s go back to the Swiss Franc case study from the WMD lesson. If you were unlucky or stupid enough to sell a put option on SF at say 1.15, because you wanted to collect an easy $100, when the “1 in a million” event happened, and the currency collapsed 35pts overnight, you would have been liable for everything below 1.15.
The buyer of the put was smart, and hedged their risk. You were dumb by opening yourself to unlimited risk. Your max gain was $100, but your max loss was 30k+. Not good.
But what if the spouse is a fat slob that likes to participate in extreme sports you ask? “I know he is going to die. Can’t I sell a big fat juicy policy then, and collect the big fat premium on his big fat ass?"
Well, I’m glad you asked and the answer is “Sort of” – We will explain in a moment. The key takeaway here is that we want to use options to mitigate risk and not exponentially increase it. Therefore, you are a buyer of calls and puts as a low risk way to speculate on an outcome, while also totally limiting your risk to the purchase price of the policy; you are not a seller!
So after just droning on about not selling options, I've titled this section "selling options" - What gives?
You can sell options, but only if we are long or short the underlying – This is called being “covered”.
So if you are long 1 Future of Oil at say a Price of 45. You could sell a Call option with a strike price of $47 against that long position which would have the effect of doing the following:
A) You receive the option premium upfront and it is yours to keep
B) You have limited your upside because the option buyer will “call away” the underlying at the price you sold him the option – in this case $47. So it is a trade-off – You cap your upside at 47, however you have locked in a return on the option position.
So back to the fat, smoker sky diver. We bet that he is going to die and we sell the insurance policy on it! He if doesn't die, the insurance we sold reduces the loss on our mis-guided judgement regarding his "maturity". If he does die, we make some on his death + on the premium for selling the policy. Pretty good bet.
Options pricing models can be extremely complicated, but in reality there are only a few components you need to be mindful of. Any time you/we buy an option your broker will provide you with the “Greeks” so you have an idea of what you are paying for.
A) Time – This is called Theta. The longer dated the option is, the more expensive it is from a time component perspective. Theta decays over time and as you get towards expiry it will go to zero.
B) Rate of change of value - Or Delta. This measures the rate of change of the theoretical option value with respect to changes in the underlying asset’s price. So, if you see that the Delta on a option is .50, this means that as the underlying future moves 1 point, the option will move approx .5 - easy enough.
The further away from the "strike price" the lower the delta. The closer you are to the strike price or if you are “in the money” the higher the delta. Time also impacts your delta, as the closer you are to option expiry the delta component will closely mimic the underlying performance if it is near or at the money.
To further illustrate this point let's say Oil is at 50, and you buy a Call at a strike of 70, with only 2 weeks to expiration. Because the strike is so far away and there is such little time for the future to get there, the delta will be practically non-existent. Even if oil moved $10 to 60, the price of your 70 call will still barely move because you are so far out of the money with so little time left. However, if you bought a "at the money" call at 50 with 2 weeks left, your delta would be at least .50 or higher which means it will move along with the underlying.
C) Vega – Measures the volatility. All you need to know here is that as volatility increases, people will pay more for an option. So option value will increase as volatility increases, and will lose value as volatility decreases.
Because of this characteristic it is a "Rule of thumb" to buy options when volatility is low, and sell them when volatility is high. "Buy Low, Sell High" - We've all heard that right?
D) Gamma - Measures the rate of change of delta.
If this seems a little complicated, please don't fret. As you start to see real world examples, this will all become much clearer to you.
Quantitative Option Pricing Geniuses
So, how can you compete against hedge fund quants and super geniuses? - why don’t we look at a few and see how their textbook knowledge and quantitative pricing models helped them in the real world of trading. Let’s go back to the late 90’s and look at Long Term Capital.
– From Wikipedia -
Long-Term Capital Management L.P. (LTCM) was a hedge fund management firm based in Greenwich, Connecticut that used absolute-return trading strategies combined with high financial leverage. The firm's master hedge fund, Long-Term Capital Portfolio L.P., collapsed in the late 1990s, leading to an agreement on September 23, 1998 among 16 financial institutions — which included Bankers Trust, Barclays, Bear Stearns, Chase Manhattan Bank, Credit Agricole, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, JP Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, Paribas, Salomon Smith Barney, Societe Generale, and UBS — for a $3.6 billion recapitalization (bailout) under the supervision of the Federal Reserve.
LTCM was founded in 1994 by John W. Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Members of LTCM's board of directors included Myron S. Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences for a "new method to determine the value of derivatives". Initially successful with annualized return of over 21% (after fees) in its first year, 43% in the second year and 41% in the third year, in 1998 it lost $4.6 billion in less than four months following the 1997 Asian financial crisis and 1998 Russian financial crisis requiring financial intervention by the Federal Reserve, with the fund liquidating and dissolving in early 2000.
So what is the moral of the story here? Trading is not a math or science project.
It’s betting tactics, discipline, and an art. To become an artist in this field you need some teaching, you need practice, and you need persistence. Most importantly you need to remember and follow Golden Rule number one, which is....come on….you know it….say it…..Good! If our Nobel prize winning friends only could have followed this program and used the Alchymist portal, they would have saved themselves and their clients billions. Tsk Tsk.
In summary, options protect us from catastrophic loss and they provide us a low risk vehicle to place bets that generate large returns when they hit. As part of your Risk Management Strategy you never go outright long or short a future – you always buy some insurance to cover yourself in the case of some unforeseen event.
Remember, they do happen, and are occurring on a more frequent basis. You never outright sell an option as you expose yourself to unlimited risk. While you have to pay for this insurance, the peace of mind and protection it provides is well worth this small cost.