Limiting “Worst-Case” Downside with Options
05/06/2010 12:01 am EST
The recent massive oil spill that now threatens major wildlife areas along the Gulf Coast is a reminder of how “black swan” events can impact our lives in unforeseen and unforeseeable ways. Yogi Berra summed it up succinctly in his aphorism that “The future isn’t what it used to be.” It never is.
One helpful organizational concept of financial risk is to consider that risk comes in two categories. The usual type of risk analyzed by the filigreed bell-shaped curves of a Gaussian (log normal) distribution and the familiar gently oscillating movements of magnitude describable terms of one, two, or even perhaps three standard deviations. The other general category of risk is characterized by the unforeseen events that result in “sea change” alterations of the financial landscape. It is this category of risk to which Nassim Taleb has drawn attention in his books regarding the lack of predictability of consequential rare events.
How does this impact the world of the trader and the utility of options? The inescapable fact is that all funds invested in the market are totally at risk at all times, and that comfort that price stops will reliably be elected at or close to their set points is illusory. From this concept, the ability to control stock with far less invested capital becomes inescapably attractive.
Such is one core function of options: Control of stock with commitment of far less capital than outright purchase. To take a straightforward example, shares of RIG, one of the companies involved in the current environmental oil disaster in the Gulf of Mexico, are currently trading around the low-to-mid seventies.
To control 100 shares by outright stock purchase would require around $7,232. A substantially delta equivalent position using deep in-the-money calls, the June 55 strike, could be purchased for approximately $1,825. As is characteristic of a deep in-the-money option, there is very little eroding time premium for which the trader is paying.
Should Armageddon arrive unannounced, which position is better: The total loss of the value of the stock position or the vaporization of the monies paid for the option?
By Dan Passarelli of MarketTaker.com