Living In Interesting Times

by Bill Burton on September 6, 2011

Picture of a Black Swan

A Black Swan

Life is uncertain.  I live in a slow moving small community of farmers and watermen on the edge of the Chesapeake Bay that is best known for the quality of its soft shell blue crabs, its home grown tomatoes, and its slow and predictable pace of life.

The past two weeks have seen the unlikely combination of one of the strongest earthquakes ever to hit the Eastern United States and a near miss by an uncommon North Atlantic hurricane.  I promised Dan I would have this blog written before the arrival of the plague of locusts.

This recent combination of unlikely occurrences in a short period of time serves to remind us of the unpredictability of events.  It is this sort of unforeseen and unforeseeable risk that Nassim Taleb has termed “Black Swan risk”.  When considered in the context of an investment portfolio, it is critical to recognize that the markets may be severely impacted by events previously considered too unlikely to consider.

I find it helpful to remember the historical fact that Black Swan events derive their name from a very logical sequence of observations.  Prior to 1697, all swans known to the western world were white.  It was a common expression in sixteenth century England that events known to be impossible on the basis of a large number of observations were described as black swan events.

Unpredictably, explorers of the late seventeenth century discovered black swans in Western Australia.  The seemingly inconceivable occurrence of events long known to be impossible was forever challenged.

Similar unforeseen and unforeseeable events have been occurring apace in the financial markets as various “too big to fail” entities routinely appear on the edge of a precipice, governmental entities admit woeful performance, and central governments have no idea how to support the various economies responsible for their existence.

It is within this milieu that the trader must survive.  Given the unprecedented instability, the world of the trader has become fraught with enormous risk.   Stocks routinely gap up and gap down as a result of unforeseen and unforeseeable events.

The stock trader who goes to sleep with stop limit orders in place frequently wakes up to find the order to close his position executed as a market order when the stock gaps below or above the stop price.  This sequence of events results in losses well in excess of those predicted by assuming a stop order will be executed at or near the stop limit price.

The world of options traders is different.  Option positions are usually constructed with an absolute maximum potential loss.  While we do not routinely allow this absolute maximum loss to be approached, account “blow ups” are never the unintended result of extreme market movements.  Additionally, the fact that a position equivalent to a stock position can be controlled with far less capital means that less money is exposed to market meltdowns.

Consider, for example, the comparative risk that a trader who wishes to take a long position in AMZN faces.  As I write, AMZN is trading at $210.  To buy 100 shares of stock requires a capital investment of $21,000.  If AMZN were to revisit its recent August low of $177, the capital loss would be $3,300.

By way of contrast, a basic option spread, a 1 lot October 210/215 call debit spread can be purchased for $265.  This spread would be worth $500 at options expiration if AMZN were trading at $215 or higher at that time.  The absolute maximum potential risk to which the trader is exposed in this example is the $265 purchase price; if AMZN were to gap down to its previous low of $177, the options trader is exposed to only this limited risk.

To be the devil’s advocate, the positions are not identical.  Profit does not continue to accrue to the options position as the stock moves above the strike price of the short option.  However, as the trader considers a potential move, remember to ask a fundamental question:  Is the potential move from $210 to $215 more or less likely than a move from $210 to a significantly higher price than $215?

Seasoned traders realize that solid risk control is essential to a long and successful life as a trader.  At moments of extreme volatility, such as we are now experiencing, the ability to define and limit risk is essential to survival.



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