The Hindu Business Line : Of options and black swans

We recently met an options trader. He primarily sells out-of-the-money options that are likely to expire. And expire they mostly do. So, he keeps the option premium. His return has been around 50 per cent per annum in the last two years. We explained to him as to how risky the strategy was. Having tasted success for three consecutive years, he was unwilling to listen to us. He suffers from what epistemologists call as the “Black Swan” problem. What is it?

As David Hume, a Scottish philosopher and economist, puts it, “No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion.”

Selling options

How is this related to the options trader? At present, the trader believes that selling options is the best strategy. He has to suffer just one large loss to realise that it is risky.

All of us are aware that substantial proportion of options expires worthless. Let us suppose this number is 80 per cent. This frightfully high number gives a feeling that the strategy is, indeed, profitable.

Twist the logic a bit and you will realise the folly. You know that there are no free-lunches in the market. If option-buyers pay a premium, it is because they believe that those options will be worth more on expiry. They are right.

Though large number of options expire worthless, a good number still get exercised. What happens when options are exercised? You will have to cough up a huge loss. Why?

Options are structured in such a way that as a seller, the maximum you get to keep is the option premium; the buyer enjoys all the benefits.

The options trader may generate Rs one crore profits from 1,000 trades. It may take less than 100 trades for him to blow up, because the losses are likely to be far bigger in size than the gains. Will it happen? May be not, but remember Murphy’s Law, “If anything can go wrong, it will.”

(The author is a Chennai-based financial analyst.)

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