1

Why Will 2015 be the Year of Options?

Options Trading

2

Why Will 2015 be the Year of Options?

So far, only those attracted by the world of options have been trading options. However, from 2015 onwards, trading options is no longer an option, but a must because of the risks that have evolved. Let's see why.As we all know, the intervention of the Swiss central bank in the foreign exchange market caused tremendous chaos in the financial markets on 15.01.2015. An amazing amount of money was lost, companies have gone bankrupt, there was no liquidity and price quotation for several hours. I do not want to paint the devil on the wall, but similar events may occur any time in the near future.

3

What is the black swan?

Nassim Taleb popularized this term to describe market events whose probability of occurrence is very low, but whose impact is inestimable.

4

What is the black swan?

The SNB's intervention was clearly a black swan phenomenon. The exchange rate fell 35% almost within a tick. Everyone ran out of the market, there were no buyers for hours. Life stood still and everyone was just trying to understand the accumulated loss. Similar events were the 1987 stock market crash and the terrorist attack on 11 September 2001. Black swans do exist in the market. They rarely come, but they take everything away if you do not manage the risk adequately.

5

Market pricing of the black swan was never realistic.

Let's examine market pricing of risk from two aspects.First let's see the VaR (value at risk) risk management model, which shows the level of risk that a certain account or investment portfolio is exposed to in a given period of time. 

So VaR therefore examines three things: the amount of potential loss, the likelihood of it and the time frame belonging to it.

6

Market pricing of the black swan was never realistic.

For example, if the 1 month, 5% VaR indicator of an investment fund is $100 million, that means that it has a 5% chance to lose $100 million per month. On the basis of this, a loss of $100 million may occur once in every 20th months. These models, however, never calculate with the black swan events, because they would need to show a number that would practically make their system inoperable.Financial models never price the black swan correctly!

7

Market pricing of the black swan was never realistic.

Option models can carry out wrong pricing, too. The so-called tail risk phenomenon is not priced correctly there either, although options are more expensive at the edges than they should be (volatility smile).The term "tail risk" refers to the risk occurring at the edges of the statistical variance. I will show what I mean, but first let's look at the statistical deviation curve.

8

Market pricing of the black swan was never realistic.

9

Market pricing of the black swan was never realistic.

The mathematical variance, also known as sigma can be found on the x-axis. Let's look at the ranges:

Standard deviation 1 is in the two middle dark blue zones, i.e. the exchange rate is staying in 68.2% of the time between these.Standard deviation 2 covers the two light blue areas in the middle and the two areas next to these that assume 95.4% in total.Standard deviation 3 reaches the edge of the curve, which means a 99.6% probability.

10

Market pricing of the black swan was never realistic.

What does this mean and why is this important in trading? The pricing models need standard deviation, probability to be able to calculate option prices. In general, pricing of low-probability events is not realistic. In options language: although options with low delta strike are more expensive (fat tail risk) than they should be on the basis of their probability (Volatility smile), they do not seem to be expensive enough in the case of appearance of a black swan. E.g. the CHF movement does not appear in the above graph, its probability was so low.

11

What chance did this CHF movement have?

If you put the standard deviation channel on the daily chart, it seems that this movement fits into standard deviation 7. Here it is (click to enlarge).What is the probability of a standard deviation 7?

12

What chance did this CHF movement have?

The statistical probability of a standard deviation 7 is 1: 390,682,215,445, which occurs approximately in 1.07 billion years (one quarter of the earth's age). Now, this was the probability of such a movement. It is obviously impossible to price this with options models, if the pricing algorithm would adapt to this, options would be so expensive that it would not be worth trading them. It's another thing what statistics say about the theoretical probability. The money is in practice, and as we see, that shows a completely different picture. Similar movements have already occurred in our life at least 3-4 times, in indexes, in VIX, oil, etc., although we do not live for 1 billion years ...This means that we must prepare for it!

13

What chance did this CHF movement have?

Looking at the state of the markets, more black swans are likely to come in our lifetime, we do not need to wait 1 billion years for them!Even fat tail risk pricing does not calculate a sufficient option premium for such an event. No matter how expensive remote options (DOTMA) are, they do not reflect the real price of such a movement. Therefore, if you speculate on black swan events with buying distant options, you can earn up to 1000x of the invested capital within a few hours! Why?

14

What chance did this CHF movement have?

Because before the announcement of the SNB for example, a 0.8 EUR/CHF put option did not price the realistic probability of this movement. No model can price a 35% immediate movement. So, you can earn the most on black swan events with buying very OTM options. Of course, you must wait for the swan for this and you must know when it comes approximately, the chance of which is not very high, but it is not impossible ...

15

Managing the black swan

A stop order can obviously not handle such a movement within a tick, because there are no buyers, the market dries up, orders are not fulfilled, etc.This event once again proved that stop loss is not risk management.There is only one solution to prevent such incidents: Buying options! Nothing else protects you from a swan, nothing. Whether you buy the option with speculative or hedging purposes, you have a maximum protection when such events occur. If you bought it for speculative purposes, you could even earn with it up to 1000x as much as it was bought for!

16

Managing the black swan

What can relatively reduce the rate of loss is decreasing the leverage. If you trade Forex 1:1, you can survive such a movement, if you trade 1:100, you cannot. However, the reduction in leverage will reduce profitability as well, but everything has its price. That is why I say that options are the most appropriate tools for handling a swan. It is not possible to have unlimited loss with buying options. All you can lose is the price of the option.

17

Why will 2015 be the year of options?

18

Why will 2015 be the year of options?

After a long introduction, I think you can also see why I think that 2015 will be the year of options. People's confidence in the total financial and trading system wavered again.No matter what strategy you trade, if it is not secured, you're exposed not only to losing your money, but you can even owe money to the brokerage firm too.Yesterday a friend of mine called to ask whether it is possible that he has a € 140,000 debt on his € 3,000 account due to a CHF Long. Unfortunately it is possible ... Why? Because he had no protection, and the leverage was high. It raises another question how this can be encashed …

19

Why will 2015 be the year of options?

The market has changedI expect a much higher volatility this year than in recent years. The market is nervous! If you just look at what happened in the past two months, that is a good indication for this year. Oil prices halved, SNB intervention, the ECB's QE announcement is here soon, the Greek situation, the very low US bond yields and indexes on the peak, the dollar exchange rate, etc.It will not be an easy year, volatility will be high.

20

Why will 2015 be the year of options?

If you read my posts since a while, you know that I'm committed to options and non-directional trading. This year, it can only be carried out with due diligence and protection. A part of successful trading is also noticing when the market has changed and when you need to adapt your strategy. Covered non-directional trade methods are, for example, the credit spread and the iron condor. You can make a good use of them for non-directional trading, but the trade will have other characteristics.

21

Risk management will perhaps be strengthened this year

The majority of retail traders still regard trading as a casino, so that they have no idea of the risks involved. Many people think that they deposit $ 1000 to an FX account and they cannot lose more than that. This is not true. We have seen what happened. You can lose even 100x of that if you trade with high leverage and exposure!I think, a lot of people should review their risk management methods and their whole trading strategy in connection with the SNB case.

22

There is still no free lunch

Unfortunately there is still no free lunch. You either understand what you're doing, or you lose everything after a while. You may have luck for years, for example a Martingale robot may work for several years, but once the black swan comes and takes it all. I think the most important lesson regarding the current situation is conscious management of risks.

23

There is still no free lunch

There are three risks in trading:Partner risk: where do you keep your money, whether this institution is regulated, insurance of the account exists, in which legal setting do they operate, etc.Product risks: whether you know the product that you trade, whether you trade with too many products at the same time, etc.Strategic risk: how you deal with the risk of your strategy, how high is your leverage and exposure, etc.

The above three areas are worth considering seriously before you start trading. Once again we have seen that nothing is more important on the market than risk management!

24

Feel free to ask me!

Email: gery@optionsrules.comMy webpage: http://www.optionsrules.com/

You can find me:

Facebook: https://www.facebook.com/OptionsRules1

YouTube: https://www.youtube.com/user/optionsrules

Twitter: https://twitter.com/optionsrules

LinkedIn: http://hu.linkedin.com/pub/gery-nagy/6a/513/261

Skype: opcioguru