Black Swans

Black swan is regarded as a rare, unexpected event that could bring disastrous consequences for those that don’t have a contingency plan. Can you be prepared for something that by definition is unexpected? It depends on how do you look at the world. There is a difference between the impossible and the highly improbable. The latter is possible.  The  black swan is not the same for everyone. What looks like unexpected to one, could be totally predictable for another. For the turkey Thanksgiving day is a black swan, but this is not so for the butcher.

There is a natural tendency for human beings to underestimate the odds of seemingly unlikely events. Few realize that once in a 100 years event is equally likely to happen tomorrow as it is to happen after 95 years. And if there are insufficient data to calculate the probability of a very bad outcome, as is often the case, that doesn’t mean we should assume the probability is zero and look at contingency plans as a waste of time and efforts.

There is an Irish proverb, which I have always thought that relates very well to capital markets – The obvious rarely happens, the unexpected constantly occurs. The “unthinkable”, the “unimaginable” takes place much more often than most people are willing to accept. The stock market crash of 1987 was described at the time as a 27-standard-deviation event. That implies that the odds of such an event not happening were 99.99% with 159 more 9s after it. It was unheard of kind of event, but it happened. Those who weren’t prepared, those who were over-leveraged, didn’t survive.

When it comes to objectively assessing the real risk of any investment, there is one important question to ask: What is the worst thing that could happen and how it may impact your solvency. Human beings are naturally biased and tend to look for information that only confirms an already established thesis. Not much thinking is devoted to figuring out what could go wrong and to preparation of a contingency plan of action. People are often not prepared and when something unpleasantly surprising happens they don’t know how to react. They panick and let their emotions to rule decision making, which invariably leads to losses.

A good way to minimize the impact of emotions is to go long gamma. What are some of the characteristics of getting long premium:

– more precise risk control

When long or short equity, you don’t have full control of your potential losses. Stops are not very helpful when your position gaps against you or during sudden evaporation of liquidity. If you are long gamma, you know the exact amount of the potential maximum loss – the whole premium. Armed with that knowledge, position sizing becomes easy.

– more precise time management

You know exactly how much time you have  in order to be right. If your thesis happens to remain wrong until options expiration, your position is automatically wiped and you start clean all over again. Many investors realize in hindsight that they were right on their analysis, but wrong in their timing as the market was not ready to accept their  thesis. Being long premium takes away the whole aspect of having to worry about precise risk management. It is like paying for someone else to be your risk manager. You have an investment thesis and you want to go long GLD for the next 12 months. Going long gamma is the perfect way to do it. You pay a small amount to see if your thesis is right. Even if the option goes down a lot in the beginning to the point that it is worthless, you will still own it and you never know what might happen. Adverse market moves and emotions won’t shake you out of your position, because you already have a plan for the worst possible outcome – you will lose the paid premium.

– overpaying for premium, but still able to make money

You have to realize that in most of the time you will overpay for options. If you did proper due diligence that should not bother you as the move in the underlying asset will more than compensate the wasting effect of time and volatility. Especially when you move past one month options. There is a tendency to believe that people overpay for options because the research shows that IV is higher than realized volatility. That has to be the case for the seller to be willing to take the risk and to write you an option – he’s got to make some money. The difference is, he’s going to delta hedge and you’re not, so you are going to have to pay a little bit extra so that he gets compensated. You have to realize in advance, that yes you are overpaying. The seller is making his money of the delta hedge, and you are paying him a little bit by paying him more than what realized volatility is, but no one really knows in advance how big the realized volatility and the move of the underlying asset are going to be. Both the seller of the option and the buyer could make money. The profit for the seller comes from extracting the risk premia in the daily volatility and for the buyer it comes from the fact that most underlying assets tend to exhibit trending behavior.

– smaller capital allocation

Being long gamma via options allows for getting the same risk/reward with much smaller capital allocation; therefore you have less money at risk.

– smaller liquidity risk

Liquidity seems to disappear when you need it the most. If you have a huge equity position, a quick exit might be impossible. While is true that most options have wider bid/ask spread than their underlying assets, when it comes to exiting a big position options offer more alternatives – you can either exercise them if they they are ITM, roll them over to latter date or just offset them.

Despite the fact that there is substantial statistical evidence that implied volatility is less than realized volatility, (especially in shorter time frames), many experienced hedge fund managers are reluctant to go short gamma. The horrific memories from selling OTM calls against tech stocks in the late 1990s, the losses experienced due to shorting the housing sector too early have scared many for life. Being short premium via naked calls or puts exposes you for more than 100% losses. From risk management point of view, being short gamma is much harder to deal with, because as your position goes against you, it becomes larger part of your portfolio.

Insurance companies are in the business of writing premium. Those which managed to survived over time diversified properly their risk, hedged their losses by making deals with reliable counter parties and more importantly invested the received premium wisely. As Warren Buffett likes to say: “The curse of the insurance business, as well as one of the benefits of it, is that people hand you a lot of money for writing out a little piece of paper. What you put on that paper is enormously  important. The money that’s coming in, which seems so easy, can tempt you into doing very, very foolish things… Simple mistakes can wipe out a lifetime of earnings – a few cents gained when you’re right and a fortune lost when you’re wrong.”

When you are leveraged 100:1, it doesn’t take an armagedon, to wipe out your equity. A one % move in unfavorable direction and you are practically insolvent. You can’t insure against all losses, but you can make sure that you will remain solvent no matter what.

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