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.

1. Why Will 2015 be the Year of Options?
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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.
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3. What is the black swan?
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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?
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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.
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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! 6

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.
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8. Market pricing of the black
swan was never realistic.
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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.
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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.
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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?
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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!
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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?
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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 ...
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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!
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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.
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17. Why will 2015 be the year of
options?
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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 …
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19. Why will 2015 be the year of
options?
The market has changed
I 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.
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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.
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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.
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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.
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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!
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24. Feel free to ask me!
Email: gery@optionsrules.com
My 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
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