In the previous two blog posts, we explored the role that excessive leverage and poor liquidity played in the “blow-ups” of some options-based strategies. In this third and final piece, we will examine the role risk controls play in preventing catastrophic losses.
Virtually every option trader will tell you they have risk controls in place. Whether or not they’re useful depends primarily on two factors:
A major contributor to poor risk management decisions lies with not understanding the distributional choices when dealing with financial instruments. Many assume that a security’s distribution is Gaussian, or normally distributed, like the graph below illustrates:
Source: Cboe
The problem with assuming this kind of distribution is many option-based strategies will not fit into this neat structure. Options are often described as having “asymmetric” payoffs, which do not match the above image at all. If the data does not fit, assumptions about “worst case” scenarios made off the above curve might be wildly inaccurate.
Even before a proper distribution can be estimated, a series of questions must be addressed when vetting the data:
This is just a small sample of the many questions that must be answered before any trade or position is placed, especially when using options which have asymmetric payoffs. Most blow-ups occur simply by an underestimation of the convexity, or non-linear behavior, that options bring into a portfolio.
These are points to bring up when considering an options strategy as it can give advisors a better handle on how the risk controls are developed.
That said, simply having risk controls is not enough. One must actually stick to the risk controls when the going gets tough. Failing to implement risk controls can have catastrophic consequences. Although risk controls exist to protect against major losses, investors can let emotions overcome logic, and let their well-designed risk controls fall by the wayside. The best risk controls in the world are useless if they are ignored or overridden.
In some of the historic blow-ups, there was a tendency to “let it ride” or even worse, “double down” on a losing position. After the fact it is difficult for outside observers to determine what decisions were made by a doomed manager in the heat of the moment. However, it is sometimes possible to identify when a desperate strategy hangs on to a losing trade far too long in hopes of a reversal. In extreme cases, a desperate strategy might increase their exposure in hopes that a big win in a trade will recover any previous losses. Like a Blackjack player using a “Martingale” strategy, this is a risky approach that can bankrupt a player.
When evaluating an options strategy, gain insight into the manager’s risk controls and methods for following them. Some questions you might ask are:
While the names change and the circumstances are different, a few “common threads” or themes emerge when examining options strategies that have blown up.
Excessive leverage, lack of liquidity, and insufficient risk controls can often be primary drivers of blow-ups. While each are major stand-alone risks, a multiplier effect can occur when all three are in play. Problems can snowball and get out of hand quickly resulting in a nightmare for advisors and clients. For a case study, read the white paper “Learning from Others’ Mistakes: Three Common Missteps of Failed Options Strategies.”
Armed with a better understanding of options-based strategies, what they can do for you and your clients, and how to best evaluate them for your portfolio construction, these strategies can play a pivotal role in helping you achieve client objectives.
Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Client Portfolio Manager, is responsible for helping clients and prospects gain a detailed understanding of Swan’s Defined Risk Strategy, including how it fits into an overall investment strategy. Formerly, Marc was the Director of Research at Zephyr Associates for 11 years.
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