Options – Riding Black Swans

The expression “Black Swan” existed as a description of something that couldn’t possibly exist, at least as far back as ancient Roman times. It was used in that way until black swans were actually found in Australia in 1697. Since then it has described things that were only thought to be impossible, until they occurred.

The world of finance has had many black swans. The market crashes of 1929, 1987 and 2008 are obvious examples. No one predicted them beforehand; they are understood only in hindsight. Black swans are not always negative events, however. The rise of the internet and the personal computer were also black swans.

One of the most interesting writers about black swans is Nicholas Taleb, in his books Fooled by Randomness (2001) and The Black Swan (2007). Taleb says:

“A small number of Black Swans explains almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives.”

Taleb himself, besides being a philosopher and mathematician, was a trader in options. It was a job he more or less fell into as a young man after his family lost their money in war. Most successful option traders operate like the insurance business, making trades based on the idea that unlikely events, by definition, do not happen often. Taleb’s focus was on profiting from them when they did.

This is possible because options are priced based on what the market perceives as the probability of a stock reaching a particular price by a particular date. The more likely that is considered to be, the higher the price of the option. If the probability is considered small, the option will be cheap. This sometimes gives the opportunity for long-shot trades that make mathematical sense and, hopefully, payoff due to the size of the occasional large payoff more than making up for the many small losses. Sort of like the insurance business in reverse.

This type of trade requires finding options that are underpriced in relation to their potential. The two parts of that equation are equally important: Underpricing of the options, together with a large potential for stock price movement. While it sounds paradoxical – if the stock has a big potential for movement why would its options be cheap? – in fact, these opportunities can be found. Most of them will lose (a limited amount), so we must risk only small amounts on each one. These are not the bread-and-butter trades we will use for our weekly paycheck, but some of them will pay off in a big way.

While the complete method is beyond the scope of this article, this is the outline.

For the underpricing part, we search out stocks whose current implied volatility (options’ relative expensiveness) is extraordinarily low for that stock. Knowing what constitutes low implied volatility is key here. What’s low for one stock is high for another.

Within that small group, we check for those stocks whose price action reveals a strong likelihood of an unusual move. Some weeks we may have twenty candidates, while other weeks there may be none.

Next we select the strike price and expiration of the options to be used, and allocate a small amount of money to the trades.

Finally, we settle down to wait for the move to materialize, or not.

They may be black swans, but these trades provide lots of excitement when they hit and not much pain when they don’t. While they are only part of a more “balanced diet” of option trade types, they make wonderful desserts.

 

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