The Market Can Do Anything (and often does)

02/18/2014

The title of today's column is one of the most important market aphorisms ever. It is literally true that markets can do anything, however seemingly unlikely.

I read a lot of options advice online. A lot of it so staggeringly inept that it is mind boggling. It's actually one of my motivations for writing The Liss Report. To offer simple, sane, sound explanations of how to use options always keeping two keys in mind: Discipline and Risk Management.

As an example of some of the dangerous idiocy that is out there, I read a piece by an options advisor (I won't say who) that recommended an absolutely fabulous way to make money, quarter after quarter. They advised selling naked short any quarterly strangle (OTM call + OTM put) where the wings are two standard deviations away from the price of the underlying. Giving, as they said, "A 98% chance of making money".

This may work for 10 straight expirations. And then the eleventh can blow out your whole portfolio. In fact, this is exactly what happened to Long Term Capital Management in 1998, a mega fund run by 5 Nobel Prize winners. They did not hedge for any move greater than 2 SD's away. Then the Black Swan (see under the education heading on this site) flew in the form of a Russian debt default and they blew out so huge that it briefly threatened the entire financial system.

Any position that can cost you everything, however unlikely that event may be, is in my view the absolute height of hubris and fecklessness. The strategies I discuss here are designed to have a favorable Risk Reward Ratio. You won't get rich overnight, but you'll never blow out, either.

Randall Liss, The Liss Report