Unforeseen Risk Scenarios (Geeky Options Talk)

Today was quite an interesting day on the markets with the Fed injecting another Trillion dollars into the economy. The equity markets reacted reasonably well with the major indices closing up a percent or two after trading down most of the day. The S&P spent a few minutes just above 800, which is significant for a number of technical reasons, and I found it interesting that the stock market backed off the highs rather quickly after the meeting. You can take a look at my last post to see what my opinion moving forward from here is (which has not changed and is not positive). Personally, throwing a trillion dollars around doesn't seem like a good indication of a healthy economy. Although the movement in equities was interesting today, the reactions in markets that are more directly affected by monetary policy were downright violent. Bonds, currencies, gold and related assets were moving in staggering ranges.

There are a number of things I considered writing about today, but the one I wanted to highlight was an area of risk that's hard to forecast from a trading perspective. As an options trader, the concept of risk can become very complex and there are a number of factors that need to be managed in an options trade. The beauty of options is that there are a variety of strategies available to define your risk related to direction, volatility and time. At the end of the day, however, there is a market maker on the other side of your trade, who is also interested in managing risk. Typically, market makers collect the lion's share of the bid/ask spread (slippage) on transactions and will periodically hedge themselves from directional risk in whatever they are trading. When markets start to really move, the market makers will typically widen the bid/ask spread to price in the additional risk they are willing to take on because they realize they have more directional risk in their positions.

I happened to be in a delta neutral position on the Euro today. There were two parts to the trade. First, I placed a straddle, which consists of a simultaneous call and put and is designed to make money with a significant move up or down in the underlying asset. The problem with a straddle is that it typically loses money most days while you're waiting for the big move. To mitigate this I placed calendar spreads on either side of the straddle, which would also make money with an up or down movement, but would make some money if the Euro goes nowhere and offset losses in the straddle. So the idea here is that I don't care whether the Euro goes up or down, but I'd like to see some signs of life in the next month or so. The last couple days, the Dollar has been drifting down, so the overall strategy was working pretty well, although slowly. The plan for managing this trade is to close out the calendar spreads if they hit the target strike price and open new calendars around the straddle. If there are good gains in the straddle itself, then additional adjustments to lock in profits are necessary.

Today I got very happy because I checked the quotes and the Euro was trading right at the strike of one of my calendar spreads (making money) and I went to make my trade adjustment. (This was a huge move in the currency markets and was quite unexpected in such a short timeframe.) What I found however, was a bid / ask spread of $0.00 / $4.60 across the option chains. This wasn't a data issue – the market makers got freaked and essentially stopped trading. So here I am with a trade that did what I wanted it to do and no market to sell into in order to carry out my trade plan. By the end of the trading session, the market opened up to a certain extent, however the Euro had moved beyond my target by that point and I wasn't able to get my optimal exit. Luckily, the overall trade strategy benefited from the moves today, but the reaction of the market is an important risk management consideration. The lesson here is that when markets reach extreme stress points, assumptions about market efficiency and liquidity can fall apart very quickly.

Correlate this experience to the leveraged debt markets and it's not a big leap to see why the economic fallout has been so extreme. When big moves started happening in the debt markets the same phenomenon happened and the markets dried up. The problem is that these bets were all in one direction and had highly leveraged penalties for being wrong. I would love to see some of the TARP money going to education about Risk Management rather than bonuses to (expletive) executives that just don't get the concept. The "Likely Worst Case Scenario" is quite different from the "Worst Case Scenario."