Date: 4/15/2009 3:05:50 PM

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Subject: C:\inetpub\wwwroot\CataChoo\option_risks.cnt

URL: C:\inetpub\wwwroot\CataChoo\option_risks.cnt

The Top Deadliest Mistakes in the world of Financial Derivatives:

 

1.  Participating in a concentrated position with a risk/reward relationships corresponding risk dollars being greater than an acceptable percent capital loss (as compared to the account size).  In this case, the trader has an affinity to a position that is so strong, he believes it is only possible to have the desired (winning) outcome.  He ignores the possibility, even remote, that if the unthinkable happens it will result in a major loss to the net liquidation value of the account.  My rule of thumb is to not enter a concentrated position that can cost more than 1-10% of the liquidation value of the account.

 

2.  Speculation.  This risk entails entering a position where the trader believes the market will move in his direction.  Whether right or wrong, eventually the trader will be wrong.  I recommend evaluating both sides of the position and realizing it is just as possible for the market to move against you.

 

3.  Vega Drop Sucker Play:  In this case, the trader sees ultra cheap calendar spreads (many times with wide spreads) and believes that vega will stay constant.  If Vega does stay constant the trader is mesmerized by the potential profit and enters a position too large for the size of the account.  It is my belief that the trader should limit position size to a percent of the equity in the account.  The real risk here is that month to month volatilities are not necessarily constant.  If news breaks and volatilities drop in both months, the calendars will actually decrease in value even when the underlying stays within the target range.

 

4.  European non-exercisable calendar inversion:  This risk lures the trader into believing a calendar spread (the too good to be true adage) with an ultra low price can pay hundreds of percent of return in only one expiration.  The real risk lies in the possibility that the spread will become inverted, or negative, and the trader will owe money at expiration. 

 

5.  Early exercise risk:  In this case, the trader sells deep in the money put calendar spreads as an example.  When the extrinsic value of the put is less than the carry costs of the call at the same strike, an exercise will usually occur.  When this occurs, the trader is forced to buy stock at the strike price and it is delivered the next morning.  The buying power on the account is reduced by the margin required for the stock.  The trader can either exercise his long option (if he owns one) or sell the stock.

 

6.  Early assignment risk:  In this case, the trader sells deep in the money call calendar spreads.  When the extrinsic value of the call is less than zero, assignment may occur.  If assignment occurs, the trader is forced to borrow stock at the strike price and the stock is shorted in the morning.  The buying power on the account is reduced by the margin required to be short stock.  The trader can exercise his long option (if he owns one) or buy back the stock.

 

7.  Delta risk on boxes: Most of the time, delta risk is negligible on boxes, but some boxes carry real deltas, specifically boxes written on tickers that do not respect put call parity.  This is usually found on hard to borrow stocks.  If you are short boxes on a stock with a hard to borrow skew, you may find you are actually short deltas.  If you do not hedge them, you are exposed to delta risk.

 

 

Date: 4/15/2009 3:05:52 PM

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