One of the strategies that I run at Mystic Wealth is Selling OTM options with hedge of further OTMs. This is infact the staple of earning consistent return on investment. Its called PUT SPREAD or CALL SPREAD.
I have taken a lot of flak for that and the critics have called this being sheer lucky, collecting pennies in front of a steam roller and one black swan away from RUIN.
Nasim taleb in his book Black Swan in fact propagates taking the other side and do things which benefit from disorder and not ruin with it.
So I was waiting for a black swan to happen to check the robustness (or survivor ability) of the lucky insurance business i am running.
And we have a Black Swan ladies and gentlemen. Ranbaxy collapsed yesterday under the news of USFDA ban.
I was (again) luckily not involved in collecting pennies here but for the sake of taking it as an example and take a learning out of vicarious experiences of others, lets presume that I participated in the game.
I would have basis my TAZ set up sold Rs 400 put and bought Rs 380 Put. The difference would have been my stable income.
Lets say we built a position on 21st January. Sold 400 PE @ 8.00 and bought a hedge 380 PE @3.00
our income from the trade is Rs 5.00*1000 =Rs 5000 per contract.
Now since we are calculating the overall impact of black swan on entire corpus, lets calculate the roi on it too. On a corpus of say 30 lakhs this income comes to 0.16%.
Now the black swan happened, destroyed the stock a whooping 20%. 400 pe became Rs.62.00 (ouch 7.7x move against you)
the 380 put saved you a bit and became Rs 43.00 (14x in ur favor)
the total loss is Rs 62-43-5 =14 *1000= 14000.
this whooping loss comes to dent of 0.46% of your corpus.
Was it too bad. Lets do the maths. To figure out if this kind of black swan destroys you and create a ruin, we need to figure out how many times in 100 can something like this happen.
Lets say if it happens 10 times out of 100. (black swans as the name suggests are rare and it cannot happen 10% of the time. Black swans are sigma events are suppose to happen once in some 100, thousand instances. But for the sake of example, lets say the world is collapsing and 10 out of 100 events are catastrophic.)
10 such events will result in equity drawdown of 10*0.46 =4.6% of your corpus whereas the other 90 trades will give you a roi of 0.16*90= 14.4%.
so in a worst of worst case scenarios you will end the Quarter (lets say it takes you 3-4 months to do 100 trades) with a return of 9.8%.
- Black Swans are a reality, they happen more often than the probability predictions of black scholes.
- Gaussian curve is a fallacy in stock market; FAT Tails if not accounted for can destroy your edge and can/will render you homeless.
- Insurance business works as long as you have wide distribution. (diversification in our case, 100 trades). We would have been shirt less if we had loaded up on this 01 trade.
- Naked option selling is a sure shot way to go bankrupt. The hedge invariably saves u. (reinsurance for insurance business). We would have been taken to the cleaners if we didn’t buy the 380 put.
What I do ain’t bad actually, it is filled with horror stories because people don’t do it right. They are either under capitalized for this kind of business and by default take risks more than their capacity or play without protection (hedge) because they don’t believe in black swans.