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Option Premiums and Events.

Option Premiums and Events.

Following a Multi disciplinary mental model approach has benefited me no end. Instead of discarding a topic due to commitment bias, one should always be on a look out to broaden his horizons, Learn new things.

According to Charlie Munger, at the age when people are contemplating retirement, if not death, Warren buffet is a Learning machine. In fact the results would have been nothing like this spectacular, if he had stuck on to his initial “Circle of Competence”.

This is a very important point to ponder when we talk about Warren’s concept of circle of competence. Learning machines keep expanding that circle on a daily basis.

It is almost funny how people stereo type an individual to fit in their limited mind sets.

Warren is tabled as a value investor and may be a lot of amateurs will be surprised that What he knows about options and premiums and time decay can actually put a lot of Option traders to shame.

Warren has been playing the Probability vs Possibility game long before these high roller option writers were even born.

What else is Insurance by the way if not pocketing the premium of way OTM puts with a less than 5% chance of being ever in the money. If you can add 02 things to it, you have a winning system at hand.

First. Make sure you have thousands of these bets and no single one creates a ruin and
Second. Have the ability to say NO, when the Premiums don’t justify the Risk.

If you read his annual letters, you cannot miss it. He is all praise for his insurance fellas.Warren realized early that if you create an environment where your managers are not judged on Quarterly results, then you can have a system in place where these intelligent people can SAY NO to any new business which does not make ROI sense.

That by the way is a huge EDGE in a place where you are competing with idiots with wrong incentives.

Funny as it may seem, at the time of giving the loan, do you really think that a smart banker does not know the odds of its ever coming back. When you and me can do a credit risk analyses which is almost 99% full proof of our friend/relative/neighbor who has come for help, bankers with all the checks in place can definitely do a better job.

BUT… its the institutional imperative and wrong incentives and a quarterly growth number that their CEO has promised to the media. As a Rule, they never say NO to business no matter how shitty the deal is.

Lets relate this with NIFTY.
You see, if you were writing options in the month of August, because of low volatility, the premiums writers received were minuscule. And it did not justify the risk undertaken.

A warren run company would not enter such a scenario and would have balls to SAY NO whereas other insurance companies would work business as usual because its not in their DNA to say NO ever.

And then the crash happens. The Monday blip which created mass panic and Nifty crashed some 500 odd points. Those OTM puts that smart writers sold are now worth 50x their sell price.

While this situation can definitely be salvaged by savvy writers as it was not as bad (rolling over to next month, selling further OTM on both legs) but for the sake of bigger example either that insurance company which did a lot of business at a wrong time would incur losses more than their 6 years profits, would go bankrupt or bailed out depending on how Big it is.

This is where it becomes even more interesting. Now when the time is RIPE and the volatility is HUGE, these insurance companies/option writers do not have the fire power to take the business.

And even if they do, the conventional wisdom suggests them to stay out till the storm settles.

This is where Warren’s managers jump in, They do business like there is no tomorrow. And because they are probably the only ones writing insurance, they charge the premium they want.

Lets relate that to Nifty, after the crash some of smart option traders I know depending on their risk profile created Ratio Spreads ( sold 02 7500 PE and Bought 01 7200 PE) sold Strangles (selling of OTM Puts and Calls, lets say 7500PE and 8200 CE) and created IRON Condors. (Spreads on both legs)

As it turned out, Fed chickened out, Options collapsed on its head and Probability wins over possibility AGAIN.

Now the question I keep getting from Taleb Fans is that what if there WAS a black swan and if something Huge would have happened. To answer that I have 02 basic points.

First , if you can predict it, its not BLACK SWAN. Rate hike and beyond was priced in the options with such huge volatility.

And Secondly even if you got it wrong, who on earth is asking you to bet your entire corpus on this 01 trade.

Idea is to have multiple of these trades where the ODDS are aligned with you. As Warren says, we are willing to look stupid as long as we have not done anything STUPID.

Its all about Process and not Outcome.

Disclaimer: This is just academic, intellectual blah blah. I did not participate in the trade and therefore a truck of hindsight bias.

Comments are welcome.

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