Do You Know How to Measure Risk?

Karim Rahemtulla By Karim Rahemtulla, Options Strategist, The Oxford Club

Alternative Income

Managing Editor’s Note: Exchange-traded options can help you manage your investment risk and generate serious cash. But most investors don’t understand how they work and don’t know how to trade them. If you’re curious about options, today’s article is for you.

It’s the first in a multipart educational series from the Club’s Options Strategist, Karim Rahemtulla. The best part? Karim’s not going to just show you how options work, but he’s also going to give you the chance to put his safe trading strategies to work in the coming weeks. Be sure to stay tuned for more details…

I remember being at my desk some 27 years ago. I was the CFO of a brokerage firm in South Florida. We cleared our trades through the now defunct Bear Stearns, a Wall Street megaplayer back then.

Each week, I would cut checks to our brokers. These weren’t their normal paychecks, but advances on commissions. I did reconciliations for net capital requirements daily, sometimes more frequently, to make sure we were better than solvent all the time and that my traders weren’t taking undue risks.

There was one older gentleman in particular – he was a trader and a broker – I’ll call him Dave. Dave loved options, and he was really good at making money from them.

Unlike the other brokers who focused on stocks and bonds, Dave traded only options. And it wasn’t just one type of trade… He used spreads, strangles, puts, calls, butterflies, put sells, naked call sells and covered calls on some stocks his clients owned. His repertoire ran the gamut.

It didn’t make any sense to me. I wasn’t a broker, and, at the time, I didn’t have experience trading or explaining the difference between a put and a call to a customer.

I’m sure many of you feel the same way right now. If you’re new to options, you’ve probably thought… what the heck is an option anyway? Why does the options market exist? And worse, why do people lose money trading options?

The questions are endless. And at the time, I wanted to know the answers to these questions too!

The Basics for Beginners

It’s going to take a few weeks, but I’m starting a Wealthy Retirement “options for beginners” series to cover everything you need to know.

Because, if you’ve got the time, I’d love to share my experience, dispel the myths and teach you how to profitably trade options.

You may not become an expert. You may never even touch an option in your life. Or you could become like me… a believer in options as a way to boost your income, wealth and understanding of markets.

This series may even help you to understand why the real estate market crashed so hard during 2007 to 2009… and why it could easily be just as bad again.

Let’s start with some history…

Options have been around forever. They’re contracts derived from underlying physical assets. That’s where the term “derivative” comes from. An option is a type of “derivative,” and it’s basically created out of thin air.

Without an underlying asset (or event for the purposes of the following example), there cannot be an option. Think about making a bet on a game. If there’s no game, what would you bet on?

The option is the bet.

Or think about buying a house. You put down a deposit to secure the right to buy a house at a certain price by a certain date.

If you don’t buy it, you lose your deposit. If the value of the house increases before you close on the sale, your deposit is worth more. If the price heads lower, your deposit suddenly becomes more expensive to you in relation to the home’s market price.

Everything I just mentioned is an option.

To spin it another way, think about what used to happen in the high seas…

Merchants would finance a ship carrying cargo. Most ships made it through the journey intact. Others shipwrecked, got lost or were raided by pirates.

In order for the merchant to stay in business, he had to figure out what his risk was. Every time he wanted to offset risk, say by taking a longer but safer route, it would cost him more… but his chances of success were higher as well.

It was a trade-off. Insurance for safety.

His cargo was worth the same as that of his competitors, but the act of paying more insurance meant his profit was less.

Calculated Risk

Risk-based decision-making was just a way of life. No one put a number on it. No one created a formula for it.

That is, until French mathematician Louis Bachelier began to put numbers and formulas together in the early 19th century…

But it was not until the 1970s that two Nobel Prize-winning economists, Myron Scholes and Bob Merton – along with Fischer Black, who died before the prize was awarded (the Nobel Committee does not award prizes posthumously) – came up with a model that measured risk.

It was the genesis of the options pricing model, the underlying basis for all options pricing, public and private. And in 1997, both Merton and Scholes were awarded for their work. (You can read the release here.)

Here’s what their model, the Black-Scholes formula, looks like.

Even if you’ve got a finance background like me, it still probably looks like gobbledygook!

Next week, I’ll decipher the formula for you in terms that are a lot easier to understand.

Good investing,