Happy Tuesday to you!
I received overwhelmingly positive feedback from yesterdays Rude on Taleb and shorting options. Thank you!
But I thought Id elaborate on what can happen - though admittedly very rarely does - when youre short volatility, and you dont know what youre doing.
- Following on from yesterdays short option piece, I thought Id tell you a horror story.
- This is what happens when what you dont understand collides with what you didnt expect.
- Ill tell the story without any advanced mathematics or Greeks.
The Rogue TraderNick Leeson was an ordinary boy from the ordinary London suburb of Watford. He was going to live an ordinary life until he got the opportunity to work in The City. Thats The City of London, where serious international banking gets done. Its the British bastion of capitalism, whose profits pay for the folly of the British Welfare State.But Nick didnt have the right background, nor the right accent, to succeed there. So when he was given the opportunity to move to Singapore, he jumped at the chance.As a side note, when mediocre bankers are sent from London to Hong Kong, theyre pejoratively called FILTH - Failed In London, Try Hong Kong. Hint, hintNick got on a plane and went to Singapore, where he was named as a floor trader and Head of Settlements. In the early 90s, that nonsense could happen. Let me confirm it means he was responsible for checking his own trades. And yes, youre right; it was a recipe for disaster.Without overegging the pudding, let me get straight to the trades that brought down Barings Bank, HM The Queens Bank, in 1995.Much of this is by memory, as my edition of Rogue Trader, Leesons autobiography, was lost in one of my many moves. Thus, any errors are my own.
Straddle This!Im going to proceed in a plain English manner, not making it too geeky or Greeky. If youre a pro, please forgive me for the oversimplification. If youre a retail trader, write email@example.com if what I write isnt clear enough.First, lets get long.This is the payoff profile of a long call position at expiry. Its a bullish trade. In this case, the call buyer pays $5 per share for the right to buy 100 shares later at $225. Therefore, the breakeven point is $5 + $225 = $230.The buyer can only lose his premium, no more. Thats still 100%, to be sure, but its not as much as he may lose holding the shares.The upside is unlimited. Think TSLA call buyers and how much they made!Next, is a long put option.A long put option is where the buyer has the right to sell shares at a specific price in the future. In this case, the buyer paid $6 for the right to sell these shares for $225.This a bearish trade, as the buyer must think the price will decrease. The breakeven point is $225 - $6 = $219. That is also the maximum gain, as its not unlimited (though itll feel almost as good)!So a long call and a long put, separately, are directional trades. But what happens when we put them together? Remember, these calls and puts will have the same underlying, strike price, and expiry.Et voila! Youve got a volatility trade! That is, youre long volatility.(I always write the olatility next to the payoff profile to make it easier for grads to remember.)Just looking at that payoff profile, you see something obvious: it doesnt matter which direction the underlying goes, as long as it goes pretty far.So youve got the unlimited gain potential from the call. Youve got the limited but still substantial potential gain from the put. Now, there are two breakeven points. This will be the strike price plus and minus the combined premiums.,The upside breakeven point is $225 + $11 = $236. The downside breakeven point is $225 - $11 = $214.As long as the underlying either goes up beyond $236 or down below $214, you will make money.Of course, the pros will manage these trades minute to minute and make adjustments accordingly. However, this is something retail investors, who have other jobs, will find very difficult to do.But for now, know that a long straddle is a long volatility trade.
Derivatives Are a Zero-Sum GameDerivatives are a zero-sum game. That means no wealth is created or destroyed by trading them. Of course, there are winners, and there are losers. Its capitalism at its very finest. But overall, nothing is lost.That means if you can buy a straddle, then someone must have sold it to you.Someone like, say, Nick Leeson.To illustrate, lets take the long straddle we just looked at, and flip it upside down.Its the exact same trade but from the sellers perspective.Let me ask you this: whats the best thing that can happen to the seller?Answer: nothing.Literally.If the straddle expires at $225, the seller will keep the $11 per share premium. Anywhere else, he doesnt maximize his gain. Below $214 and above $236, he loses money.Again, if a pro entered this trade, hed keep his eye on it and manage it accordingly. He can use stop-loss orders, or close out a side, or turn the straddle into an iron butterfly. Dont worry about these things right now.Because if your name is in Gods book on a particular day, hes going to get you no matter what. And that happened to Nick Leeson.
How Straddles Killed Nick Leeson and Barings BankLeeson was already down.He was supposed to be running an arbitrage operation, that is, taking on no risk. But he couldnt help himself. Leeson already racked up millions in losses. Moreover, he was losing nearly from his first day in the office in 1992.It just turned 1995, and he was running out of options - no pun intended.So how could he get that money back with little risk?Boom! He could sell straddles!That would let him take in the premium from both the calls and puts. The markets are quiet anyway, so its a sure thing.The date was January 16, 1995. Leeson sold a bunch of straddles on the Nikkei Index.He probably went down to Harrys Bar on Boat Quay after work, thinking all was well.Incidentally, Harrys is right next to my favorite SG watering hole, the Penny Black. Harrys used to have a plaque on the bar that read, Here sat Nick Leeson. I saw it, myself!Then, in the early hours of January 17, 1995, the unthinkable happened.The Kobe Earthquake struck.Leeson, already down GBP 208m, was crushed. The Nikkei gapped down on the open. Of course, the call options would expire worthless, but he was now short deeply in the money puts.To counteract this, Leeson bought futures as the market couldnt go down anymore. But, of course, it did.Nick Leesons losses totaled GBP 827 million, about $1.4 billion. I know that doesnt sound like much now, but it was enough to wipe Barings, The Queens Bank, from the map.A friend of mine once told me of an event he held in Singapore. A member of the Royal Family was present to open the event. My friend pointed out the window onto Raffles Place and said, Thats where Barings office used to be. Allegedly, the reply was, My family lost a lot of money that day.That is the story of Nick Leeson, told as plainly and as Greeklessly as I can.Its a great cautionary tale to both retail options traders and professionals alike. Heck, it can be said that Leeson inadvertently wrote todays derivatives regulatory structure.But if yesterdays article didnt convince you, there are far better, less risky, and less stressful ways to participate in the market than by shorting options.Have a great day today!All the best,Sean