Experience is something you don’t get until just after you need it. – Steven Wright
Let me start out by saying I’m amazed how little valuable information is being delivered after the Facebook (NASDAQ:FB) “episode”. Here we are, having just witnessed the biggest one day drop of market cap in history for a single stock, and most of what I see are variations of “wow”, “… never saw it coming” and “…told you so”.
My view, on the other hand, is that it was simply a shame that so many investors lost so much money when it was totally avoidable if they understood risk and how to manage it.
A little over a week ago, I wrote an article about Amazon (NASDAQ:AMZN) that set forth my pre-earnings strategy. The purpose of that article was to put forth a method to fully protect against a large potential downside move in the event of a big earnings miss. The strategy was slanted towards downside protection but also presented an opportunity to increase returns on a up move. Sort of a “have your cake and eat it too” strategy.
Of course, the odds of a big down move are always slim, but the result can be devastating. We saw that with Facebook.
What I found interesting about Amazon is that after having reported overall successful quarter, the stock was all over the place and ended little changed. I can’t help but to wonder what the outcome would have been on a miss, another Facebook?
Though that article concentrated on Amazon, it also mentioned Apple (NASDAQ:AAPL), whose earnings were soon to follow. I did mention that the strategy could be applied to any stock facing risk uncertainty.
Unfortunately, I made one BIG MISTAKE. A mistake that nags at me and forces me to write this article to “get it off my chest”.
I chose Amazon and Apple because they are positions I owned. I didn’t include Facebook because I didn’t own Facebook and don’t even use Facebook (old, old school, I guess). Facebook was “out of sight, out of mind”.
I am somewhat relieved that at least one reader e-mailed me and said that the article inspired him to apply the strategy to Facebook. We discussed strikes and strategy. He did, in fact, institute the strategy with Facebook. Thankfully, he avoided a complete catastrophe. I’d like to think others also benefited. I wonder how many would have benefited had I tagged Facebook.
I’m not much for closing the barn door after the cow has left. What good would it do to just remind Facebook investors? It’s too late for them to institute the strategy I wrote about. On the other hand, it can benefit those that want to avoid the next Facebook and can read the last article and tuck it away until they need it.
So, this article will be more generic in nature. It won’t focus on one particular stock or strategy (I have plenty of articles on that). Instead, I’ll discuss risk and why it’s important to manage it. I’ll also provide some guidelines.
Understanding Risk, Probabilities, and Expectations
Most investors completely misunderstand the concept of risk. Some manage to survive ignorant of its grasp while others, such as we saw with Facebook, falter for lack of understanding.
Let me start with my favorite example: We load a six-shooter gun with one deadly round and play Russian Roulette for $100 per trigger squeeze. The odds are 83% (5/6) that you win. Does that make it low-risk? What would low-risk look like? How about a 13-round Glock where your probability of success is over 90%. For certainly, if one defined risk as favorable odds, we would expect many takers, but I’ll bet there wouldn’t be any.
The reason is simple: One doesn’t define risk by the probability of success. I often see this mistake when pundits promote investing strategies such as selling deep-out-of-the-money-puts (DOTM) on volatile stocks and lauding the low-risk-nature of the trade. “The stock would have to drop over x% (6%,7%, 10%) for you to lose”. Well, Facebook reminded us of the real risk in such strategies.
Yes, risk isn’t the chance of loss, it is the magnitude of potential loss. Too many simply confuse probability with risk.
This confusion is because investors don’t understand there is a completely other operative metric. They can easily put their hands around the potential loss and even recognize when a probability is very high or very low (I hope).
But probability isn’t risk. And, though maximum loss is risk, maximum loss is very, very rare. The maximum loss on the S&P is it going to ZERO, and though that’s possible, it isn’t helpful for us to evaluate investing loss.
So, with neither probability or risk telling us much when isolated, we can combine them into the operative metric: Expected Result.
Expected Result
Let me clarify that Expected Result isn’t what one actually expects to happen. It is a methodology to quantify whether there is potential for gain or loss and the most likely result of all the things that could happen.
Expected result is simply the probability of an event happening multiplied by the result of that outcome and adding together all the outcomes. This equals the Expected Result. So, if we look at the Russian Roulette six-shooter, there are five chances out of six to win a $100 and one chance to be dead. So, your expected gain is $83 (5/6 x $100). It’s hard to monetize the expected loss, but, let’s say, being dead is like losing $1,000,000. You have a 1-in-6 chance of this loss, so you’re expected loss is $166,666. Adding expected gain to expected loss and the expected result is a loss of $166,583. That’s why we don’t play Russian Roulette.
Important: Expected result doesn’t mean that’s what will happen, or even that is most likely to happen. The probabilities actually predict nothing. Instead, when the expected result is negative it means that if “played” enough times one will be a loser. The more negative, the sooner they are likely to be a loser or the greater the loss or both. Unless, of course, there is some compensating factor that the probabilities don’t take into account. More on this, later.
In the meantime, let’s look at selling a DOTM put on a volatile stock. First, we must calculate the probability. Too many investors simply do this by the seat of their pants. Well, “low-probability” and “high-probability” are not probabilities. Probabilities are numbers ranging from zero to 100%. Most investors are lost at this stage. That’s one reason why so many investors make mistakes: they start out not knowing the probability of success, let alone the Expected Result.
It’s a shame because there’s a simple proxy for the probability, and it is easy to find and free. No special skill involved. It’s the Delta of the option.
Let me give an example, using Apple. I choose AAPL, because its earnings is in a few days, and the premium and volatility pre-earnings are what we saw in Facebook and Amazon.
Apple is trading at $191. Let’s look at selling a put 10% DOTM with an August 3rd strike of $170. The premium credit is 17 cents. The “pundits” claim it is easy money and very, very low risk. But we’re taking a more scientific look. “low risk” is Russian Roulette thinking.
Using the DELTA as a probability proxy, the Delta is -3.25. that means there’s a 96.75% chance one wins. Not bad “odds”, but is it bad as an Expected Result?
Let’s look: a 96.75% chance of making 17 cents is an expected gain of around 16.5 cents. What is the expected loss? This isn’t as easy as using the Delta proxy, and it’s probably why so very, very few look at it.
Here’s how the expected loss must be calculated. We could start with a drop to $169, that’s a $1 loss and a -3.1% Delta. So, the expected loss at $169 strike is 3.1 cents. Now, we must continue with every possible strike below the $170. That means $168 … $150, $149 … all the way down to $1 and multiply each strike by the ever-diminishing probability (Delta proxy) and add them together. Wow! what an arduous task. And an inaccurate one, at that, because it doesn’t calculate AAPL landing between strikes.
However, one can calculate a very exact number using differential and integral calculus. But that’s out of the realm of most people, and computer algorithms are the game.
But there’s a proxy for all this too. A proxy so simple, it’s unconscionable that it isn’t used. The proxy is simply the ask price of the option. Let me explain:
The expected loss selling a put is exactly the amount one expects to gain having bought the put. This may be a little hard to follow, but I’ll try my best. Whatever the expected loss on selling a put calculates, it can be zeroed out by buying the put. So, unless there’s a mispricing of options (exceedingly rare), the ask price for a put must be the expected loss.
So, since the bid price is used to determine the expected gain and the ask price the expected loss, the difference between the two, the bid/ask spread will provide us the Expected Result.
Applying this to our hypothetical AAPL trade, the expected gain is 16.5 cents, the expected loss is (ask price) 19 cents, and the expected result is minus 2.5 cents.
Expected Return Conclusion:
Every option trade, at every strike, on every underlying has a negative expected return, and that negative expected return can be expressed, simply and easily, as the difference between the bid and ask prices. And, as we all know, it will always be a cost item. There is no free lunch.
Let me take this a little further. The “odds” heavily favor DOTM puts. So, there is a good likelihood that one will see immediate, positive success. The problem is that the more they “play” it, the more they risk ending up a loser. It all depends on how many “plays” they make and if they can walk away before catastrophe strikes. It may be interesting for readers to know that if they “play” a 96.75% once each week, they have a 50% chance of becoming a loser in less than six months.
And, of course, if the loss (as in Facebook) comes early or is massive, then everything is out the window.
Putting the Odds in Your Favor
Some may be disagreeing and claim having made money on a consistent basis selling puts. They do so at-the-money, OTM and ITM. I don’t doubt this.
That’s because one must look into the “odds” a little closer. There are “odds” in games of chance, such a dice and roulette. There are also “odds” in games that combine probability and skill such as Poker and Bridge.
Over the long haul, games without a skill component will prove as Expected. But in games that allow a skill component, the “odds” can be broken by skillful play. In fact, many believe that a poker player that relies solely on an accurate understanding of the probabilities of a draw is most likely going to be a loser, rather than a winner. The “odds-only” poker player misses bluffing and reading the opponents and other skills that the persistent winners have learned to use most effectively.
Now, if one doesn’t know the odds, they are doomed in all games. But, and this is important, if they have better than average skill in games of “skill-chance”, they can be persistent winners. It is not the odds that are working for them it is their skill in the game, knowing the odds, reading the opponents, etc.
Never Confuse Skill With “Odds”
In investing, that means doing research. Invest in what you know. Invest in your “skill set”. The option Delta’s don’t factor in skill. They just assume that for every skilled investor, there’s a matching fool. My experience is that they are correct.
Refining the Odds
Let’s take the standard no-skill “Coin Toss”. You toss a coin and it has a 50/50 chance of coming up either heads or tails. Theoretically, if you play long enough, you break even (assuming there’s no “vig”).
But what if after watching the results of that particular coin toss, over long periods of time and many tosses, you noticed it came up heads, 60% of the time. Can you suspect that the coin is out-of-round and the odds are not 50/50 but 60/40 and you can actually win, consistently, betting on heads?
Do you figure to bet on heads because of some exhibited bias, or do you bet on tails expecting “mean reversion”? What would you do if I told you that the coin is bent and will favor heads? How much and how often do you bet on a bent coin?
What would a skilled person do? Unfortunately, studies show that the majority make the wrong bets. Yes, even knowing the odds are in their favor, they make the wrong bets. If you’d like more information and a “solve” for this dilemma, see a previous article of mine.
Well, the bent coin toss is sort of a proxy for the stock market. The stock market has ups and downs (heads and tails) but consistently, over time, it is up. In fact, it is up by some measurements as much as 70% of the time. That means that investors that favor long positions are persistent winners. That’s why buy-and-hold is such a successful strategy.
But lack of skill causes too many investors to make the wrong choices. They buy at the top and sell on a drop. Underperformance by the masses is so prevalent, it’s mindboggling that it persists.
That is also why shorting a top is often wrong. Up means up. Maybe down, then up, but the market is relentlessly up. That is why selling puts often wins.
It also means, over the long run, that selling puts – at any strike – wins and selling calls – at any strike – loses. Plain and simple, the Delta of options doesn’t account for the upward bias in stocks. The Delta assumes the “coin” is normal, and history tells us it’s bent.
With all this said, when one sells puts DOTM, they squander the inherent advantage. The odds actually favor ATM or slightly ITM puts, and as one goes to OTM, they lose some of the advantage, and as they go DOTM, they can lose all the advantage. I won’t go into the reasons, but those interested can look at a previous article that explains it in detail.
Summary
This article has explored the concept of Expected Result. Big moves down are always a risk, and one is playing Russian Roulette if they think there’s some safe strike. That simply means that big moves may be rare, but we must weigh the magnitude of loss against the rarity of occurrence.
But that doesn’t mean we’re helpless. Quite the contrary. By applying skill and understanding, we can easily tip the odds in our favor. The stock market should be viewed as a combination of probabilities and skill.
If one finds oneself eager for a particular trade based upon “low risk”, they may well have it wrong. On the other hand, if they evaluate a trade based upon their knowledge of the stock or other influencing factors, then they probably have it right.
Of course, there will always be times when going short is the best strategy. But, absent clear defined reasons, going long is the proper strategy.
Then, there are times when we want to be long but face risk. That’s where hedging comes in. That’s where my last article on Amazon comes in. That’s where I regret not having written on Facebook, or tagged Facebook in the last article.
These times can be differentiated from times to sell or be short. They represent all those times that up is likely but so is a big move down. Prayer isn’t the answer. Hedging is the answer.
The key to investors, the real key, is to acknowledge to oneself that there are times when the downside potential is beyond the norm. For FAANG stocks, it is certainly around earnings. For retail stocks, it is certainly around the Holiday Season. One can decide to “wish it away”, but it won’t go away. One must accept that, once in a while, they can get hammered.
When downside potential exceeds the norm, one must act. I’m not saying sell or short, but at least put on some sort of hedge.
It is beyond the scope of this article to explore any particular hedge. Those desiring that information can easily find it in previous articles. I will, however, stress the importance of being cautious, especially with volatile stocks, like FAANG, around earnings. Many of my other articles deal with more long-term, permanent hedges.
Amazon Update
After my last article was published, a reader applied it to Facebook. He avoided a catastrophe. In our dialogue, he said he would have done even better if he also had set a stop loss/limit on FB. I told him I never thought of it, but it is a good and valuable addition to the strategy. Just makes sense.
So, Thursday after hours, after the report and the AH pop to $1,890, I figured it was worth setting a stop on the 70 “extra” shares and placed it at $1,870. Friday morning, things were crazy, and I was stopped out quickly at $1,870. These shares were bought a week earlier at $1,840 as part of the hedge, so I made $2,100 on them.
Next, I turned to closing out the option positions, but by the time I got to that, AMZN was down to $1,840 and dropped to $1,820 before I could even arrange my trading platform. I closed these out for a gain of $1,400. So, I gained on the 70 shares and options a total of just about $3,500. Now, the initial 30 shares dropped from $1,840 to $1,819, and I lost $360 on them. With a little bit of luck, I’m up $3,000 because I hedged.
Or, was it just dumb luck? Perhaps, at the suggestion of that reader, I implemented a new skill, adding stop-loss to the strategy. Maybe that extra little skill put into motion a series of events that would have otherwise not been achievable. Or, maybe it was just dumb luck.
However, if I wasn’t stopped out of the 70 shares, I would have just held the position a little longer and see where it goes. Losses are covered. Time is on my side.
Had I not closed everything out, a variation would be to sell the 100 shares and replace them by selling weekly ITM puts looking to pick up some extrinsic if Amazon doesn’t have a post traumatic run-up. But that’s for another article.
Disclosure: I am/we are long AAPL, AMZN.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I buy and sell options on AAPL and AMZN
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