Check out this description of a famous option strategy example…
In this video we are going to talk about Option strategy. Now there are so many different option strategies, and so many different reasons to use options. I am actually only going to focus on one example, we are going to talk through it, and my goal is to give you a sense of what is possible with options. Just to be clear up front. I am not giving any investment advice. This is purely a hypothetical educational example.
So here is the example. We are going to create a hedge position on a stock. We are going to purchase a stock and then also purchase a stock option that shorts the same stock. So if the stock increases in value, we make money. If the stock loses value, we also make money because of the option. I am going to say this again. No matter if the stock goes up or down, we make money. So if we look at this strategy on a theoretical level. In a mathematically perfect world, we have eliminated risk. The risk of this investment is zero, in a mathematically perfect world.
In my last video we discussed the Black Scholes pricing model. This is the same example that was used in the famous academic paper by Mr. Black and Mr. Scholes titled “The Pricing of Options and Corporate Liabilities.” And it was this paper where they first published the Black-Scholes pricing model. So this paper looked at this option strategy and said, how much would this strategy be worth? What would be the rate of return on this strategy? That is an interesting question, and the answer turns out to be our good friend, the risk free rate. Now I made a video earlier on the risk free rate, so go check that out. But it is essentially the rate trading in the market for the least amount of risk. So here we have zero risk, so it makes sense that we would end up with the risk free rate. Now this also makes sense when we look at our other good friend, the capital asset pricing model. And I also made a video on that subject. But if we look at the CAPM, the rate of return on the stock is based on some premium over the risk free rate. So if we have an option strategy that eliminates risk, what we are left with is the risk free rate. So this is the basic idea behind the starting point for the Black Scholes pricing model. Because it calculates a value investors would be willing to pay in a perfect mathematical universe for an option to create a hedged position where the return matches the risk free rate.
So let’s go back to the example. Here we own stock and an option, so we are protected on both directions. Now this paper was based on a mathematically perfect universe. And we know life is not always mathematically perfect. So what is the problem with this example? I am not so certain it’s completely accurate to call this example risk free. What if the market stays flat? What if it stays flat for the next ten years, and you are holding this position. Well you wouldn’t make any money, in fact, you would lose money because it cost money to set up these financial derivatives.
The risk with financial derivatives is there is usually a catch. Finance people set up mathematical models to make decisions about the future. These models are usually based on distributions. So you figure out the most likely outcomes and create hedged positions. Then because you hold investments that are theoretically zero risk, it makes sense to fund those investments with a lot of leverage. The only problems occur when something happens at the tail of the distribution. Every once in a while something out of the ordinary will happen (like the market staying flat for a decade), that will make your hedges completely ineffective.
So here are my takeaways from this example.
- Financial derivatives can be used to hedge and create very low levels of risk
- Be careful of any opportunities that claim “zero” risk
So that is my example of option strategy. There are a lot of different strategies out there, so if you are interested I recommend you looking into it. I just wanted to show you one example, and give you a glimpse of how powerful options can be.
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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.