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High Risk High Reward



In Pricing Options, I talked about two different types of risks in pricing options: normal day-to-day volatility and event (tail) risk. The official name given to estimating tail risk, caused by one-off events that can send a stock's price ballistic is "kurtosis," a statistical methodology that measures the "fatness" of the tails. This statistical calculation is linear in nature, however, so it has little value other than a guide. This is where options become more art than science.

The following example illustrates how I might look at tail risk. Before I begin I want to make one thing clear: This is very dangerous stuff and I am explaining it for educational purposes. The proper amount of diversification, low leverage and experience allows me to play these situations.

USG Corporation (USG:NYSE), a manufacturer of building materials, has been extremely volatile due to its asbestos exposure and certain recent events affecting the company's likely future liability. Specifically, Congress is debating a bill that would put limits on asbestos liability for certain companies. Further details are unimportant; suffice it to say that there will be an announcement in the near future that will greatly affect the company's stock price.

Let's look at the options for a lesson in high-risk, high-reward and the importance of timing in valuing options.

First we'll analyze some facts on which to base some assumptions. The stock price over the last six months has been as low as $4 and as high as $13.75; it is currently trading near its high at $13. There is very high open interest in the near-term July (25 trading days left) 12.5 strike options, the closest strike to the current stock price: 12,000 in the calls and 7,000 in the puts (this equates to 1.2 million and 700,000 shares respectively).

The implied volatility of the July 12.5 puts (it is only necessary to look at either the calls or the puts for a relative price; see my earlier column as to why, if they were much different, arbitragers could make risk-less profits) is a very high 165%. This option price implies that the stock will move 165% either up or down over the next year, or 33% by expiration over the next 25 trading days (165%/(25**-2)). The company has a book value of $12.85 per share and $14 of cash per share. The company has $80 per share per year in sales. And finally we have a Republican congress.

The facts lead me to these assumptions:

1.) The stock is still hanging around the highs, despite that we are getting closer to a decision (at least time is passing). This means to me that those with good information who are holding the stock are still not getting overly nervous. The fact that it traded down to $4 has little valuable information other than it can trade there again (this statistic will affect kurtosis and I use it merely as a guide).

2.) Open interest is higher in the calls than the puts. I respect that. And most of the calls and puts seem to have been purchased at lower stock prices, so the benefit of the doubt goes to the call buyers. Option speculators (buyers of naked calls and puts) often have good information and are eventually right, but are just as often bad at timing so that their options expire worthless.

3.) The option prices are extremely high because these speculators expect a decision soon and are willing to pay a lot, betting the stock will move tremendously. Some further analysis shows that they may not be right on timing.

4.) The fundamentals show a lot of cash on the balance sheet. The company may be in a position to settle and with $80 per year per share in revenues, the company could make up for lost book value fairly rapidly.

5.) A Republican Congress may on the margin favor the corporations, even though there will be compromise with the Democrats.

My conclusion is that the kurtosis implied by the options prices is too fat (and I can profitably sell it) if I am willing to conclude that it is not equally weighted and that there is a reasonable probability that the event will not occur by expiration.

Based on the above assumptions (and a little further fundamental analysis) I conclude that the probability of a good event is higher than a bad event and that the downside is $9 and the upside is $18. More importantly, I conclude that there is a fair probability that there will be no event by July (we don't think that we can say that about August). I decide to sell the July 12.5 puts at $1.95 and sell short stock on only a .3 delta to lean delta long (the right delta is .38). This gives the trade breakevens of $9.5 and $19.55.

If we are wrong and the stock goes to $4 before July expiration, the trade will experience a large loss. In this situation I would be basically long stock and will deal with it over time. If a positive announcement drives the stock higher I am somewhat prepared for it and assume I can buy some stock under my breakeven. The risk of the situation dictates that it must be sized (negative leverage) to make a possible loss acceptable (risk management). It is necessary to do these trades as often as possible in relatively small size (versus long gamma trades) to allow the probabilities to work over time.

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