Trading Options in Turbulent Markets: Master Uncertainty through Active Volatility Management

Chapter 12. The Married Put: Protecting Your Profit

An investor friend was managing a small hedge fund with $200 million in assets. When the markets plunged in 2008, the hedge fund blew up and he lost 35 percent of his trading capital in the span of a few days. He had nonchalantly placed stop-losses of around eight hundred points on a couple of index futures (thinking they would never, ever be hit) with large wagers, and all his stops got hit! He stated, "There was nothing in the history of the markets over the last year or so to warn that such a debacle was coming!" This notion was patently ridiculous. He had also gone long on most of the equity markets and consequently became a casualty of a strong positive correlation, a rare event.

Rare events are an oddity and a paradox; yet in the financial markets, there is actually no such thing as a rare event. No set of statistics can uncover the rare event, nor can any time series help in predicting a rare event. It could be a twenty standard deviation event—something that is likely to come about only once in more than a billion years—and yet it seems to occur every ten years or so. Traders make money more often and lose money less often, but when they lose, they lose big time. They may make money for a while, maybe even for quite long time, and then take a big hit; they eventually go down in flames!

Volatility, Downside Risk, and the Case for Portfolio Insurance

In the world of investment theory, any unpredictability is defined as risk ...