The numbers around options and options trading can sometimes be confusing and even deceiving, especially when it comes to risk, but our guy will help you understand why the actual results can vary largely from the theoretical results and help you to see things clearly. Dr. Data (Michael Rechenthin, Ph.D.) is here set things straight.
The question asked in this segment is “Am I understanding my risk?” Pay attention because if Big Data is asking a question then you need to know the answer and it may not be what you think it is. Our Good Doctor begins by asking what the probability is of a portfolio consisting of 5 different strangles, each with a 70% probability of expiring OTM, all losing money. First he shows us the formula for calculating the result and then he explains what's wrong with the formula.
Despite different stocks having various correlations to the S&P 500 we know from experience and our statistical research that large market moves often result in much higher correlations, especially during sharp down drafts. This is why the plain formula does not work. The five positions all being completely correlated isn't realistic. Mike explains that the truth is somewhere in the middle.
During large down moves the correlations between stocks can be practically total. Every stock in the S&P 100 went down in price and up in IV during the August 18th-August 24th market pummeling this year. Had a trader established positions the day before things would have looked bleak. By September expiration though, as a table showed, things looked much better.
Tom emphasized the importance of staying small and Dr. Data provided some ways to stay less correlated. Country ETFs and commodity ETFs are two things that were mentioned.
Watch this segment of the Skinny on Options Data Science with Tom Sosnoff, Tony Battista and Dr. Data for the takeaways, how to understand your real risk and how to minimize it and how Dr. Data and his team are truly changing the way we look at risk and options data.
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