264  •   The Intelligent Option Investor
Market risk is a factor that investors in levered instruments must 
always keep in mind. Even an ITM call long-term equity anticipated 
security (LEAPS) in the summer of 2007 might have become a short-tenor 
out-of-the-money (OTM) call by the fall of 2008 after the Lehman shock 
because of the sharp decline in stock prices in the interim. Unexpected 
things can and do happen. A portfolio constructed oblivious to this fact is 
a dangerous thing.
As long as market fluctuations only cause unrealized losses, market 
risk is manageable. But if a levered loss must be realized, either because of 
an option expiration or in order to fund another position, it has the poten-
tial to materially reduce your available investment capital. Y ou cannot ma-
terially reduce your investment capital too many times before running out.
A Lehman shock is a worst-case scenario, and some investors live 
their entire lives without experiencing such severe and material market 
risk. In most cases, rather than representing a material threat, market risk 
represents a wonderful opportunity to an intelligent investor.
Most human decision makers in the market are looking at either 
technical indicators—which are short term by nature—or some sort of 
multiple value (e.g., price-to-something ratio). These kinds of measures are 
wonderful for brokers because they encourage brokerage clients to make 
frequent trades and thus pay the brokerages frequent fees. 
The reaction of short-term traders is also wonderful for intelligent 
investors. This is so because a market reaction that might look sensible or 
rational to someone with an investment time horizon measured in days or 
months will often look completely ridiculous to an investor with a longer-
term perspective. For example, let’s say that a company announces that its 
earnings will be lower next quarter because of a delay in the release of a 
new product. Investors who are estimating a short-term value for the stock 
based on an earnings multiple will sell the stock when they see that earn-
ings will likely fall. Technical traders see that the stock has broken through 
some line of “resistance” or that one moving average has crossed another 
moving average, so they sell it as well. Perhaps an algorithmic trading 
engine recognizes the sharp drop and places a series of sell orders that are 
covered almost as soon as they are filled. In the meantime, someone who 
has held the stock for a while and has a gain on it gets protective of this gain 
and decides to buy a put option to protect his or her gains.