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264 •   TheIntelligentOptionInvestor
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, lets 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.