Papale on the Free Lunch

The Masters is this week and if anyone out there is lucky enough to have what might be the most exclusive ticket in sports, here are some helpful hints before you hit the gallery.  Don’t take off your shoes.  Can’t do it.  No phones allowed.  Spectators are allowed to place chairs to hold their spot and then leave.  We used to do that in Chicago in the winter to hold parking places.  And finally, no yelling “Noonan” during putting.

No free lunch.  Or as an old partner used to say “no free cheese”.  Point is there is no free money laying around these days when it comes to the markets.  What I mean by this is every potential return or payoff has a potential risk.  For example, when buying a call my potential payoff is unlimited.  If the stock takes off to the moon the holder can make unlimited money.  The only cap is how far the stock moves up.  The risk is that all options are decaying or wasting assets.  So if the stock fails to move or does not move enough, the call can lose much or all of its value.

Selling options produce the mirror image of the risk and return of long options.  Generally there is a finite potential return with larger or even infinite risk.  One is not necessarily better than the other –  they just have different risk/return profiles.  The same goes for position adjustments.  When markets move part of a trading strategy may be to manage or adjust the position.  For short gamma trades when markets move dramatically, an adverse delta position is produced – short delta on rallies and long deltas on selloffs.  Position management often includes flattening out these deltas to allow the trader to stay in the position if the market continues to move in the direction that produced the adverse delta.

There are a number of ways to do this.  And whether the adjustment involves using options or the underlying, it means locking down at least a partial loss on the trade.  If you are short 1000 deltas and no matter what you do and your new delta position is short 500, you have bought back and banked a loss on 500 of your short deltas.  There are no magic adjustments that will allow you to cover some risk and make money no matter what the market does.  There are different ways to cover risk and different payoffs, but all have risk and or locked in losses.  So beware of the magic adjustment someone may advertise.  Learn to take your medicine and move on.  Forget about the free lunch.  It does not exist.

 

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