4 ms·

That's very interesting; basically a reverse lottery. What are examples of such a bet?

by ahelwer 10y ago

cletus 10y ago
Writing a call option. Say the underlying security is trading at $100. You write a call option with a strike of $110, 3 month expiration and sell it for $10. If the underlying never goes above $115 in those 3 months you make money. If it discovers the cure for cancer and gets a hostile takeover offer sending the price to $5000 well then you're out $4885. An experienced options trader will limit their potential loss in this situation by say buying a call at $150 for $1. There are lots of examples like this. Warren Buffett once likened this to picking up pennies in front of a bulldozer.
pjc50 10y ago
Things which can lose you more than your investment: Options which can go a long way out-of-the-money. Short selling when vulnerable to short squeeze. Most kinds of heavily leveraged investment. Some kinds of trading that depend on volatility and liquidity. Anything with lots of unexamined counterparty risk. One case study is LTCM: http://www.prmia.org/sites/default/files/references/Long_Term_Capital_Management_Shory_version_April_2009.pdf http://www.prmia.org/sites/default/files/references/Long_Ter... .. which is an interesting read because it's kind of a TBTF "near miss", that could have blown up the system through defaults but didn't.
smallnamespace 10y ago
Historical example: https://en.wikipedia.org/wiki/Martingale_(betting_system) https://en.wikipedia.org/wiki/Martingale_(betting_system) FYI, bonds are the one of most common examples of such a asymmetric bet. If you buy a nice, safe, investment-grade bond that pays you ~2% more than Treasuries, it's because the market prices in a 2% chance every year that the company goes bankrupt. So in return for 2% excess yield, you get a 2% chance to lose your entire principal. This is a lot like selling a call option -- if you get paid $2 on a $100 stock for selling a call, but if it goes badly against you, it's very possible to lose $100. In fact, you can view 'buying a bond' as essentially buying the assets of a company, and then selling back a call option to the equity holder [1]. The difference is that people at least generally understand that with a bond, your entire principal is at stake, and bonds are hard to lever up compared to selling a call -- but the actual economic risk profile is quite similar. [1] https://books.google.com/books?id=0TTiiI6CGj4C&pg=PA25&lpg=PA25&dq=equity+debt+call+option+firm&source=bl&ots=27dtkQHoI7&sig=1qk_pyhRmmflX1Jv_BWksy_ZsDM&hl=en&sa=X&ved=0ahUKEwj_tMCr27fPAhVI3WMKHQNkC6w4ChDoAQhMMAc#v=onepage&q=equity%20debt%20call%20option%20firm&f=false https://books.google.com/books?id=0TTiiI6CGj4C&pg=PA25&lpg=P...

That's very interesting; basically a reverse lottery. What are examples of such a bet?

by ahelwer 10y ago

That's very interesting; basically a reverse lottery. What are examples of such a bet?

Writing a call option. Say the underlying security is trading at $100. You write a call option with a strike of $110, 3 month expiration and sell it for $10. If the underlying never goes above $115 in those 3 months you make money. If it discovers the cure for cancer and gets a hostile takeover offer sending the price to $5000 well then you're out $4885. An experienced options trader will limit their potential loss in this situation by say buying a call at $150 for $1. There are lots of examples like this. Warren Buffett once likened this to picking up pennies in front of a bulldozer.

pjc50 10y ago

Things which can lose you more than your investment: Options which can go a long way out-of-the-money. Short selling when vulnerable to short squeeze. Most kinds of heavily leveraged investment. Some kinds of trading that depend on volatility and liquidity. Anything with lots of unexamined counterparty risk. One case study is LTCM: http://www.prmia.org/sites/default/files/references/Long_Term_Capital_Management_Shory_version_April_2009.pdf http://www.prmia.org/sites/default/files/references/Long_Ter... .. which is an interesting read because it's kind of a TBTF "near miss", that could have blown up the system through defaults but didn't.

smallnamespace 10y ago

Historical example: https://en.wikipedia.org/wiki/Martingale_(betting_system) https://en.wikipedia.org/wiki/Martingale_(betting_system) FYI, bonds are the one of most common examples of such a asymmetric bet. If you buy a nice, safe, investment-grade bond that pays you ~2% more than Treasuries, it's because the market prices in a 2% chance every year that the company goes bankrupt. So in return for 2% excess yield, you get a 2% chance to lose your entire principal. This is a lot like selling a call option -- if you get paid $2 on a $100 stock for selling a call, but if it goes badly against you, it's very possible to lose $100. In fact, you can view 'buying a bond' as essentially buying the assets of a company, and then selling back a call option to the equity holder [1]. The difference is that people at least generally understand that with a bond, your entire principal is at stake, and bonds are hard to lever up compared to selling a call -- but the actual economic risk profile is quite similar. [1] https://books.google.com/books?id=0TTiiI6CGj4C&pg=PA25&lpg=PA25&dq=equity+debt+call+option+firm&source=bl&ots=27dtkQHoI7&sig=1qk_pyhRmmflX1Jv_BWksy_ZsDM&hl=en&sa=X&ved=0ahUKEwj_tMCr27fPAhVI3WMKHQNkC6w4ChDoAQhMMAc#v=onepage&q=equity%20debt%20call%20option%20firm&f=false https://books.google.com/books?id=0TTiiI6CGj4C&pg=PA25&lpg=P...