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How To Use Options To Profit From Black Swan Events
Options can be an excellent way to make money on back swan events and other unexpected market movements. Options allow you to make small investments on the market to earn significant profits if you can predict events that other traders find unlikely to happen.
Your downside is limited to the small amount that you invested, while the upside is unlimited. Some traders have earned a lot of money by investing in options that nobody thought would mature.
This allowed them to buy very cheap options. Most black swan options will mature outside the money, but the few who mature in the market will give substantial returns. This makes it possible to earn high returns even if most traders fail.
To understand precisely how this works, you must understand what black swan events are and what options are.
What are black swans events?
A Black Swan event is an infrequent event that no one thinks is ever going to happen. These events are very hard, almost impossible to predict but might seem obvious in retrospect. The name black swan metaphor can be traced back to the roman empire in the second century when the Roman poet Juvenal described someone as a black swan.
Like something that didn't exist, people in Europe continued to believe that all swans were white for a very long time. A black swan could not exist. Then in 1697, the Dutch explorer Willem de Vlamingh discovered black swans in Western Australia, and the impossible became possible.
Nassim Nicholas Taleb made the term black swan events popular in the early 2000s when he used it in his books Fooled By Randomness (2001) and The Black Swan (2007). Black swan events in now a widespread term to use to describe unexpected events on the financial markets.
What are options?
An option is a contract that gives its owner (holder) a right but not an obligation to carry out a specific transaction at a specific price before or on a specific date.
This options contract give the holder the right to buy 100 NASDAQ: AAPL shares for 132.00 each on March 1, 2022.
The issuer (writer) of the option is obliged to carry out the transaction if the holder of the option elects to carry out the transaction (exercise the option).
The downside for the buyer of an option is limited to the price he paid for the option. The downside for the person issuing the option is unlimited. There are many examples of investors who have lost huge sums of money by issuing options.
Retail investors should NEVER ISSUE OPTIONS:
Today, most standard options are cash-settlement only, and the issuer is therefore not obliged to provide the actual shares. The issuer only has to pay the buyer to settle the profit earned by the buyer.
If you want to purchase an option that gives you the right to become the owner of an asset and does not allow the issuer to give you cash, you need to make sure that you are buying that exact type of option. (They are much rarer than cash-settlement only options.)
Call options and put options
The owner of a call option has the right, but not the obligation, to buy the underlying asset at a price specified in the option. The issuer of the option is obligated to sell the asset at the specified price.
A trader who purchased a put option has the right, but not the obligation, to sell the underlying asset at a price specified in the option. The issuer of the Put option must buy the underlying asset at the specified price. It is the owner of the option that decides if he wants to exercise the option or not. The issuer is bound by the terms specified in the option.
Most options are either American-style or European-style.
An American-style option can be exercised at any point until it has expired. This gives the trader a lot of control and makes it possible to close a position at any time to realise a profit.
A European-style option can not be exercised whenever the owner wants to. They can only be exercised when the option matures. A European option can sometimes have maturation dates far into the future.
A European-style option gives the trader a lot less control. It needs to mature in the money for the trader to exercise it for a profit. European-style options are usually exchange-traded, which allows the trader to sell them before maturation if he wants to realise his profit.
Are options exchange-traded?
Some are, some are not.
Options that are not listed on any exchange are known as OTC options. OTC is short for over-the-counter.
Exchange-traded options are highly standardised, while OTC options exist outside the realm of exchanges and their strict requirements for standardisation.
Retail traders should normally not invest in OTC options. Only in exchange-traded options. It can be tough to sell or liquidate OTC options before they mature. On the other hand, exchange-traded options can be liquidated at any time provided that there are buyers in the market.
How to make money trading options
Now you know how options work, and we can move on to how you can use them to make money from black swan events.
Black swan events are very hard, impossible, to predict. The market will, therefore, always price the options accordingly. The issuer will accept whatever he can get for these options as he will see it as free, risk-free money. They are expected to mature outside of the money, and the issuer assumes they will never be exercised. The market will also consider these options as worthless. This allows you to buy them very cheaply. You can often buy them for less than a cent.
It can sometimes be hard to find suitable exchange-traded options if you want to trade on black swan events. OTC options can be the only solution if you want to make a certain trade. Make sure you understand exactly how the OTC options work before you buy them. Do not buy OTC options if you are an inexperienced trader.
The low market value of black swan options means that you can buy many options for a small amount of money. 10 000 options at 1c each will cost you a mere USD100. This is the maximum amount of money you can lose. The upside is unlimited.
You think that the value of a certain stock will tank and that the stock will be trading at 50% of the current market value within six months. The stock is currently trading at USD1000, and you think that the value will drop to USD 500. You buy 10 000 American-style put options at a strike price of USD 600. No one thinks the stock will drop this low so that you can buy the option at 1 cent each. You invest a total of USD 100.
Four months later, the value of the stock crashes as you predicted, and the value goes down to USD475 a share. You think that this is the bottom of the market and chose to exercise the options.
Each option is now worth USD125 (600-475) apiece, and the total value of the 10 000 options is USD 1,25 million. You have turned your USD100 investment into 1.25 million. You earned 12 500 times your investment.
It is very hard to predict black swan events, and most trades will fail. But the very high returns that you can earn allow you to earn a lot of money even if just a very low percentage of your trades are successful.
You can earn money even if only 1 in a 1000 trades are successful. Using the example above, you would still make 12,5 times your investment even if only 1 in 1000 trades succeed.
Black swan options trading is not for everyone. You must be willing to and be able to afford to make a lot of losing trades to make a few successful trades. You can increase your success rate by viewing and analysing the market in different ways than anyone else.
Most retail investors and trader will be better off investing in dividend and blue-chip stocks. Stocks that are low risk and require a limited amount of research. I Do not recommend that anyone start trading black swan events.
You can lose a lot of money before you can make a successful trade. With this said, black swan trading can be extremely profitable if you can see what others can not.
Options can also be an excellent way to make money from an event that you are convinced will occur even if conventional wisdom says it won't. You can invest a small amount of money and get a large reward if it turns out that you are right and everyone else is wrong.
The small amounts you need to invest means that anyone can make these types of trade regardless of whether they are rich or poor. Options allow anyone to earn large profits if they can predict what others can not.
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If you enjoyed this post and have the time to spend diving deeper down the rabbit hole, then we suggest you check out the following posts about improving your finances in South Africa.
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