Risk Migrates

Key Concepts

• Risk Migration: The principle that risk doesn’t disappear when hedged or altered in a trade; it simply shifts to another area or dimension.
• Local Volatility: The risk specific to an individual trade.
• Structural Return Risk: Risk affecting the overall portfolio returns, often resulting from changes in asset allocation or concentration.
• Opportunity Cost: The potential gain forfeited by closing a profitable trade.
• Gamma Risk: Sensitivity of an option's delta to changes in the underlying asset's price.
• Vega Risk: Sensitivity of an option's price to changes in implied volatility.
• Extrinsic Value (Time Value): The portion of an option's premium attributable to the time remaining until expiration, as opposed to intrinsic value.
• Intrinsic Value: The in-the-money amount of an option.

Understanding Risk Migration in Options Trading

This discussion, led by Bill Johnson and Stu from Market Rebellion, centers on a critical, often overlooked concept in options trading: risk migration. The core argument is that risk is not eliminated by hedging or adjusting trades; it merely shifts to another area. Understanding this principle is crucial for effective risk management and avoiding potentially costly mistakes.

The Illusion of Risk Elimination

Many traders believe that actions like rolling options, closing positions, or using hedging strategies (like vertical spreads or covered calls) reduce or eliminate risk. However, Johnson and Stu emphasize that this is a misconception. These actions don’t destroy risk; they reallocate it. As Johnson states, “You have changed your risk and you might unknowingly have made it worse.”

Risk Lives in the Market, Not the Trade

A fundamental point is that risk resides within the market itself, not within a specific trade. Options simply allow traders to “slice and dice” risk into different dimensions. The analogy of sweeping dirt under the rug or into a closet is used to illustrate this: cleaning up one area doesn’t eliminate the dirt; it just hides it elsewhere. Similarly, driving a different colored car doesn’t change the inherent risk of highway traffic.

How Risk Migrates: Examples & Mechanisms

Several examples are provided to demonstrate how risk migration occurs:

• Closing a Position: Closing a profitable trade (positive expected value) isn’t risk-free. It represents an opportunity cost – the potential future gains forfeited. Reinvesting the proceeds can introduce new risks, particularly if the new trades are less favorable. Furthermore, closing a position can lead to portfolio concentration risk if it leaves a disproportionate allocation to certain assets.
• Vertical Spreads: While often used to reduce the upfront cost of a trade, vertical spreads don’t eliminate risk. They shift it. The example using a $500 call spread demonstrates how the break-even point changes when a short call is added, concentrating risk closer to the strike price. The initial $3 cost can balloon to $22 if the trader attempts to “bank” a small credit by rolling the short call.
• Rolling Options: Rolling options to collect premium can create the illusion of reducing risk, but it often concentrates risk closer to the current stock price, increasing gamma and vega risk.
• Receiving a Credit: The discussion highlights that any credit received in a trade implies the acceptance of risk or the sale of probability space. The market doesn’t pay traders for nothing; there’s always a corresponding risk involved.

Technical Details & Calculations

The presentation includes a detailed breakdown of a vertical spread example:

• Initial Setup: Buying a $500 call for $23 and selling a $505 call for $20, resulting in a net debit of $3.
• Risk Graph: The risk graph illustrates a maximum profit of $2 (the $5 difference between strikes) and a maximum loss of $3 (the initial debit).
• Break-Even Point: Calculated at $503.
• Post-Adjustment: If the stock rises to $508, attempting to close the short call for a $1 profit (selling at $19 after initially collecting $20) increases the cost basis of the long call to approximately $22, significantly increasing the risk.

The Conservation Law of Risk

The concept of risk migration is likened to a “conservation law” in finance, similar to those in physics (e.g., conservation of angular momentum). Just as energy cannot be created or destroyed, risk cannot be eliminated; it must be transferred or transformed.

Practical Implications & Actionable Insights

The key takeaway is to be aware that risk doesn’t disappear when a trade is adjusted. Traders should actively consider where the risk has migrated to and assess whether the new risk profile is acceptable. Johnson and Stu advise traders to “hit the brakes” and logically analyze the consequences of any trade adjustment. They also suggest asking, “Where did the risk migrate to?” when reviewing trades.

Notable Quotes

• Bill Johnson: “You have changed your risk and you might unknowingly have made it worse.”
• Bill Johnson: “Risk lives in the market not in the trade.”
• Bill Johnson: “You can’t eliminate it. Only change where risk lives.”

Conclusion

The discussion provides a valuable perspective on risk management in options trading. By understanding the principle of risk migration, traders can avoid the common pitfall of believing they have eliminated risk when they have merely shifted it. The emphasis on careful analysis, tracking cash flows, and considering the broader portfolio implications is crucial for making informed trading decisions and achieving consistent success. The core message is that risk is a constant presence in the market, and effective trading requires a proactive and comprehensive approach to managing it.