Measuring Risk vs Reward Using Your Own Mental Framework

2/11/12

The other day I mentioned wanting to watch the VIX index (volatility) because the market had been so calm. Didn’t take long for things to change. Perhaps it was heightened sensitivity to losses that made the VIX spike 15% + on Friday, Because the US markets weren’t down that much (0.5% or so).

Another explanation is that the index futures, long credited with representing the dumb money (smart money being the bond and credit markets) hold more “hopeful” buyers as some credit markets (eg high yield) were hit much harder than equities. Of course with debt markets in flux, bonds have had their own odd dynamics.

All I know is this-stocks were down a bit with a spiking VIX and bonds and credit offered some more negative impressions. It could have simply shaken out some weak holders but who knows. I did have one risk management signal hit and subsequently dumped the holding (watch it reverse in a false bottom formation! I’d “love” that as I’ve held it a while), an emerging market telecom stock.

Markets

Overall unexciting though very strong stocks were positive or barely negative on the day – Apple, MasterCard, and a few others were rock stars but materials and commodities stocks were slapped. Gold recovered most of its pre market losses and most stocks came off lows of the day. Greece issues caused worry and lots of investors bought put options for protection as the VIX spiked.

Not too much else to say as this market hasn’t been down much in 2012. We’ll have to watch and wait for more clues.

Risk &Reward Logic Lesson

No other risk management signals triggered as market losses were minimal. I would like to reflect more on my thinking regarding the NUAN 

call I own. I think this lesson would be helpful for readers (and myself!).  Let’s recap first. I bought a February call on NUAN strike price of 29 for 95c. I bought a few weeks ago and was waiting for earnings to be a catalyst. Interestingly after dipping for a few days, the stock rose into the eve of earnings report. The option rose as high as 2.75 (almost a triple). My options before earnings were announced after hours were either sell before the days close at a triple or wait for a blowout quarter potentially and make even more. Of course that risked downside too. As you may know the earnings call was lame in investors eyes and the stock dropped well over 10% making my option near useless.

Some of you might be saying I did the right or wrong thing either I was following my plan (earnings) or I was greedy. Let me share my thinking and why I think I did the wrong thing (without factoring the  actual outcome). I was expecting a 10-15% pop on a good earnings report (had other examples in this market of that happening). So let’s think this through- the stock closed over 30 right before earnings and the option was 2.65ish. If I expected a 10% pop, it had already moved 3% from the breakout level. 10% above closing price of ~ 30.50 would equal about 33. A 29 strike option at 2.65 assumed  a 31.50 price already so if I expected it to go to 33 that would make my option (so close to expiration) have an intrinsic value of 4 dollars. I was already at 2.65 so – follow me here – my likely additional gain on good earnings would be 1.35 and my downside was 2.65 on bad earnings (option value goes to or close to 0).

I am risking 2.65 to make 1.35 

Some of you might say “hey Chris you were risking 95c to make another 1.35. I would reply no, I had the 2.65 in hand that night and therefore I was risking that because I could have sold and pocketed the 2.65. In other words it was a similar risk scenario to buying an option for 2.65 expecting it to go to 4. Now you can argue that my expectations were wrong but I have to make decisions in the framework of my thinking and in my framework, I was expecting 10% pop on good earnings. I should have sold once I had that much gain before the announcement! I had most of my expected gain (2.65 out of 4) before risking the earnings call.

Bottom line: using my thinking framework I should have logically come to a sale conclusion. Would I change my mind if earnings popped the stock 20%? No that would just have made me lucky. My rational thinking should not be different. It’s a lesson I will carry forward: reassess risk/reward scenarios factoring in changing information.

At the time of this writing, I or my clients own the following investments mentioned in this column: Gold, NUAN call

Note: this article is meant to be some helpful thoughts to share and not investment advice specific to you. Please consult your own advisor regarding investment and financial decisions. See our disclosures page