Introduction

This is a short brief on the booklet “The Standardized Risk of Options Trading” and the problems that arose from the published material

in the booklet that led investors to a false understanding of financial instruments used for risk reduction strategies. Investors that used them

during the financial crisis, “paid more and got less” it is argued. In fact, more time was more wasted value.

In this brief, we indicate how the publication presents a disconnect from reality that led to substantial market

declines for investors who used these instruments and how they failed to protect investors.

You may download this booklet published by CBOE at http://www.optionsclearing.com/components/docs/riskstoc.pdf.

These opinions are my own. Comments may be sent to my email address at brett@brettfleisch.com.

The Basics

Please begin by examining page 59 of the document where the use of options is described in the detail and the description of their financial “purpose” is explained.

The basic use of the “PUT” option as a hedging strategy is explained in simple terms. The “academic” explanation of the value of using put options in hedging is expounded

on in detail. Please read the section carefully and digest what the document explains about how put options reduce risk in financial portfolios. The booklet goes further

to explain that longe dated put options provide more protection to the first time investor because they are more expensive longer-dated financial hedge

to a position in an investor's portfolio. The use of the put option to protect the underlying stock implies “if you buy more time you get more protection” and more reduction

of your financial risk.

Margin Trading Accounts

Margin trading accounts allow more sophisticated investors to purchase stock and borrow money against the stock to create “so-called” financial leverage.

The SEC and trading houses require that the value of the stock compared to the debt be at least 30% over the the value of the debt in the portfolio. The brokerage

house / and or listed exchanges have margin requirement for individual stocks that vary and so the 30% that is required to be maintained in many margin accounts

is listed as your “maintenance requirement”. For example, TDAmeritrade has a tab one may click on to determine the maintenance required for all the positions in

the account by simply clicking on a tab in the “balance and positions” tab.

Each day, if you trade daily, weekly, monthly and you borrow some of the brokerage house's money to create leverage in the

investment, the financial value of your portfolio is computed and calculated to assure the portfolio has sufficient

equity capital as required by regulators and the brokerage firm itself. The investment house and/or SEC generally require

investors to have 30% equity in the portfolio.equity of the total account is computed to be roughly 30%

(depending on the calculations of individual stocks maintenance for those stocks with higher maintenance requirement). This value is computed daily and any value less than the

“maintenance requirement” places the investor in a “Margin call” that requires immediate action (selling assets to reduce debt, or deposit funds to reduce debt).

PUT OPTIONS in Margin Trading Accounts

The booklet “The Standardized Risk of Options Trading” gives the investor a simplified presentation that roughly presents the

simplified notion that PUT options protect a portfolio and reduce risk.

This note contends that PUT options have failed to reduce risk in a financial portfolio, increase cost to the trader, have failed to deliver the risk

reduction when used with the underlying stock trading and contributed to larger financial losses to individual investors that used them in decling markets.

The simple examples in the “The Standardized Risk of Options Trading” booklet disconnect from the real world because it appears that academics wrote the

booklet without an understanding of how many brokerage houses manage the investor's portfolio.

PUT Options and Financial Risk Reduction

The use of PUT options is to reduce financial risk and the use of time-value associated with the PUT is supposed to increase the length of time the put option protects the

underlying asset in the investor's portfolio. The assumption is that an investor who pays for a more expensive and longer dated put, gets protection for a longer period

and reduces financial risk during periods of decline in the underlying assets value. For short periods of volatility, the analysis presented in the booklet would seem to make

sense. For longer swings in volatility it would appear longer dated more expensive options should be purchased by the investor.

Brokerage House Management of Investor Accounts

Many brokerage firms manage individual investor accounts with logically two subaccounts. One is the margin account. The other is the account called the “cash side”

of the investor's portfolio. Options, for example, are placed in the cash subaccount because all options must be fully purchased from funds and may not be margined.

An investor that fails to understand this and who reads ““The Standardized Risk of Options Trading” might otherwise assume there is a linkage between the investments

in the margin ledger with the cash investments used to hedge the margin side of the account and this disconnect has consequences explained in the next section.

Steadily Declining Markets and Financial Risk

When a position in an investor's margin account decreases in value the “The Standardized Risk of Options Trading” booklet would seem to imply that

the PUT instrument would protect the position from the decline in value. Steadily declining markets presumably could be hedged with PUT options that

would protect the investor over a period of time specified by the PUT according to the “The Standardized Risk of Options Trading”. Unfortunately, due

to the relationship between the cash positions and the margin positions being in separate subaccounts, in many cases PUTs fail to deliver the risk reduction

promised. A margin call will be issued when the underlying asset declines in value. Consequently, the investor has a choice 1) sell some of the underlying

stock or 2) hold the stock and sell the put against the stock to come out of the margin call. This choice is immediate at the time of the margin call and consequently

the put options must be sold that one purchased to protect the underlying position. In many cases, even the longer-dated puts would need to be sold immediately.

However, the “Standardized Risk of Options Trading” seems to suggest that having purchased long-dated puts would protect a portfolio for longer period of time.

Instead, they are more costly and are not correlated with the length of the time specified.

Consequences

During substantial market declines, PUTS have failed to protect investor positions and more costly puts in fact “cost more, protect less”. We believe the PUT option

must be a risk reduction rather than increase cost hedging instrument as intended in their design. However, the implementation of the design as shown above did

not match the reality of the implementation and drove investor to increase purchases of PUT options that failed to protect a margin account's position in a steadily

declining market.

Alternate Strategies

ThinkorSwim has devised a system that links the length of time of the put with the underlying investment called “portfolio margining”. Puts work properly

when this strategy is used. We encourage investors at TDAmeritrade to lobby for

portfolio margining to be carried forward in investor accounts. We also, believe, as a personal opinion, that SEC regulators should observe that

there was a disconnect between the published materials in “The Standardized Risk of Options Trading” and real world trading accounts that led to a circle of

continual purchase of PUTS after declines, that failed to work, that failed to protect accounts as the hedging instrument was designed to do.

Your comments to brett@brettfleisch.com are welcome.