Why Options? (Part 2)

I’m just getting started with a new blog series aiming to make the case for options trading.

Options are tradable instruments of value that represent rights to ownership or sale of the underlying stock or future.

I do not believe society’s fear and reluctance toward options can be understood without knowing about the debacle of Long-Term Capital Management (LTCM): a hedge-fund management company that employed options in its trading portfolio. On the LTCM board of directors were Myron Scholes and Robert Merton, who shared the 1997 Nobel Prize in Economics for a new options pricing model. Over its first three years, LTCM posted net gains of 21%, 43%, and 41%.

In 1998, LTCM lost $4.6 billion over a 4-month span. LTCM did business with many key financial firms. Wall Street feared a LTCM failure could cause a chain reaction, which might cause catastrophic losses throughout the financial system. As a result, the Federal Reserve supervised an agreement among 16 financial institutions for a $3.6 billion bailout.

While being supervised by the very deans of options pricing (Merton and Scholes), the trading approach failed!

From http://www.nytimes.com/2008/09/07/business/07ltcm.html?pagewanted=print: “A financial firm borrows billions… to make big bets on esoteric securities. Markets turn and the bets go sour. Overnight, the firm loses most of its money… Fearing that… collapse could set off a full-scale market meltdown, the U.S. government… encourages private interests to bail it out. The firm isn’t Bear Stearns — it was LTCM… and the rescue occurred 10 years ago this month.”

“The LTCM fiasco momentarily shocked Wall Street out of its complacent trust in financial models, and was replete with lessons… But the lessons were ignored, and in this decade, the mistakes were repeated with far more harmful consequences. Instead of learning from the past, Wall Street has re-enacted it in larger form, in the mortgage… credit crisis.”

The financial industry sends a clear message: trading options is like making a deal with the devil.

Is this understandable based on the historical arrogance and mistakes of highly-respected professionals?