What options you might say are really for is managing risks. So that, for example, someone who owns a stock, suppose you are looking at a company, and you think it's very promising, so you wanted to invest in it. So you want to hold shares of a company. But you also have worries that the price could fall, and you would be left with nothing, could fall a lot. So you could buy a put option on the shares that you own. This is very common, and therefore, put a floor on your loss. You can't fall below the put option. If the stock price falls below the put option, the strike price on the put option, you just exercise the option and you're out. It cancels out your losses on the stock. But here's a basic question that I want to just kind of conclude mostly with this thought, and that is there's another way to insure yourself against losses on the stocks you own. It's something called a stop-loss order. Here's what you do. You call your broker and you say, "I have a thousand shares of Intel stock, and there were $31.63 today. I'm worried. I just can't sleep at night. I need some help." So instead of recommending a psychiatrist or a sleep aid, your broker says, "Well, why don't you just put a stop-loss order. Just leave it with me. I'm your broker. I have it under instruction for you that if the price ever falls below that's what do you name, give me any price." Then you say, "$20 a share." "Okay, I'm ready. I'll sell the stock whenever it falls below $20 a share." So then you can sleep easier at night, you put in a stop-loss order. So what's the difference between doing that and buying a put? This often puzzles people. Well, you might say it's better to put a stop loss order in because it doesn't cost anything. It's just a transaction fee. But there's no option price. You don't have to pay for an option that might end up worthless if the stock doesn't fall below the strike price. So why would you do that? Well, I think this gets into some technical details, and I'll tell you what it is. Suppose you told your broker to sell your shares of Intel when they fall below $20. Now, this broker is operating as a real human being in real time and has to make some, by probably, just fill your order. But what'll happen? The stock will be fluctuating, and it's gotten close to $20, and it dips down to $19. The broker say, "I better sell right now. I said I'd sell it 20." You're not going to get 20 exactly. If you have a stop-loss order, it merely says the broker starts trying to sell it at 20. So you probably get less than 20. So it didn't protect you fully. So suppose the stock falls to 19. And he sells your stock, and then it jumps up again to 21. Then what do you do? Well, you can tell your broker, "I guess it's not below the threshold I said anymore, so buy it back. " So the broker says "Okay, I'll buy it back." And then suppose the next day it falls to 19 again. You're faced with the same decision again. What do you tell your broker? "Well, buy it back." So we've just gone through two days where you both lost two dollars on a trade because you sold low and you bought high twice in a row. So that's why you buy a put instead of a stop-loss order. I'm not saying one is right and one is wrong, but I'm just saying that, ideally, you have to compare the option price with the losses you might make as I've just described in dealing with stop-loss order. Do you think options prices have a predictive power on the stock prices? Like, for example, can we sort of foresee a stock market crash by looking at the put options prices? Well, there's something else that the Chicago Board Options Exchange computes, and it's called SKEW, S-K-E-W, CBOE SKEW. It's computed also from options prices, but instead of looking at the second moment, the variance or squared standard deviation, they look at the third moment implied by options prices. So when put options, out of the money puts are getting expensive, that suggests that the market is worried about a crash. And the prices of those puts will go up. And then there's a tendency, ever since the 1987 crash, there's been a tendency for out of the money puts to predict to be expensive. If you want to protect yourself against a market crash, it's expensive. So, now, what you're asking is does a high SKEW index predict the next crash? Now, my thought on that, first of all, there's a literature. There's so much finance there. I don't know, I don't recall all of the information about. I seem to remember a paper about the CBOE SKEW index predicting volatility. But you're right. It sounds like it should be predicting a crash. I'm also thinking of a plot of SKEW. And since the SKEW only goes back to 1990 that the CBOE has published, and there were a couple of periods of high SKEW. One of them was in, I think, around the Russian debt crisis in 1998. And the market did take a tumble. Remember, SKEW is a 30-day ahead thing. You have to be careful whether the 30 days when the market tumbled, fell into the 30 days that it was forecasting. My guess is that SKEW might be helpful in predicting stock market declines of a short-term nature, but not necessarily in forecasting the big events that you care about. The really big stock market crashes didn't happen in 30 days. For example, the 1929 stock market crash is remembered everywhere. And people remember it as October 28, 1929. The bottom fell out of the market. But what they forget is that the market came right back up on October 30, 1929, and they kept bouncing around. The real decline took over almost three years. It was until '32 that it bottomed out. So you could have been investing in puts to protect yourself against the 1929 crash. And I don't know. I'd have to go back and do complicated calculations to figure out what doing a sequence of 30-day puts would have done. I suspect it might not have protected you. It's a complicated business. Once again, talk to your financial advisor and make sure you have a good advisor.
