31 March 2011

Danger of being short volatility

I usually try to avoid investment jargon and warn clients to be suspicious when they are bombarded with exotic terms that require at the very minimum an advanced degree in mathematics in order to be understood. I use the term 'being short volatility' in order to send a wake-up call to readers. In the ordinary course of investment it is recommended not to write naked options as the investor is exposed to an open-ended risk. Sometimes these option exposures are cleverly packaged (hidden?) in complicated structures that look perfectly innocent to the naked eye.