Investment Risk Guide - Part 6: Gamma
The thing about gamma, is that it is very different to all the other categories of risk. Here, we want to take high risk, we want to punt, bet big, do crazy things, because it might just work, and we could win the lottery. I always find it amazing that people prefer to only invest in low risk strategies and limit their return potential, not to mention miss out on so many opportunities. Maybe that’s why it works, but the fact is, the same rules of finance still apply: higher risk, means higher returns. And lest we forget, there are 5 other categories of risk to balance our exposure. Being optimally invested means we have to be on the efficient frontier on the risk curve, and that means we need a bit of everything, including the extremes. So let us free ourselves of any notions of restraint. Let’s see what we can get, if we are prepared and willing to take high risk.
Events, such as elections or corporate actions occur with frequent regularity. The one satisfying quality that entails, is that we know more on any such day, as it can only go one way or another. Speculating on events is quite easy in the current world of finance. Moreover, we can adjust the size of bet as a function of the odds the market puts on the outcome of any such event. Let’s say you have £1m in your overall investment portfolio and you want to put a trade on Brexit. The market makers are currently putting a probability of 25% that the UK will leave the EU without a deal. Given current implied prices on (OTM) options for Sterling versus the US Dollar, we could easily get 10 times our money if we get it right. Very importantly, it will only cost us the premium we put into the trade. If we were to risk a mere £10K on such a trade, we could get 100k for a return of 10% on our portfolio. If we lose, it only costs us 1%.
Such is the beauty of financial engineering and opportunities are endless, once we begin to structure our trades and seek diversification in the way we speculate. After all, we still need to get it right and if we bet on 10 things, rather than 1, it would certainly increase our chances of winning by a significant statistical margin. So, what are good bets to make? As with everything else, gamma risk wasn’t created equal. There are trades with a high probability of working out. The pay-outs are hence much smaller, but using financial derivatives and leverage, the returns can be much higher. Event driven, risk arbitrage or merger arbitrage strategies will produce very steady returns, until something goes wrong. Hence the risk, and the simple solution is diversification across many different situations or events.
Then there are the algorithmic, trend following or volatility-based strategies that quite frankly, very few people on this planet will ever understand (and that includes the ones that think they do). These models will work, until they won’t, and you just have to hope you are on the right side of the trade for as long as possible. There is a risk premium here, just on complexity alone, and the returns of some of these strategies historically can be in the hundreds and even thousands of percent per year. Venture capital is also a form of gamma risk. Many small companies fail or grow as expected, and we are taking a relatively large bet on a very uncertain outcome. In other words, gamma risk can be anything, as long as the returns are not driven by any of the risks we already have on in the other (risk) categories. And we want to have a chance of making excess(ive) returns. So free your mind, free yourself and happy hunting in the least constrained (and fun) risk category of all.