Reg,
You comment, The investors primary risk is that they will lose money
That is the investor's primary fear. The risks in any investment situation are numerous, including the obvious risk due to market fluctuations.
You also comment, Raw historical volatility has failed on many occasions to manage risk in the REAL WORLD. Again, depends on the risk. (Also depends on who's doing the managing.) A major pricing component of options is the volatility of the underlying issue. Options are used quit successfully to hedge portfolios against market risk--that's why they exist, for Heaven's sake! They hedge changes in price and changes in price are how investors lose that money.
In addition, you comment, Before we go on, I think it is imperative that you see risk as the investor sees it, loss of capital, as compared to fluctuation in that capital which includes reward. It is the mother's milk of investing that risk and reward go hand in hand. Since people buy stocks long and also short stocks, they sell both puts and calls to hedge against those positions without risking loss. More importantly, volatility typically declines as a stock rises in price and shoots up as a stock falls, an expression that investors see the issue as less risky and will consequently take less of a reward for owning it.
Understanding volatility beyond the superficial repays the effort, certainly more than making qualitative (subjective) assumptions about risk. If we define risk specifically, we might actually wind up understanding something about it.
Best,
--Steve |
