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Technology Stocks : Internet Analysis - Discussion -- Ignore unavailable to you. Want to Upgrade?

To: Steve Robinett who wrote (134)	2/8/1999 12:05:00 PM
From: Joe E.	Read Replies (2) \| Respond to of 419

Risk and reward do not go hand in hand except in the low risk to the middle ground of the cash-bond-stock market. At the riskiest end, risk is underrewarded, because of a significant portion of the "investing" population who need what you guys are calling a "volatility fix." Usually the riskiest end of the equity market are the penny stocks, where the bid-ask spread is often 50% of the bid price. In the institutional world there are certain tranches of mortgage-backed debt that fulfill this role. Anybody can create this same risk-reward profile (high risk, low reward) by trading in short term well out of the money puts and calls, where again the bid-asked spread consumes most of the investment before the market movements are considered. Some people simply want the juice. If you find yourself needing this, I recommend buying one lottery ticket. That's what I do. As to the risk of downward movements in stock price being the risk to be most importantly considered in analysis of internet stocks, why not use the implied volatility of LEAP puts at the asked price? This represents what the market is willing to pay to take the downside risk. (Yes, I know about put conversions, but that doesn't change the point IMO.)

To: Steve Robinett who wrote (134)	2/8/1999 12:19:00 PM
From: Reginald Middleton	Respond to of 419

That is the investor's primary fear. The risks in any investment situation are numerous, including the obvious risk due to market fluctuations. Can you think of any risk that does not result in the possibility of losing money? Credit, political, market/directional, franchise, strategic, business. The very reason any of these risks are assessed are to preserve capital. I repeat, losing money is the consummate risk. It can be framed in the context of oppurtunity costs, but it still boils down to the same thing. If I am wrong, give me an example of a risk that does not mirror the probability of losing money. < 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! > I thought we were referring to equities, not options. Regardless of which, tell that to the poor overconfident purchasers of portfolio insurance (basically put options) in the crash of 1987. The insurance looked good on paper with the volatility and all, but in the real world, many other real risks appear - such as in '87 when liquidity and credit risk reared it ugly head. Just last summer, many electric utilities used options to hedge thier energy portfolios and reality it hit them like a hurricane. Prices spiked, credit and liquidity risk became apparent left and right, and companies lost money. The rampant use of plain vanilla and exotic option hedging has actually been a catalyst for diversification related risks. Investors who wish to hedge in markets with significant movement (read volatility) compare the higher transaction costs associated with a volatile market with the tracking (comparable) risk in hedging in a correlated market. As long as the tracking risk is less than the actual transaction cost of investing directly in the volatile market, investors gravitate towards the correlated market rather than directly to the volatile market. The result of this behavior is markets that have increasing correlation. Areas that were considered relatively uncorrelated tend to move much more closely together. Voila, we now have correlation where many thought there was none. This diversification risk due to correlation spills over into the actual volatile market, exacerbating its volatility. Rapid movement in one direction tends to dry up liquidity and parties/counterparties start to default. The you know what hits the fan, and people realize that this risk stuff was much more than static volatility to beging with, ultimately teh real risk shows up, people LOSE MONEY. Of course it usually to late by then. Those are two quick examples of how the risks overlap and interrelate. This is not picked up in studying static historical volatility, yet it manifests itself clearly in prospective volatility and relates directly to investors risk, percieved and real. I am not saying that hedging with options does not work, but during extreme market moves where its benefits are needed most, it fails more often than expected - portfolio insurance is historical proof.