Imagine a drunk man walking down a dark, rainy road one night after his car breaks down. He gets out, and begins a "random" walk along the road, looking for help. Neither you (the trader), nor he (the stock), can see anything - it's raining, and it's dark. The man stumbles along the road and your job is to predict his future path, and in return, you get paid money.
A lot of money.
Here's the problem: the guy is both drunk and blind (and probably just a little stupid) - he can't see anything and hence his movements are erratic. How in the hell can you predict where this idiot is going to end up? You have bills to pay, derivatives to price and insurance to sell. So you latch onto the closest thing that'll work - volatility (anchoring bias).
You use his volatility and assume that, dependant upon his past movements, and in turn his apparent level of drunkenness, you can, more or less, predict the possible range of his future random walk. This is a very useful model for predicting where he will be within the next 30 seconds. It works very well, and you make a lot of money.
It feels good.
Now you become confident. You start projecting it out just that little bit further, putting on more precise predictions with tighter spreads, and levering up your bets - because, of course, everyone else is competing with you and driving down your alpha. You have now mistaken past movement for the actual risk of movement - they are not the same thing.
Unfortunately for you, of course, the man has broken down on the edge of a steep cliff. He continues his random walk, blissfully unaware of his impending doom. You continue your bets on his volatility. I mean, why wouldn't you? You're king of the fucking world after all - in fact, not only are you rich, but you also have a Nobel Prize in Economics from a Swedish Bank!
Oops - too late. Your man has just fallen off the cliff, and you, and your savings, along with him. You yell inefficient markets, beta sucks balls, VAR is a trap, the CAPM is a lie and modern portfolio theory is fucking stupid. The last thing we hear, before that final, brutal, resounding thud is the faint line: "It was all a fucking lie."
You have just met real risk. It has not been a pleasant experience. Welcome to the real world.
This is just plain rhetoric and has nothing to do with real world trading. Anybody trading options who takes an outright view is doing it wrong (unless they have extremely good reason to do so).
The market is not dumb and prices volatility accordingly (hence a skew).
What you're talking about is a tail event - most sane option strategies protect against tail events (unless you're writing options and not covering your behind).
Most views via options are on spreads or on volatility where the maximum downside is known (in fact, betting in favor of a tail event is an extremely cheap strategy - via a strangle centered around the current spot - the deeply-out-of money options trade near zero while if a tail event does happen, you're entitled to a handsome payout - the max you lose is the amount you paid upfront - which might be as little as a few hundred dollars - essentially it's a lottery).
So even though your underlying stock may fall off a cliff, you wouldn't care if you had a sane option portfolio because what you get paid for is the distance covered by the drunkard - whether he covers it by falling off a cliff or going zig-zag ad infinitum doesn't matter.
Professional options traders prey on ineffiecent markets, never curse them. Beta and CAPM literally have nothing to do with options trading, pricing, or theory. VAR, like all models, is a trap. Options traders would know this; they are ingrained with a deep distrust of models since they forced to use them all day every day and understand their appropriate uses and limitations. It would be unreasonable to expect any serious options trader to blame her model or worse, "all of it", for failure.
A lot of money.
Here's the problem: the guy is both drunk and blind (and probably just a little stupid) - he can't see anything and hence his movements are erratic. How in the hell can you predict where this idiot is going to end up? You have bills to pay, derivatives to price and insurance to sell. So you latch onto the closest thing that'll work - volatility (anchoring bias).
You use his volatility and assume that, dependant upon his past movements, and in turn his apparent level of drunkenness, you can, more or less, predict the possible range of his future random walk. This is a very useful model for predicting where he will be within the next 30 seconds. It works very well, and you make a lot of money.
It feels good.
Now you become confident. You start projecting it out just that little bit further, putting on more precise predictions with tighter spreads, and levering up your bets - because, of course, everyone else is competing with you and driving down your alpha. You have now mistaken past movement for the actual risk of movement - they are not the same thing.
Unfortunately for you, of course, the man has broken down on the edge of a steep cliff. He continues his random walk, blissfully unaware of his impending doom. You continue your bets on his volatility. I mean, why wouldn't you? You're king of the fucking world after all - in fact, not only are you rich, but you also have a Nobel Prize in Economics from a Swedish Bank!
Oops - too late. Your man has just fallen off the cliff, and you, and your savings, along with him. You yell inefficient markets, beta sucks balls, VAR is a trap, the CAPM is a lie and modern portfolio theory is fucking stupid. The last thing we hear, before that final, brutal, resounding thud is the faint line: "It was all a fucking lie."
You have just met real risk. It has not been a pleasant experience. Welcome to the real world.