Risk, Probability and Psychology

It is important to remember that risk depends on the skills of a specific trader. Risk is all of the things outside our control. So traders with different sources of edge will have different remaining risk factors. If I have an edge in volatility prediction and you don't, volatility is my edge and your risk. This is true in most of life. For a heart surgeon, doing a bypass is a low risk operation. For me, it would be murder.

But before we get to specific risks and edges, we need to know why there should be an edge at all. The EMH isn't strictly true but it is still very hard to make money. Why should we be able to do that? 

One reason is that people are exceptionally poor intuitive statisticians. Even when they are intellectually aware they are doing the wrong thing, they often let their gut over-ride their brain. If the intuition is vivid enough and comes readily to mind, it feels subjectively true even when we know it is objectively false. As Reagan said during his Iran-Contra testimony, “A few months ago I told the American people I did not trade arms for hostages. My heart and my best intentions tell me that's true, but the facts and evidence tell me it is not.”

All investing is probabilistic, but options are exposed to probability in pricing and payoffs as well as in any forecasting we do. Most option traders don't understand these specific exposures. It is common to conflate delta with probability or to make inferences of real probabilities from risk-neutral distributions. These are just wrong. So, given that many traders misunderstand option specific probability issues and also that most people can't help reasoning incorrectly about probability in general, if we can avoid these errors we can find an edge in options. 

We still need to find one. But at least we have a plausible reason for why there might be one.

In the land of the option traders, someone who understands probability can be king.