While trading options can be an incredibly lucrative exercise thanks to the underlying leverage, the practice is also wildly risky. With open-market securities, the most common risk is suffering a decline in paper value. On the other end, a paper loss in derivatives may wipe out your entire principal — or much, much worse for unhinged exotic strategies.
Given the dangers, it’s prudent to apply frameworks from risk-management disciplines, particularly the insurance industry. One popular and powerful methodology is known as catastrophe modeling or cat modeling for short. Essentially, this approach simulates natural disasters and develops exceedance probability (EP) curves — distributions that measure whether losses will be equal to or greater than a specified amount over a given time horizon.
