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Even small investors should beware of counter-party risk

|Includes: American International Group Inc (AIG), GS

  The theoretical impact of a bankruptcy of AIG on "the system" (= Goldman Sachs) has been used to justify a Lot of intervention to prevent that event (or more properly, the recognition of that event). But the potential sting of a counter party failure is not just something that the Big Boys should worry about. Retail investors, too, could be in that position.

  As the relatively low VIX testifies, option premiums are low. Real low. I have been picking up out of the money LEAPS for nickels. But it occurs to me that someone is writing them. And not just to me. And if I end up being right, that someone is going to be losing, Big. And at precisely the time when most of their other assets and potential creditors are racking up losses, as well.

  Now, I am vaguely aware that financial institutions, of the sort that might be on the other end of my trades, practice the arcane science of "risk management" of some sort. But the last year of market history has taught me that that term frequently equates to "risk obfuscation" - they convince themselves, their shareholders, and their regulators (if such can be found) that everything's taken care of, when the reality turns out to be for from that. 

   The short version is, some of these guys may end up being effectively "naked".

  While I am getting pretty picky about who I do business with, in a liquid system, I cannot effectively control who they do business with. So it may well be that, when the time comes, the guy on the other end of my contract can't deliver. I fear a lot of financial institutions will be shutting down in the next couple of years, some with very little advance warning, and I don't want to be just another unsecured creditor in those lines. 

   Accordingly, I am not plannning to hold these puts I am piling up to expiration, even if they go deep into the money, and show signs of going deeper. Rather, I plan to sell them into any panics, collecting whatever time premium is still left on them. And then, in the words of another commenter, "take my profits and run like a little girl".