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There's No Such Thing as Free Money

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This week brought a sad tale about the collapse of a Commodity Trading Advisor called Optionsellers.com that completely wiped out the accounts of 290 customers and threatens to leave those clients on the hook for additional losses over and above the previous cash value of their holdings.

A surreal video that featured the head of the firm, James Cordier, making a tearful apology for losing all of their money quickly became fodder for email comedy in the professional trading community. Cordier’s choice to wear French cuffs and a Rolex watch while recording his mea culpa certainly cast doubt on his sincerity.

It’s a nightmare situation for those who had invested with Optionsellers, but it’s also a cautionary tale for anyone who trades options. In short – there’s no such thing as free money.

Until recently, the strategy employed by Optionsellers appeared deceptively simple as well as highly successful. The trade that took them down was naked short selling of calls in Liquid Natural Gas. This strategy delivers outsized returns in all market conditions except a sharp rally, and the profits can roll in for years, lulling investors into a false sense of security about the soundness of the approach.

The minimum investment at Optionsellers was $250,000 and some accounts may have been worth up to $10M prior to the collapse.

Last week, the biggest one day price move in natural gas futures in eight years put all of those short calls in the money and their value exceeded the cash in the accounts. In cases where the net liquidating value of an account becomes negative, the standard industry agreement would allow the clearing firm, FC Stone, to suspend customer trading and immediately liquidate any or all positions held at its sole discretion.

As is common in CTA agreements, customer accounts were margined separately, meaning if losses exceed the value of the account, the clearing firm handling the accounts can pursue the customers for the debit balance in their accounts after all holdings have been liquidated.

Cordier described the rapid price movement in Natural Gas futures as a “rogue wave” that capsized the boat, but in reality, these types of events are far less rare than they might appear. The collapse of Long Term Capital Management and two spectacular blowouts by formerly lauded hedge fund Manager Victor Niederhoffer were also caused by the failure to anticipate a seemingly unlikely chain of events that ultimately occurred anyway.

In those cases – as well as the Optionseller debacle – once the clearing firm decides to liquidate the holdings by buying back short options, the prices they end up paying are often absurdly high because they’re buying the entire position, all at once, in a market that has no natural inclination to sell.

Also, once competitors smell the blood in the water, they tend to quickly raise their offered prices on the contracts in question, safe in the knowledge that the buyers have no choice but to pay up.

This is the important lesson. If a money manager offers gains that are in excess of what you could earn elsewhere while also claiming that those returns don’t involve increased risk, run away. This can be especially difficult when family or friends have already invested with the firm and are extolling the virtues of the manager with the magic touch who’s making them buckets of money.

Cordier’s video includes references to hockey games, fishing trips and visiting the French Riviera, subjects that he had apparently discussed with his former clients – all the trappings of a wealthy life.

The longer the returns last, the more comfortable and confident investors tend to become, making them blind to the existence of those not-so-rogue waves.

Unfortunately, there’s a good chance that manager is simply “picking up nickels in front of a steamroller.”

Not All Options Selling is the Same

In the Know Your Options feature, I’ve previously explained several strategies that involve selling options.

Aren’t these just as risky as Optionsellers’ approach?

No.

I’ve described covered calls – selling calls on shares of stock you already own. “Cash-covered” puts – selling puts on stocks you’d be willing to own if the price declines and for which you have the strike price of the options available in cash in the account in the event you need to make the purchase. And we’ve looked at spreads that involve buying at least as many options as you’ve sold.

In each of these cases, we know the maximum risk associated with the trade. Selling options “naked” in the hopes of collecting the premium if nothing goes wrong is a long-term losing strategy disguised as free money. You might be able to collect those premiums for a while, but when that rogue wave appears – and it will appear – you’re going to get wiped out.

When trading options it’s vital to know exactly what your maximum risk is and to trade at a size that means that if you incur that maximum loss – and sooner or later, you will, trust me – that you live to trade another day.

Also, stay well clear of any manager who promises to fund your retirement in the South of France with his low risk income strategies. His gold watch and cufflinks didn’t buy themselves…

 

 




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