It's All About Leverage and Margin
The author is mentioning some low priced gold options:
"So, you're recommending the August $1,100 puts. That gets us out there far enough, decent premium, $500. The margin is less than 2 to 1. So, you're taking in about $500-600 for each one you sell. The margin requirement is about $800-900. It's a quite small margin requirement to hold this position, and it makes it quite easy to put in a portfolio. Once you put it on, if that value does start decaying, the margin requirement goes away with it. So, your margin requirement drops"
What Mt. Cordier forgets to mention is that if the position goes against you, the margin actually increases. It can double, or triple, in a very short time period. Also, one contract gives you control on $120,000+ of gold futures. Based on margin requirements, that's over 1:100 leverage.
The article implies that those strategies are almost free money. And then there is no mentioning of risks at all. ZERO. Anyone who was reading the article could see this coming. The writing was on the wall.
But the really scary part came about two weeks later.
Catastrophic Loss Event
On November 15, 2018, OptionSellers.com notified its investors in an email entitled “Catastrophic Loss Event” that it not only lost all their money, but that they would also owe money to Intl FC Stone for margin calls. According to OptionSellers.com, they lost a substantial portion of their investors’ assets due to a short call position in natural gas that, according to Optionsellers.com “was so fast and intense that it overwhelmed all risk measures in place.”
Mr. Cordier then informed investors that they have a debit balance in their accounts which they need to bring back to zero by paying INTL FC Stone the difference. So, in addition to trying to process the news all their money is gone, they also have INTL FC Stone breathing down their necks demanding they pay the money they owe for its margin calls.
According to Investors Watchdog,Tampa-based OptionsSellers.com touts itself as premier and highly experienced commodities options trading firm. The firm’s president and head trader, James Cordier, explained in a recent interview: “Our goal is to take an aggressive vehicle and manage it conservatively.”
Unfortunately, Mr. Cordier did not trade options conservatively. It traded “naked” rather than “covered” options, leaving investors subject to unlimited exposure. This unlimited exposure is what caused to lose all their money and more in the last few days. Thus, OptionSellers.com and its principals negligently engaged in a risky trading strategy that was unsuitable for its clients and breached its fiduciary duties to them by putting its interests ahead of its clients.
What Happened?
This is a pretty good explanation from Palisade Research:
James Cordier blew himself up by selling naked call options on Natural Gas. . .
Mr. Cordier with his expert financial opinion thought it was wise to sell naked call options on Natural Gas.
The thesis was that the 2018 winter was expected warmer than previously thought. And with the over-supplies of Nat Gas coming in from higher prices – Nat Gas would weaken over the next few months.
So Mr. Cordier made a bearish bet on Nat Gas by writing naked call options.
Remember – a naked call option is when a speculator writes (sells) a call option on a security without ownership of that security. It is one of the riskiest options strategies because it carries unlimited risk. . .
He thought that he could take advantage of the ‘peak’ natural gas price two ways.
First – since Nat Gas prices were up recently, he could sell options for higher premiums as bullish investors came in. Giving him more upfront profits.
And Second – he believed that Nat Gas prices peaked. And would soon turn south. Which meant the options he sold would expire – and he would be off the hook.
And at the very least – he didn’t think Nat Gas prices were set to go that much higher.
But they did. . .
Nat Gas shot up nearly 20% in a single afternoon last week – to its highest price since 2014. Some say that the added buying sparked a ‘short-squeeze’ – when a heavily shorted stock or commodity moves sharply higher, forcing more short sellers to close out their short positions.
Soon after the smoke cleared he had to break the news to investors and clients.
He sent a letter – and made a video apology – telling everyone about the unfortunate “catastrophic” situation.
The Numbers
Our contributor Chris Welsh provided some real numbers how those catastrophic losses were possible:
Traditionally you can get about 16x leverage trading oil futures contracts, based on the margin requirements (though with oils recent major drop offs those margin requirements are now higher). Using some actual older prices, this means to open a $90,000 oil and gas position, each account would have to only invest $5,610. So if an account had $56,100 in it, he could purchase a position worth $900,000. Then if the price of oil goes up 1% (and he's long) then his investment would go up close to 16%.
This is not abnormal, and exists in the normal option trading we do too. However, that is just really, really, really poor risk management to use that much leverage.
Which gets us back to those pesky margin requirements. Margin is NOT static. So If I bought that $90,000 position for $5,610 of margin, when the price starts moving against me, I have to put up more margin, because the risk to the position increases. It's not uncommon to see margin requirements double, or triple, in a very short time period.
Well his margin requirements went THROUGH THE ROOF. That $100,000 account now had a margin requirement of over $100,000. This means he's now subject to a margin call and has to either liquidate positions or put more cash up. He did neither, which means all those accounts got forcible liquidated....but after the prices had moved even more.
Now that $100,000 account has a value of -$50,000, of which the owner is responsible for putting up. And since these are separately managed accounts, that means each separate "investor" is responsible for their share.
These things only happen to people that don't understand risk or don't care or are idiots or are greedy idiots....or fill in your superlative here.
One of OptionSeller.com clients shared his statement for 1mln portfolio where you can see all his positions. The level of leverage is just scary.
Is Selling Options Really Superior?
In his interview from couple years ago, James Cordier said: "Once I realized that 80% of them expire worthless I started selling commodity options instead of buying them."
Not only this is factually not true (according to CBOE, approximately 30%-35% of options expire worthless), but this is also completely irrelevant, as we demonstrated in our article Do 80% Of Options Expire Worthless? This is an argument used by many amateur traders, and also by some options trading "gurus" to attract new subscribers.
Even if the "80% expire worthless" myth was true, it doesn't matter - if you gain little when options expire worthless but lose big when they go in the money, your bottom line is still negative. But the most important thing is that most options are not held till expiration.
Selling options has its advantages and disadvantages, so is buying options. It's not about the strategy, it's how you use it.
Saying that 80% of the options expire worthless is like saying that 100% of the people eventually die. "Experts" like James Cordier should know better. And maybe he does - but those claims definitely helped him to attract new money from people who don't know any better. The fact that those people are considered gurus and are featured on CNBC, WSJ, Bloomberg and MarketWatch is scary.
The Lessons
James Cordier is obviously not the first money manager who blew up his clients accounts (or experienced catastrophic losses). Victor Niederhoffer, Karen Supertrader, LJM Preservation And Growth Fund.. there are probably many others less famous.
Naked options by themselves are not necessarily a bad thing. The problem is leverage and position sizing. If implemented correctly, naked options can make money in the long term. But if you overleverage, you just cannot recover from the inevitable occasional losses. We warned our readers about the dangers of naked options and leverage on several occasions.
As our contributor Jesse Blom mentioned:
All 3 of these examples, and the newest one, share the common element of leverage. Excessive leverage, and also lack of diversification. Strategies like naked option selling work fine if you ignore margin requirement and view risk based on notional exposure. Parametric's VRP paper shows how a SPX naked strangle has been less risky than owning the underlying index when sized based on notional exposure. For example, that means selling 1 SPX strangle per ~$265,000 of capital today.
But in this case, James Cordier took commodity futures (NG) which is itself a leveraged instrument, and applied even more leverage using naked options. Here are the elements that contributed to the failure:
- Using highly leveraged instrument like Natural Gas futures.
- Writing naked options that have theoretically unlimited risk.
- Using leverage on already leveraged instrument.
- No diversification.
-
Using no hedging or risk management.
The result was disastrous and inevitable. It always is when someone is using extreme leverage like this one.
As one of our members wrote: "People see these crazy returns and think these personalities are doing something magical when really most are just levered to the hilt and taking dumb risk when there are several reasonable ways to hedge".
One macro hedge fund founder faulted both Cordier and his investors for the outcome. “The nature of the strategy is that you make a little bit of money until you blow up. The probability of losing it all is fairly significant. With derivative contracts — if you don’t understand them — you really need to give money to someone you trust, and to couple of them. Have some checks and balances.” OptionSellers.com “basically took advantage of guys who didn’t know any better. I instantly thought of my grandmother, my grandfather. I honestly was thrown when I heard about it.”
Conclusion
To add insult on injury, it turns out that James Cordier enrolled his clients into managed accounts and not a fund. This was the reason why his clients not only have lost all their money, but that they also owe money to their broker for margin calls. As Chris explained:
The media keeps referring to this as a "hedge fund." But that is NOT what it was. It was 290 separately managed accounts, all trading the same strategy. Whereas a hedge fund is an actual "company," typically a limited partnership or limited liability company, that insulates investors from losing more than they invest (unless specifically structured to make investors liable, which is VERY rarely done). The wheels started coming off here. Since these are block accounts, that means EACH client owns their own accounts and is responsible for them. So if he loses MORE than is available in the account, the account owner gets the bill....not the fund "manager."
Should we feel sorry for the Mr. Cordier? There is no sympathy from Josh Brown, the Reformed Broker:
Some people made me aware of how he was marketing this fund. He called it a retirement strategy. It’s not a retirement strategy, it’s speculation. I don’t feel bad for James Cordier, or his “clients.” Taking in premiums from selling calls – picking up nickels – and having no idea of the potential for a blow-up is the most childish thing I’ve ever heard. No, the laws of risk and reward are not repealed just because someone sounds sophisticated when discussing derivatives. Risk cannot be eliminated, only transformed. This man sold investors a lie. And now he compounds it with a new lie – “a rogue wave came along and capsized us!” GMAFB.
Google this guy’s sales pitch when you get a chance.
If your strategy bets on the movement of commodities and it isn’t durable enough to survive the movement of commodities, perhaps you have no business managing money in the first place. So no, no sympathy. Fuck you and your cufflinks too.
“The problem with experts is that they do not know what they do not know.”
― Nassim Nicholas Taleb.
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