Search the Community

This is particularly true in the current markets. We are seeing a rise in people who think they are trading geniuses and new funds launching, just as we saw in the late 1990s. In the United States, we are currently in the largest bull market in HISTORY. If you invested in almost any 100% long strategy, you likely have made money in the last ten years. (In fact, if you haven’t made money over the last ten years in a long stock strategy, quit). A prolonged bull market like this can lead to certain strategies developing track records of five, seven, or even ten years that look quite successful – when in reality they are merely a function of a prolonged bull market. Consequently, they carry excessive risk. By way of example. I had a long-term client, past retirement, that was quite well off. Our firm had him in hedged positions and conservatively invested. In order to maintain his current lifestyle, he needed a withdrawal rate of between one and two percent per year – well below the threshold considered safe by most advisors. He was the textbook example of a “low risk” client. That said, his son convinced him that we, as his financial advisors, didn’t know what we were doing because his 3x to 5x leveraged FANG fund had been returning over 100% per year for several years in a row. Over my strenuous objections (even offering to help transfer his accounts to another competent advisor), he took his money and invested in a strategy that had a track record of over 7 years of returns of 25% or more every year. The argument was “this fund returns this every year. Why aren’t you putting money into a fund such as this? Don’t you know what you’re doing?” As a firm, we did everything we could to convince him that he was risking his retirement chasing returns without understanding risk. He made the move in the second quarter of 2018. With the vast majority of his capital. From July 2018 to December 2018, stocks like NFLX were down over 30%. This was a problem if the fund was using 3x to 5x leverage, because the funds were bankrupted. In other words, a track record of five to seven years making amazing returns went bankrupt in a matter of a few months. (Such a strategy could have been bankrupted in a few days at any time). Unfortunately for this investor, his future moving forward looks quite different. This is because the strategy had not been back-tested and not vetted through different market conditions. He didn’t ask the right questions, nor did he even know the questions to ask. When a new fund is created, at least by our firm, or when we want to create a new fund or strategy the typical process is (with some variance depending on the strategy): Come up with idea and mathematically test it; Put it through extensive Monte Carlo testing; Back test it across multiple market conditions, using actual rules (in order to have an effective back test, there MUST be firm rules followed, “judgment” calls cannot be used); Then we try to blow the strategy up. In other words, do everything we can to develop theoretical market conditions that will destroy the strategy including assuming 100 down days in a row, having volatility plummet, and then go to an all-time high, and collapsing commodity prices. If we can find things that hurt, adjust accordingly or develop a plan for how to handle the change. We also make sure there won’t be volume issues. Then we attempt to figure out how big of a market impact the strategy can withstand. This is done through a volume and price movement analysis. If we want to trade the market indexes, we can likely plan for hundreds of millions in trades fairly easily. If we want to trade options on VXX —- well, good luck with anything over $100,000; We then paper trade it for ideally a minimum of six months, preferably a year; and We put our own money into it, along with trusted individuals that understand the risk, and live trade it for, again ideally, a minimum of six months, preferably a year. If, during paper trading and live trading, we have had different market environments, we develop higher confidence. If we haven’t had market swings, volatility swings, rapid moves down, slow moves down, rapid moves up, slow moves up, etc., we have less confidence in the strategy and will need to make appropriate risk disclosures. That said, if it is a prolonged bull market, it is not rational to wait until the strategy has actually had live experience in all market conditions. If that was the case, advisors might have had to wait for over a decade before starting. Not good for business. But that does mean those advisors need to EMPHASIZE these risks to investors, and they should have a multi-pronged strategy on what to do when things don’t go as expected. Potential investors should ask about the plan for how to handle different market conditions. This is particularly true if the strategy has not been through a variety of conditions. Even then, I don’t care how much advisors have tested, back tested, thought about, and modeled, when market conditions change, advisors and investors alike are likely to be surprised by the results. Maybe in a good way, maybe in a bad way. Investors should always be warned about what the maximum theoretical loss is when trades are live. (For a 100% long portfolio, even with stop losses in place, the maximum theoretical loss is always 100%). Discussions should be had under what conditions those max losses could occur. An advisor should be able to give an opinion on how likely they are (with appropriate caveats). Once the above is done, advisors should write it all up in a format acceptable to investors. Risks should be emphasized and discussed, not hidden. To many funds attempt to hide risks instead of disclosing them. When looking to invest in a fund, always ask questions. Always be sure you understand the risk. And no matter what, never, over allocate to one fund or strategy. Christopher B. Welsh is a SteadyOptions contributor. He is a licensed investment advisor in the State of Texas and is the president of a small investment firm, Lorintine Capital, LP which is a general partner of two separate private funds. He offers investment advice to his clients, both in the law practice and outside of it. Chris is an active litigator and assists his clients with all aspects of their business, from start-up through closing. Chris is managing the Anchor Trades portfolio.

Whenever I see trades that I’m not necessarily executing, but that I feel will give my Cabot Options Trader subscribers a feel for market tone, a trade idea or, if nothing else, a bit of options education, I email them a feature I call, “Stocks on Watch.” Here is an options trade made on June 12th which is a perfect example of how hedge funds use options, from a recent “Stocks on Watch”. Stocks on Watch: Workday (WDAY) As I’ve written several times in the last week, option order flow has turned mixed. In fact, all five days last week, bullish and bearish trades were split nearly 50/50. This, along with the many upcoming global events, has kept me from adding new bullish positions. However, this morning a trader opened a massive bullish position in Workday (WDAY). Here are the details of the trade: Buyer of 12,500 WDAY January 110 Calls for $23.70 – Stock at 126 This trade is interesting for a couple of reasons. The $29.6 million of money at risk is clearly a large amount of premium bought. And is the largest single call buy that I can remember in the last month. Also, with the stock trading at 110, this trader is buying deep in-the-money calls. So why would he pay such a high premium vs. buying calls at the 130 or 135 strike for significantly less? The answer is all about leverage. With this purchase, the trader risked $29.6 million in premium. However, he has big upside potential as he is buying-in-the-money calls, which will move almost one for one with the stock. If WDAY stock goes up $2, these 12,500 calls will go up nearly $2. He essentially controls 1.25 million shares because the calls are so far in-the-money. If the trader wanted to have similar exposure through a straight stock purchase, 1.25 million shares would cost him approximately $157 million. So the trader gets similar upside exposure to WDAY with the purchase of the calls, but with $127 million less at risk. Typically traders execute this strategy if they have high conviction that the stock is going higher. Choosing which expiration date and what strike to purchase when evaluating calls and puts can be overwhelming for beginner options traders. There are seemingly endless choices. My general rule is that if you don’t have high conviction in a stock’s direction, buy slightly out-of-the-money calls/puts. This reduces your dollars at risk in case your stock thesis is incorrect. And if you have high conviction in a stock’s direction, much like the WDAY trader, buy in-the-money or at-the-money calls/puts. And in the past year we have seen similar deep in-the-money trades in Micron (MU), Alibaba (BABA) and Square (SQ). And buying in-the-money calls is a favorite strategy of legendary hedge fund traders David Tepper, George Soros, Carl Icahn and Warren Buffett. This WDAY trade is what makes the power of options so intriguing. When you use options, you risk pennies to make dollars. Or in the case of hedge funds and institutions, millions of dollars to make many millions of dollars. Jacob is a professional options trader and editor of Cabot Options Trader. He is also the founder of OptionsAce.com, an options mentoring program for novice to experienced traders. Using his proprietary options scans, Jacob creates and manages positions in equities based on risk/reward and volatility expectations. Jacob developed his proprietary risk management system during his years as an options market maker on the Chicago Board of Options Exchange and at a top tier options trading company from 1999 - 2012. You can follow Jacob on Twitter.

Here's the criminal case against him, and the Securities and Exchange Commission press release and order. I have to say, it sure sounds like Canarsie's risk management was terrible. And prosecutors and the SEC make out a fair enough case for fraud, in that Li submitted fictitious trades to his prime broker to get more margin, and lied to investors about his performance in some months. But that stuff doesn't seem closely related to the actual blow-up, which was achieved in the time-honored way of putting all the money into risky options and hoping for the best: Beginning on or around December 31, 2014 and continuing through January 15, 2015, Li used cash in the account and proceeds from stock sales to buy long positions in market index options. Virtually all of these purchases were in long call options with an expiration date of January 17—in other words, short-dated long options. At the same time, Li took down and eventually eliminated all short positions in the account. The result was an entirely long portfolio with no hedge. On January 16, the market for index options moved against Canarsie’s positions, resulting in losses of approximately $39 million (approximately $28 million in expired premium and approximately $10.5 million in trading losses), leaving the Master Fund with no equity, short or options positions, and only $211,685 in cash (plus approximately $289,568 in its bank account). As a result of Li’s risky trading, Li caused the Master Fund to incur approximately $56.5 million in losses between December 31, 2014 and January 16, 2015, substantially depleting all of the Master Fund’s assets. I often tell you that, if you have material nonpublic information about a merger, you shouldn't use it to go buy short-dated out-of-the-money call options on the target. But buying short-dated call options with all of your investors' money with no information, as a pure gamble for redemption, doesn't seem great either. In other words, don't invest 100% of your total net worth in a short dated out of the money call option that expires next week. You just might go broke.