Palisade Research - Tue, Nov 20, 2018

'Blowing Up': How This One Fund Blew Up Overnight - And What We Can Learn From It

image of a businessman catapulted through the air

"The problem with experts is that they do not know what they do not know."
— Nassim Nicholas Taleb,

Giving you a little background - Mr. James Cordier ran the website - a Florida-based investment firm that specialized in writing commodity options for high net-wealth individuals. He's even authored a book about option selling that's in its third edition.

And all was well for him and his 290 clients - that is until a few days ago. . .

Seemingly "out of nowhere" - overnight - investors were wiped out entirely. Some even negative - meaning they actually owe money to the brokerage-house.

How did this happen?

Well, he blew himself up by selling naked call options on Natural Gas. . .

I'll explain. . .

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.

line chart of U.S. natural gas price since December 2017

Because of this - Mr. Cordier was insolvent almost immediately as the spot price of Nat Gas blew past the strike price for the options he wrote.

This now meant he had to go on the open market and buy a large amount of Nat Gas at higher spot prices. Only to turn around and immediately sell it all to whoever bought his options at lower prices (the strike price he promised via the options).

Putting it simply - he had to buy very high and sell really low.

Soon after the smoke cleared from his blown-up fund - he had to break the news to investors and clients.

He sent a letter - and made a video apology (you can watch here) - telling everyone about the unfortunate "catastrophic" situation.

He ends by telling them "I truly invested your funds like you were a family. . .I'm sorry this rogue wave capsized your boat. . . I wish you great luck and good health."

Of course he blames the Nat Gas 'short-squeeze' as a "rogue-wave" that he or no one could have possibly seen.

But at the bottom of all this mess - it was his fault for setting up a negatively asymmetric (high risk - low reward) trade. He positioned himself so that his upside was capped but his downside was unlimited.

This is why I constantly write about the danger of selling options - especially naked ones.

It's no different than picking up loose change in front of a steam-roller. You're risking so much for so little - that all it takes is one slip and it's fatal.

Sure - you collect the upfront premium for writing the options. And sure - the probability of a 'rogue-wave' event is very low.

But it's not impossible. And it's a lot more common than many 'experts' think.

Mr. Cordier fell for the Turkey on Thanksgiving problem - a concept created by former trader-turned-philosopher Nassim Taleb.

Imagine a turkey on a family's farm. . .

The turkey is fed every day and trots around in a roomy pen.

And as time goes by, it becomes use to how things are. It feels secure.

That's until suddenly the turkey is beheaded and eaten for Thanksgiving dinner.

The irony is that as each day went by, the turkey felt its risks declining as he got used to his everyday life.

But in reality, with each day that goes by, the risks were growing - meaning Thanksgiving neared all while the turkey grew fatter and more comfortable.

If you graphed this up until Thanksgiving, one would see an upwards trending line. In fact, you could use the past and fancy math to make projections of what will happen next year. Incorporating these inputs makes you feel confident that the trend will continue.

But then November 23rd arrives and suddenly it all 'blows up'. . .

Turkey Problem line chart of growing turkey well-being until thanksgiving day

"Consider a turkey that is fed every day," Taleb writes, "Every single feeding will firm up the bird's belief that it is the general rule of life to be fed every day by friendly members of the human race 'looking out for its best interests,' as a politician would say. . ."

. . ."On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief. . ."

And just like the Turkey - Mr. Cordier and his clients - got a rude awakening. Even more ironic was that this happened a week before Thanksgiving.

So what are the lessons here?

One - Don't set yourself up for negative asymmetry (high risk - low reward).

Making small gains at the risk of ruinous (although improbable) downside is not a sound strategy over the long term.

We've seen many great 'expert' investors and their funds blow themselves up because of this mindset - such as Victor Neiderhoffer (twice), Long Term Capital Management, and Bear Stearns.

Two - Always hedge yourself and don't risk more than you can afford to lose.

Unfortunately that's why many option sellers use leverage. Since their upside is small - they need to sell a lot of options to make meaningful gains. But the more they sell - the more danger they're inevitably in.

Three - Set yourself up to gain from volatility. Not get ruined by it.

Don't be the one selling options - but instead be the one buying them. This means you pay small premiums for the chance to make huge rewards.

Doesn't that sound better? This is known as positive asymmetry (low risk - high reward). And I've written about this often (click here to read more). These are the situations investors should take advantage of when they appear.

And finally: Five - Don't set yourself up to be the Turkey.

Just like the Turkey before Thanksgiving - Cordier felt more secure and increasingly confident each time he successfully sold options in the past. This gave him a sense of false confidence and pseudo-knowledge that he knew what the future held.

I hope Mr. Cordier's clients can still find a way to enjoy the holidays.

Although I'm sure it wont be easy. . . publishes interesting contributor articles in addition to its own content. We have not verified any of the above details.

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