Right around the time when I wrote my options selling update a few weeks ago was when everyone in the option seller circles talked about the blowup of OptionSellers.com. Option Sellers, LLC was a Tampa, Florida based Registered Investment Adviser and CTA (Commodity Trading Adviser). They managed money for 290 clients. Considering the minimum investment was $250,000 and most investors likely had more money with them, I’d surmise that they were managing around $150m. On November 15, 2018, they informed their investors that not only was all their money lost but that clients would likely owe more money. Wow, let that sink in: they had a loss of more than 100% and clients are left with debts they have to cover now! Bad news for the clients who invested all their money with OptionSellers!
A failure of a small obscure adviser probably would have stayed under the radar but the co-founder published a tearful apology video, confessing that all customer accounts were wiped out “by a rogue wave.” The movie was since taken down – probably the lawyers didn’t like the idea of this kind of mea culpa so much – but it’s still available on YouTube. The story went viral (or at least as viral as something as obscure as options trading can go) and was then picked up even by the national news media, including the Wall Street Journal, CNBC and many others.
Quite intriguingly, their strategy imploded over the span of just a few trading days. And just to be sure, this wasn’t fraud a la Bernie Madoff but investors actually lost their money “fair and square” if there is such a thing. Is this something all option sellers should worry about? Yes, if you are as reckless as Option Sellers. If you had bothered to check what these clowns were doing it was clear that this debacle was all but unavoidable. Let’s take a look at what they did and the five obvious mistakes that lead to the meltdown…
Quick Recap: what were they doing?
Well, it’s in their name; they were selling options. Option Sellers quite correctly pointed out that most options expire worthless and option buyers tend to overpay for the insurance value of the options they purchase (on average, at least). Option Sellers made an investment strategy out of this well-documented observation and implemented it through what’s called a short-strangle: selling both a Put and Call option with the strike prices spaced out so that the put strike is (significantly) below the call strike price. The P&L profile of this strategy is below. If the price of the underlying stays between the two strike prices you make the maximum profit at expiration!
OptionSellers did this strategy for a wide range of options on commodity futures contracts (oil, gas, gold, soybeans, etc.). How did they blow up then? Very simple, the short strangle involves a short call option and the potential loss of that position is unlimited. In November, Natural Gas future spiked and created a loss large enough to wipe out the entire equity. It’s that simple. It has a similar flavor as the Credit Suisse Short-VIX ETN (Ticker XIV, now defunct) that I warned about in 2017 and that indeed shut down in February after it lost more than 95%. Most of that in one day!
End of story? Well, even a risky strategy like that can be managed properly by experienced finance professionals if they act responsibly. But the folks at OptionSellers did not. Here are the five steps that blew up the Option Sellers strategy:
1: Ignore the Option Greeks, especially Delta, Gamma and Vega!
I’m not really too surprised when retail options traders are completely oblivious to option math. But it’s astonishing when professional money managers ignore simple option math, too. For example, Option Sellers marketed their approach with the compelling spiel “Hey, the underlying simply has to stay within the two strike prices and we make the maximum profit!” Just look at the payoff diagram above, right? Wrong! Anyone with even a little bit of options trading experience has to cringe hearing that. It’s demonstrably false and here’s the perfect example: I got the portfolio snapshot from one poor twitter user @waklyn1 who posted his actual positions, see this link to his Google Sheet. I noticed that the Natural Gas futures price never even went beyond most of the strike prices. The futures price went to about 4.75 on November 14, while the short call strikes were mostly above $5, some even as high as $6.50. How did they still get wiped out? Let’s take a look at the P&L diagram below. It’s for one particular short call option with a February 2019 expiration and a strike of $5.25. On November 8, this contract was trading at $0.05, and if this contract had been held to expiration the maximum profit would have been 10,000 times that amount, equal to $500.00 (that’s because the underlying futures contract has a multiplier of 10,000). On the x-axis, I plot the price of the underlying and on the y-axis the P&L of the short Call, see below. Notice something? The underlying never even breached the strike price of $5.25, but the short position still racked up massive losses of about $7,000, which is about 14 times the maximum one could have earned if held to expiration.
So, this is the dirty little secret that OptionSellers didn’t mention in their sales pitch: The underlying doesn’t have to move beyond the strike prices and you still lose your shirt. That’s because prior to the expiration, the option price doesn’t give a damn about the blue P&L line at expiration. Instead, your P&L moves in response to changes in the underlying through the three major, relatively predictable channels, related to the option Greeks:
- for every point the underlying moves up, your short Call loses a certain amount (option Delta),
- this option delta increases, so the losses become successively more painful the higher the underlying moves (option Gamma), and
- in stress periods the option implied volatility moves up (option Vega), which further exacerbates the losses of the short call.
Not knowing how quickly the short call can rack up losses and only praying that the underlying doesn’t move past the strikes is a recipe for disaster!
Solution: Know your option math! It’s not that difficult. I recommend the book by Robert Whaley (paid link), which has been my standard reference for anything derivatives-related. What’s nice about the book is that it comes with an easy Excel plugin that calculates all your option-related stuff, like implied volatility and the option greeks. I use this every week when I do my options trading and when I build my risk models.
2: Use way too much leverage
Warren Buffett warns that three things will have the potential to wipe out your wealth: Ladies, Liquor and Leverage. Just as a side note, that’s funny because Buffett himself uses leverage to juice up returns as pointed out by the smart folks at AQR:
“One of the ways that Berkshire Hathaway was able to add so much return above that of the market is Berkshire’s access to cheap leverage via its insurance business, allowing it to harvest greater amounts of these style exposures than most traditional investors could.”
So, clearly, Buffett isn’t against leverage per se, just against too much leverage. And I couldn’t agree more! How much leverage were they using at OptionSellers? Again, back to the poor twitter user I mentioned above. He had around $400k with them but in his Google Sheet, he scaled up the positions to mimic the positions of a $1,000,000 portfolio. Not sure exactly why he did that, but so be it. The Option Sellers strategy piled up a spectacular loss of a just a little bit over $1,000,000 in the trading days between November 8 and November 14. It looks like the short Nat Gas call options were all forced into liquidation by the exchange on November 14 when the large jump in Nat Gas occurred.
But let’s go back to November 8, when everything still looked up and up. The account had 244 short call options and 26 long calls on Nat Gas. That means the $1,000,000 in equity had to be stretched to cover a net 218 options, which leaves only around $4,600 in equity per short call option. And this doesn’t even count the other options on the other commodities with similarly crazy leverage! In any case, we saw that the option with the 5.25 strike went to a $7,000 loss. With only $4,600 per contract in the account, it was lights out on November 14! The options exchange forced the liquidation.
Solution: Use less leverage! A lot less! I would argue that the account had at least 20 to 40 times (!) the leverage that a responsible option seller would have used. $4,600 of margin cash per short call option is just way too little, especially for something as volatile as Nat Gas. The great irony in this story is that without the margin call and forced liquidation of the positions on 11/14, the short call options might eventually turn into a profit again! The February 2019 Future retracted again as was hovering around $3.50 at the time of publishing this! If they had used only 10 short call options (less than one-twentieth of the leverage), it would have been painful to see a $70,000 loss on November 14 (7% relative to the $1m portfolio), but the portfolio would still be alive today and have the potential to even make the maximum profit by the expiration date.
3: Have a risk model but totally ignore it (especially when times get tough!)
The co-founder of OptionSellers.com claims to have developed a risk model. He even wrote a piece on SeekingAlpha.com to detail his approach. Now, considering that James Cordier ignores option math (see #1 above) I wasn’t too hopeful that he’d come up with anything intelligent in the realm of risk management. But considering the circumstances, his general idea wasn’t even so bad! He suggested that if you trade short strangles in 10 different commodities, simply assign a risk budget of 5% to each commodity and keep an additional 50% of the principal as a reserve. Seems reasonable: If there’s a “rogue wave” in one of the commodities if wipes out no more than 5% of your capital.
So, were they even sticking to their naïve risk model? Apparently not! The risk budget for Natural Gas would have been only $50k (=5% of $1m), which amounts to just about $230 per short Call option or about a $0.023 move in the option price. That $230 loss was breached on November 9, it had grown to $460 on November 12 and $1,700 on November 13. They already needed to cut their positions as early as November 9, and certainly on November 13. But they didn’t! They had suffered some moderate losses by November 12 and significant losses by November 13 and they likely wanted to recover the money, risk model be damned! They abandoned their risk model exactly at the wrong time!
Selling options and just praying and crossing our fingers that the price will hopefully never move beyond the strike probably works fine most of the time. But not in November. Obviously, the solution is to have a proper risk model and stick to it. If I had to implement their strategy I’d do so by doing a vertical spread rather than a naked short call. In a vertical spread, you’d still sell a call at, say, $5.25 but you’d also have a long call with a higher strike price, say, $6.25 with the same expiration date to hedge the unlimited loss potential. The maximum loss of that position would have been the difference between the strike prices ($6.25-$5.25=$1.00) minus the net income from the option premiums, just under $10,000 per contract. If you’re really serious about that risk model where you have only $50,000 risk budget for natural gas, you’d do the vertical spread with only 5 option pairs. Option Sellers had 218 naked short calls, 43.6 times the exposure. And that’s to the much riskier short call option without the tail protection! It’s mind-blowing to see this disregard for a proper risk model!
4: Misunderstand the peculiar features of the contracts you’re trading
The recipe for disaster of OptionSellers.com is summarized by one amazingly cringe-worthy quote by James Cordier, explaining why it’s OK to cross your fingers and hope that the price of the underlying commodity future will never break through your strike prices:
“Commodities, unlike stocks, have end-users and producers. Whether it’s crude oil or gold or coffee, if it gets too far away from its fair value, there’s someone there to take advantage of it.” Source: SeekingAlpha
That’s certifiably false. It’s exactly the other way around! Especially commodity futures can and often do deviate wildly from their long-term fundamentals. One bad storm system in the Midwest can wipe out the crop of some ag commodity and send prices up. One hurricane can halt production for Crude Oil and Natural Gas in the Gulf of Mexico and send the respective futures prices into the stratosphere. True, the price will normalize again in the long-term, but if you sold Call options on one of the impacted commodities and prices deviate drastically from long-run fundamentals between now and the expiration date you’re screwed.
Contrast that to the stock market. It, too, makes wild swings and deviates from economic fundamentals. On both sides, by the way: on the upside like during the dot-com bubble or on the downside like in March 2009. But the adjustment process is normally a little more gradual than for commodities. That Dot-Com bubble took years to inflate and about 2.5 years to deflate. Even the scary bear market during the Great Recession took a whole 17 months to go from peak (October 2007) to bottom (March 2009). Commodity misvaluations, on the other hand, come about much more rapidly. And if you write options with strike prices far out of the money, you can be trounced by a big market moves and lose all your money, just as James Cordier did!
There are also (at least!) two more important differences between equity and commodity futures that make commodity option writing much more dangerous than equity option writing:
- For equity indices, there is normally (not always, but normally) a gradual buildup of big market moves. The Lehman failure in 2008 didn’t happen in a vacuum. It happened when implied equity volatility was already elevated. If you had sold an S&P 500 put option before September 15, 2008, then, sure, you’d have lost some money, but you likely sold it far enough out of the money that the loss wouldn’t have blown up your entire portfolio if you kept leverage low enough (see #2 above). But commodity price spikes are often more sudden and out of the blue. This makes commodity option selling and especially call option selling particularly dangerous. You sell options when things look calm and some completely unpredictable event can send prices and volatility sky-high!
- Skewness: The equity index (and thus the equity futures prices) becomes more volatile during down moves (negative skewness of around -0.5 for daily returns). In contrast, commodity prices often become more volatile during price spikes with a skewness +2.5 (!) on daily moves since 1997. That’s because the aforementioned external shocks normally create supply shortages rather than oversupply. So, if you want to sell naked calls (where losses are truly unlimited) it’s particularly dangerous when doing so for commodity futures that have positive skewness. There is nothing that keeps Natural Gas futures from jumping from $3 to $10 per BTU or above if the shock is big enough. For equities, of course, naked puts are dangerous as well due to negative skewness but at least there’s a natural limit how far the market can fall. You can’t go beyond a 100% drop!
Know what you’re trading! Educate yourself. Don’t fall for the slick presentation of a pushy salesman/financial advisor. Just one look at the NG price chart with crazy swings of $10 or more in a short period (potentially a loss of $100,000 per short call option with a multiplier of 10,000!!!) would tell me that you can’t sell naked short calls with only $4,600 in margin per contract!
5: Don’t bother understanding what your financial adviser is doing
After criticizing the principals of OptionSellers.com I also need to direct a few words at the clients. Just to set the stage here, even though OptionSellers is sometimes called a “Hedge Fund” the structure was quite different. Instead of managing one or multiple funds where investor money is pooled into an LLC or LP structure, James Cordier & Co. maintained separately managed accounts, one for each client. Why does this matter? Hedge funds are sometimes extremely secretive. True, there are some reporting requirements where positions are revealed at certain dates, but still, hedge funds are often complete black boxes and normally try their best to conceal their proprietary methods and especially positions.
The advantage of the separately managed accounts is that there is perfect transparency. Every customer of OptionSellers.com has their own brokerage account and they can readily see and monitor their positions. The clients merely authorized Option Sellers to perform trades on their behalf. Of course, the disadvantage of this setup is that clients are now on the hook for their underwater accounts. So, they lost not just their investment but owe more money to cover the additional losses. In a true hedge fund structure you can only lose your principal but as an LLC equity holder or Limited Partner in an LP you owe nothing further.
In any case, when clients now complain that they had no idea how risky their investment was, I just have to shake my head. A quick look at your brokerage statement would have revealed the crazy leverage these guys were using.
Know what your adviser is doing! As a rule of thumb, hire an adviser for exotic investments such as derivatives-trading only if you could theoretically do most of this yourself. It’s only because you don’t have the time to trade your contracts and monitor your positions and expiration dates/times you hire someone else to do it for you and pay a small fee for this.
Moreover, exotic investments, like option selling, should also be at most a supplemental financial tool. I would recommend putting no more than 25 to 30% of your net worth into option selling, with the rest invested in more mundane investment options like equities through index funds and real estate. And even those 30% should never be at such high leverage that you risk a complete wipeout a la OptionSellers during a pretty garden-variety market move like in November. Never ever give your entire net worth to one single RIA trading stuff on margin!
After a big drop in the market or a blowup like OptionSellers, people always ask me how I’m doing with my own option trading strategy and if I still have confidence in it. So far I’ve done pretty well even during the recent volatility episode. Cases like OptionSellers are actually reassuring in that the funds that crash are exclusively the irresponsible ones. It’s amazing OptionSellers lasted so long and didn’t go under sooner!
OK, enough venting! Excuse me if I get worked up about but clowns like Cordier and his firm give the (responsible) option seller community a bad name!