My little blog here may be mostly known for the Safe Withdrawal Rate Series. But I’m surprised how many people share my other passion: options trading. Both here on the blog and at FinCon last weekend lots of fans of the blog asked me when I’m going to write something about derivatives again. Wait no more! I have been thinking about this one for a while; it’s another cautionary tale about markets going haywire and unsuspecting and unsophisticated investors are caught in between. And then they realize the “safe” and “conservative” strategy marketed by their financial adviser can blow up in their face!
The Wall Street Journal came out with a pretty detailed article (subscribers only) a few weeks ago, but the story has been around for a while. See, for example, on WealthManagement.com or SeekingAlpha.com. And this time it’s not some obscure small shop in Florida that got into trouble. No, it’s one of the big fish: UBS! Their so-called “Yield Enhancement Strategy (YES),” marketed as a conservative and low-risk strategy to risk-averse investors with mostly bonds in their portfolio, racked up heavy losses late last year. Well, at least people weren’t completely wiped out like the poor sobs in the OptionSellers mess. But a purported 20% loss (about $1b) is still a hard pill to swallow for investors that were told that this is completely safe. Sure, if you were 100% invested in the S&P500 last year and lost 20%, then yeah at least you knew what you’re getting into. But for the average mom-and-pop muni bond investor, a 20% loss is pretty epic. And not in a good way!
Of course, looking at the low-yield environment right now – in some places we even have a negative-yield environment – I don’t blame investors for shopping around for higher yields. But be aware of the charlatans. If they tell you that higher yields come with no side effects run away! There is always a catch with a higher yield! Even if it’s your trusted personal wealth advisor at a shop as famous as UBS!!! This yield enhancement strategy involved a risky options trading strategy. With 5x leverage! And most of the investors didn’t even know what they were getting into unless they had read the pages with the fine print! So, let’s do a post-mortem for this strategy. What were they doing and how and why did this go so horribly wrong?
I’m still running that same strategy but it definitely evolved quite a bit over time. This might be a good time to write a quick update on what I’m doing and what I’ve changed since then. And for everyone who’s wondering what’s the use of this: I’m planning a future post on how selling options may help with Sequence Risk, so this is all very, very relevant even for folks in the FIRE crowd!
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…
October was a scary month for stocks: the worst monthly S&P 500 return in seven years! And November is off to a volatile start as well! We haven’t even seen a real correction yet but apparently, the drop was bad enough for me to got inquiries from friends and former colleagues asking how I’m doing with our portfolio and if (and when?) I’m going to come back to the office again! Sorry, not anytime soon! As I detailed in the post two weeks ago, we are not too concerned about one month of bad returns early in retirement.
Some friends and readers of this blog were specifically concerned that my options trading strategy might have been hit badly by the wild swings. After all, I’m doing this with a little bit more than 2x leverage and with the market down about 7% does that mean we lost more than 14%? Of course not! To all the rubbernecks out there who suspect we had a bad car wreck in our portfolio last month, I’m happy to report that we actually made a small profit with this strategy in October! And continued to do so in November! How awesome is that!? Well, there were a few close calls but I was able to escape any major damage. It took some HoudiniSkills (or luck???), hence the title image of escape artist Harry Houdini (Picture Credit: Lomography).
Part 3: Some updates on the strategy as I’m currently running it as of 2019
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Last week we made the case for generating passive income through option writing. A quick recap of last week: buying puts to secure the downside of your equity investment is a bit like casino gambling: pay a wager (put option premium) for the prospect of winning a big prize (unlimited equity upside potential). Unfortunately, the average expected returns are also quite poor, just like when you gamble in the casino or buy lottery tickets.
Since we can’t beat the casino, let’s be the casino!
Part 3: Some updates on the strategy as I’m currently running it as of 2019
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On the path to early retirement (and most likely in early retirement as well), the ERN family will be writing options to generate passive income (in addition to equity and real estate investments, of course). This may be something that people either haven’t heard before or even if they did, they might be turned off by the involvement of derivatives. After we got over our initial aversion against trading exotic instruments like options we found that it’s actually a reliable and profitable strategy to generate passive income. We mentioned this strategy already in a previous post on trading derivatives on the path to FIRE and thought that others might find this interesting too.
Since 2000, the SPY ETF (S&P500 index fund from iShares) returned about 101% (Dec 1999 to August 2016, dividends reinvested), or about 4.3% p.a. What would the return have been if we had participated only when the market went up, i.e., if we had avoided every single down month and received a 0% return during that time?
Derivatives and FIRE (Financial Independence and Early Retirement) sound like two things that don’t mix. Like oil and water. Financial derivatives (options, futures, etc.) have the aura of opaque and highly risky investments. On the way to Financial Independence, most people are either oblivious to derivatives or avoid them like they carry communicable diseases. Probably derivatives are also traded in some smoke-filled backroom or an illegal gambling joint, right?
Update: If you’re coming over to this article from Mr. French’s article over at RetirementResearcher, please note the last few paragraphs below where I shoot down his shockingly sloppy analysis.
Bonds diversify your equity portfolio risk. Everybody knows that, right? Well, how much diversification potential is there, really? Much less than we thought! (For full disclosure, though, bonds still serve a purpose, but it has nothing to do with diversification!)
Pop Quiz: Over the last 10 years, a portfolio of 80% stocks (U.S. Broad Equity Market) and 20% bonds (U.S. Aggregate Bond Market) had what correlation with the stock market?
The correct answer is A: the correlation was +0.998, so an 80/20 Stock/Bond portfolio would have been extremely highly correlated with the stock market. We might as well round it up all the way to 1.0 because from a statistical, financial and economic perspective that’s pretty much a perfect correlation. This correlation coefficient is for a broad U.S. stock market ETF (use Vanguard’s US Total Market VTI) vs. a portfolio made up of 80% Vanguard’s VTI and 20% Barclays Aggregate bond index (we used the iShares AGG total returns). Monthly returns are from 07/2006 to 07/2016. Continue reading “The Great Bond Diversification Myth”→
You heard that right! You can use leverage the smart way and reduce risk, all the while keeping the expected returns the same as in an unleveraged portfolio. Leverage has gotten a bad reputation, sometimes for a good reason, think Global Financial Crisis in 2008/9 or the LTCM debacle that almost sank the financial system in 1998. But every force can be used for good or bad, think Star Wars. So how do we change leverage from a Darth Vader to a Luke Skywalker? Continue reading “Lower risk through leverage”→