How to Lose 2,000% (Don’t Forget About Everyone Else)

In 1994, three of the brightest, most successful and fiercely calculating minds in finance formed a hedge fund called Long-Term Capital Management (LTCM). John W. Meriwether, former head of bond trading at Salomon Brothers, was joined by Myron S. Scholes and Robert C. Merton. The latter two would share the Nobel Prize in Economic Sciences three years later. Prior to opening, they raised just over $1B.

For awhile, the fund, which employed various and complex bond trading strategies, enjoyed some success, as you can see from the chart to the right. But then, in early 1998, it blew up. With an asset base of a little under $5B and outstanding debts of $124B, they had no other option than to seek a bailout. Their lifeline came from the Federal Reserve Bank of New York who, fearful of a collapse of the financial markets, paid out $3.625B to appease LTCM’s creditors.

Here’s what Richard Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management” had to say about the reason for LTCM’s demise:

And in the late summer of 1998, the bond-trading crowd was extremely fearful, especially of risky credits. The professors (LTCM’s founders) hadn’t modeled this. They had programmed the market for a cold predictability that it had never had; they had forgotten the predatory, acquisitive, and overwhelming protective instincts that govern real-life traders. They had forgotten the human factor.

Which brings me to my next story, this one of a trader who recently lost 2,000% after boldly proclaiming “I have no money at risk.” (Here’s a link to the article, but please be advised the trader uses some pretty unsavory language.) Utilizing a complex options strategy called a “box spread” he ended up losing $58,000 on his initial $5,000 investment. Here’s a screen shot showing his losses and one observer describing what took place:

He bought 4 different types of options that gave him a $300k credit. At the end of expiration, like 2 years from now, he would’ve collected $40k or $50k. The way he bought it was set up like a hedge, so it didn’t matter if the stock went up or down because he had options that covered him no matter what. But then 283 of those options were exercised by the guy on the other end of his trade meaning he had to come up with 28,300 shares of that stock which he didn’t have. (Emphasis is mine.)

Look, we all know investing is hard. Here’s just a few of the things you must consider:

  • Will the economy grow or shrink?
  • Are interest rates going up or down?
  • Are wages rising or falling?
  • How is consumer confidence?
  • What do the lagging indicators say? What about the leading indicators? And if they contradict each other, which do you give greater weight to?
  • Is the dollar strong or weak?
  • Is the current administration helping or hurting the economy?

That doesn’t account for international investing, where you must include currency risk, geopolitical risk, etc, nor does it even scratch the surface of company-specific risks. Investing is hard.

Even if you nail all of the above, there’s still something that’s impossible to predict: “The guy on the other end.” Don’t forget about everyone else, all of whom have different goals, perspectives, and time horizons. In the latter story, we don’t know why “the guy on the other end” exercised his options. Maybe he wanted to buy a boat, or his daughter was going to college, or he wanted front row tickets to the Super Bowl (Full disclosure: I am a Patriots fan. No, I was not the guy on the other end), or was fearful of an economic collapse, or maybe he just wanted to inflict a loss on someone that was so bad it would go viral. We don’t know the reasons and never will.

It’s why our investment philosophy avoids the short-term, speculative nature of these kinds of strategies. As a client of Beacon Wealthcare, your portfolio is built based on your goals, your time horizon, and with a focus on tax-efficiency, broad diversification, and low fees.

As Morgan Housel says, “It’s hard to grasp that other investors have different goals than we do, because an anchor of psychology is not realizing that rational people can see the world through a different lens than your own.”

Different goals, different lens. It’s how “I have no money at risk” turns into a loss of nearly 2,000%.

One of the most important rules of investing is to acknowledge that your outlook, your conviction, might be wrong.

But even if you’re right, don’t forget about everyone else.

 

(Author’s note: options strategies are extremely risky and complex. We recommend you do not engage in options trading without the guidance and expertise of a financial advisor. Further, we believe there are very few instances where options strategies make sense.)

 

Author Ryan Smith, CFP®, RICP®

More posts by Ryan Smith, CFP®, RICP®

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