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A Worse-Than-Worst Case

detail of statute of person leaning on hand as if in despair or in thought

If you asked most people, they would tell you their worst-case investing scenario is abruptly losing their entire investment. But an unlucky group can now say from experience that there’s a worse possibility: losing everything, and then owing even more.

This may sound odd, but it is exactly what happened to at least some of OptionSellers.com’s clients. In a 10-minute video posted on YouTube, company president James Cordier tearfully apologized for the major losses those clients suffered in the aftermath of extreme fluctuations in the natural gas and crude oil markets. The BBC reported that natural gas prices rose by the largest one-day percentage in eight years, followed by the largest one-day loss in 15 years a day later. This “rogue wave,” as Cordier described it, effectively capsized his company.

To understand why the volatility was so catastrophic for Cordier and his clients, it is important to understand the risks of the option strategy he was using. In essence, Cordier was selling insurance, collecting small premiums in exchange for assuming the risk of large movements in commodity prices. This approach can work, to a point, but also has the potential to implode spectacularly. The list of sophisticated investors and companies that have been laid low by similar strategies is long, and includes American International Group Inc., which famously received a bailout during the 2008-09 financial crisis, and Long-Term Capital Management L.P., a multi-billion-dollar hedge fund backed by multiple Nobel Prize winners for economics that collapsed in 1998.

Of course, not all options strategies are risky. As with insurance, there is more risk involved in selling options than in buying them. At Palisades Hudson, we have bought options as a hedging strategy, to protect against large swings in security prices. But we are wary of option selling strategies, where you receive small amounts upfront in exchange for risking a lot more.

OptionSellers specialized in selling “naked” options, a strategy that is “risky but not illegal,” as Gregg Opelka observed for The Wall Street Journal. Most of the time, traders who sell option contracts hold the underlying security upon which the option is based as a safeguard against major shifts in price. When you sell naked options, you do not hold the underlying security, which can create the possibility of assuming nearly unlimited risk.

Bloomberg reported that OptionSellers effectively bet that natural gas would remain cheap and crude oil would rally, and ended up on the wrong side of both trades at once. This was unfortunate, but not unforeseeable. Natural resources, especially natural gas, sometimes experience short-term price spikes. Because of technological advances including hydraulic fracturing, natural gas has become plentiful and, as a result, relatively cheap. But price spikes can still result from short-term periods of acute demand – for instance, as a result of severely cold weather, which recently led to such a jump in natural gas prices. Some people refer to betting on natural gas prices using options as the “widow-maker trade” due to how quickly such wagers can sour.

As of this writing, OptionSellers has not disclosed how much money it managed or the size of its clients’ losses after volatility in the oil and gas markets forced the company to liquidate their accounts. Bloomberg estimated the sum to be more than $150 million; other news outlets have pegged it even higher. Jason Albin, an Ohio-based attorney who has been in contact with many of the company’s clients, told The Wall Street Journal that most understood the risk that they could lose their original investment, but few realized that they could end up owing additional money.

In a typical private hedge fund investment, the fund is structured in order to ensure that investor losses are limited to the amount they put into the fund. While Cordier referred to OptionSellers as a hedge fund in his apology video, The Wall Street Journal reported that website snapshots indicated the firm managed individual accounts on behalf of each client. Because of this, the underlying investors may not have had the same liability protection that they would have received from a hedge fund.

While it’s not completely apparent how OptionSellers was structured, it does seem clear that some of Cordier’s clients were indeed left with negative balances after OptionSellers liquidated their accounts. These negative balances occurred because INTL FCStone, the firm that handled clearing Cordier’s option trades, borrowed on margin to cover the losses in clients’ accounts. Those clients now owe FCStone for these loans, Albin told Bloomberg. The brokerage says that OptionSellers’ clients owe a collective $35.3 million, in fact.

This incident serves as another painful reminder that it is important for investors to understand the investment strategies in their portfolios, whether they are delegating investment authority or not. Most investors know that past performance is no guarantee of future returns, but it is important to take the time to consider different scenarios and what could go wrong with a particular strategy. If you can find historical instances that would have wiped out your investment (or if people refer to the strategy as “the widow-maker”), don’t fool yourself into thinking there is no risk of a blowup this time around. And no matter how impressed you are with the person presenting the strategy to you, if a strategy is too complicated to understand, you are better off passing and waiting for another opportunity.

As far as I have seen, there is no evidence that Cordier defrauded or willfully deceived his clients. But as Opelka pointed out for The Wall Street Journal, Cordier’s actions were reminiscent of Icarus, the mythological figure infamous for flying too close to the sun. Now not only Cordier, but also his clients, have crashed into the sea.

Vice President and Chief Investment Officer Paul Jacobs, of our Atlanta office, contributed several chapters to our firm’s book, Looking Ahead: Life, Family, Wealth and Business After 55, including Chapter 12, “Retirement Plans;” Chapter 15, “Investment Approaches and Philosophy;” and Chapter 19, “A Second Act: Starting a New Venture.”

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3 Responses to "A Worse-Than-Worst Case"

  • Paul Korn
    December 13, 2018 - 8:27 pm

    “Most of the time, traders who sell option contracts hold the underlying security upon which the option is based…”

    This is the same as a naked put with almost unlimited risk on the downside, except that the underlying security cannot go below zero.

    • Larry M. Elkin
      December 14, 2018 - 9:21 am

      In Paul’s example, the individual sells an option that, if exercised, requires him to deliver a share of stock. If the stock’s value falls, the option’s value rises. If the stock’s value rises, the option’s value falls. And because there is no theoretical ceiling on how high the stock’s price can rise – and thus on how much the option-seller must pay to buy a share to deliver to the option-purchaser when the option is exercised – there is no ceiling on the seller’s exposure. That’s a naked option.

      As Paul observes, most of the time the option-seller already owns the share he is potentially obliged to deliver. So it doesn’t matter to the seller how high the price of the stock rises; he’s going to deliver that share if the stock moves in the opposite direction that he assumed (or hoped) when he wrote the option, hoping to profit from a decline in the stock’s price.

  • Paul Noel Donaghy
    January 8, 2019 - 8:56 am

    Was very unlucky but we’ve seen it happen before. Regulations need to continually be improved.