The Dark Side Of Options Trading

Few Strategies Are More Lucrative Than Selling Options…

But You Must Avoid These Dangerous Mistakes

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On October 27, 1997, Victor Niederhoffer – then considered one of the most brilliant minds in finance – sat at his trading desk, wondering how it all went wrong.

The 54-year-old Harvard-trained statistician, five-time national squash champion, and George Soros protégé had recently been crowned the world’s top hedge fund manager. His fund had delivered an astounding 35% annual return over the prior 15 years – what he personally bragged was “the greatest run of success in the history of speculation.” And his New York Times bestselling book, The Education Of A Speculator, had made him a household name among investors.

Niederhoffer could seemingly do no wrong.

But by the time the market closed that day, Niederhoffer’s fund – and reputation – was in shambles. In a single trading day, nearly $100 million in client capital had evaporated in a wave of margin calls and forced liquidations.

While the financial blowup was painfully evident in the fund’s New York City office, the seeds of its destruction were sown months earlier – and thousands of miles away – in Southeast Asia.

A Butterfly Flaps Its Wings In Thailand

That spring, Thailand’s currency, the baht – which had long been pegged to the U.S. dollar – came under speculative attack. As the currency collapsed and the Thai stock market plunged, Niederhoffer saw an opportunity. Reportedly based largely on a friend’s observation that the country’s red-light district had recently become “cleaner and safer” – which Niederhoffer interpreted as a clear sign of economic development – he bet heavily on a rebound.

He bought relatively large positions in Thai bank stocks and the baht, betting that the Thai government would intervene to restore order.

Instead, the government ultimately abandoned its currency peg, triggering a further collapse in the baht in what would come to be known as the “Tom Yum Kung crisis.” Niederhoffer’s fund lost $50 million – nearly 40% of its total assets – practically overnight.

After suffering such a significant loss, most investors would have dialed down the risk in the fund and reassessed their outlook. Instead, Niederhoffer made the classic mistake of taking on even more risk in a desperate attempt to recoup his losses.

While the crisis spread across Asia, U.S. markets had remained relatively unfazed. The S&P 500 was trading near an all-time high, and the American economy appeared largely insulated from the chaos abroad. So Niederhoffer again saw an opportunity. This time, he began selling large quantities of out-of-the-money put options on the S&P 500 index.

As we’ve explained before, trading in options is like buying or selling an insurance policy for the stock market. Insurance companies charge drivers a premium to protect their cars. If a driver gets into an accident, their insurance protects them from going broke by limiting the amount they can lose.

Likewise, investors buy put options to limit the downside in stock prices. If the stock falls below a certain price, their losses are capped. In exchange for this protection, investors pay what’s known as a premium to purchase an option, just like the premiums drivers pay for car insurance.

In this case, Niederhoffer was effectively selling insurance to investors who wanted downside protection in stocks, and collecting premiums in exchange.

However, because U.S. markets were relatively calm at that time, the premiums available for selling put options on the S&P 500 were modest. Niederhoffer used significant leverage in the trade to compensate for this – to provide a boost to potential returns. He sold approximately 20,000 put contracts, representing a notional exposure of $4.15 billion – more than 30 times his initial capital base.

The logic was simple: as long as the U.S. stock market didn’t crash, those puts would expire worthless. He would keep millions in premiums and erase a good portion of his fund’s recent losses.

The trade did initially move in Niederhoffer’s favor. As the S&P made new highs in early October, put option premiums collapsed. The options he had sold for $4.00 to $6.00 per contract traded as low as $0.60.

Unfortunately, trouble soon followed…

The Crisis Goes Global

The Asian crisis that had started in Thailand’s currency markets spent the summer of 1997 spreading like a virus through global financial systems. By mid-October, the contagion had reached Hong Kong, where the benchmark Hang Seng Index plummeted 23% over four trading days. Fears of a global economic slowdown soon hit the U.S., setting the stage for what would become known as the “mini-crash” of 1997.

On the morning of Monday, October 27, U.S. stock futures opened sharply lower. The Dow Jones Industrial Average, which had closed at 7,715 the previous Friday, began a relentless descent that would ultimately see it lose 554 points – a staggering 7.2% decline that marked the eighth-largest one-day decline in the index’s history. The S&P 500 lost only slightly less at 6.9%.

For most investors, it was a painful but manageable one-day correction. For Niederhoffer, it was financial Armageddon. As the S&P 500 fell, the put options, which were trading at $0.60 just days earlier, exploded in value to as much as $16 – an increase of more than 2,500% – as panicked investors rushed to buy protection.

Niederhoffer scrambled to cover his positions, as we’ll describe below, but the losses mounted quickly.

A Liquidity Death Spiral

What transformed a manageable loss into total destruction was the unforgiving math of forced liquidation.

As the market fell, Niederhoffer’s broker, Refco, issued a margin call, demanding additional collateral to cover his mounting losses and to maintain a prescribed threshold in his trading account. He burned through his entire capital base – cash reserves, savings, and even other stocks – within hours. When Refco demanded still more equity, Niederhoffer had nothing left to give. In a single day, one of the most successful hedge funds in America was wiped out.

The aftermath was brutal. Niederhoffer was forced to liquidate his two other funds as well, sending letters to more than 230 shareholders explaining that he could not meet his margin calls. He mortgaged his home, sold his prized silver collection at Sotheby’s, and borrowed money from family and friends to pay off debts. His once sterling reputation was left in tatters.

Adding insult to injury, the market rebounded almost immediately. By November, the S&P 500 had recovered most of its losses, and the puts that blew up Niederhoffer’s funds – and career – ultimately expired worthless. Had he been able to hold on just a few more weeks, the trade would have been profitable.

Selling Options Is A Double-Edged Sword

The outcome of Victor Niederhoffer’s infamous options-selling trade is far too common – even for the best hedge fund manager in the world.

You see, when used correctly, selling puts is an incredibly powerful strategy. It gives everyday investors the chance to become their own insurance company – effectively engineering their own personal “insurance float” to generate income, reinvest in other opportunities, or to purchase equities at below-market prices.

However, if used indiscriminately – as many novice (and even some professional) investors do – this strategy can easily wipe out a portfolio. This typically occurs when investors “chase yield” or “premium shop” – that is, they sell options on riskier, more volatile stocks in an attempt to capture larger premiums – or when they take on excessive leverage, like Niederhoffer did.

Fortunately, avoiding these pitfalls is as easy as following two simple rules:

1. Only sell put options on stocks you’d be genuinely happy to own and at a strike price that reflects a good value.

This is critical. As you may know, when you sell a put option, there are generally only two potential outcomes:

If the stock trades for less than the strike price on or before the expiration date, the owner of the insurance can “put” the shares to you at the strike price. That means you will be required to buy 100 shares of the underlying stock for each put option contract you sold at the strike price, less whatever premium you collected upfront.

Or if the stock trades for more than the strike price on the expiration date, the option will expire “out of the money,” and you can keep the premium you collected and have no obligation to buy shares of the underlying stock.

If you only sell puts on stocks you’d be happy to own at a good price, you can’t really lose. Your results will be either a lucrative income stream or a vastly lower entry price on a stock you wanted to own in any case.

We generally recommend focusing on the highest-quality stocks with legendary brands. In The Big Secret portfolio, these include names like Deere & Co. (DE), Uber Technologies (UBER), Loews (L), Philip Morris International (PM), The Hershey Company (HSY), Nike (NKE), Domino’s Pizza (DPZ), and PayPal (PYPL), among others.

Of course, if you’re not trading on margin, and you’re put a stock (the first outcome above), you do need to have the capital available to make that purchase.

That brings us to the second rule…

2. Always use proper position sizing.

In short, because each option contract represents ownership of 100 shares of an underlying stock, you should only sell one option contract for each 100 shares of the stock you’d typically buy.

For example, if you would normally buy 100 shares of a particular stock, you would sell only one put option. If you would normally buy 500 shares, you could sell up to five put options. For “odd lots” like 150, 250, or 350 shares, you would round down (to one, two, or three put options, respectively).

Again, if you simply follow these two rules – and only sell an appropriate number of puts on high-quality stocks you’d be happy to own at a good price – it’s virtually impossible to lose with this strategy.

This “win-win” outcome is why we also love to sell puts in lieu of buying shares directly when we want to make a new long-term investment.

Last Call For The Trading Club

Today’s volatile market environment is tailor-made for put-selling and other options strategies. But while any investor can learn to trade safely with a little effort, we believe there’s no substitute for hands-on training and education.

That’s why Porter & Co. has launched The Trading Club. Unlike many trading services, we won’t just give you safe, lucrative trade recommendations. We’ll also “teach you to fish.”

The Trading Club is your chance to jump in the trenches with Porter and see everything we’re doing in real time, with real money ($100,000) on the line. Nothing held back. Every trade we make, every decision, every win, every loss… you’ll be with us every step of the way – and it will all be laid out, step-by-step, so you can follow along with your own money.

This is a service Porter has wanted to provide to our readers for years. And today, it’s finally a reality… In fact, our first round of trades is hitting subscriber inboxes tonight.

But if you’re interested in joining us, we must hear from you soon. Your chance to become a charter subscriber ends permanently tomorrow at midnight. Click here for all the details.