One of the most distinctive elements of intelligent option investing is the modest and prudent use of leverage to accentuate the positive effects of careful, thoughtful valuation analysis.
This may not seem as exciting as following 15 separate equity and commodity markets on a bank of flat-screen monitors, but what it lacks in excitement, it makes up for in results and peace of mind.
A news story came across my desk this week from a LinkedIn group about a 20-something hedge fund manager named Li who had run afoul of the authorities in a wholly expected way. Reuters tells us that…
The SEC, which banned Li from the securities industry, said his trades caused $56.5 million of losses in his main fund from Dec. 31, 2014 to Jan. 16, 2015, leaving it with just $211,685 of cash.
My first thought upon reading this article was the Japanese saying that is often heard when someone particularly skilled in a given field makes a bad error: “Even monkeys fall from the trees” (猿も木から落ちる).
The details of this story were interesting for a few reasons that those who have taken an IOI training course should especially appreciate.
First, the mechanism for young Li’s downfall was an almost total loss on none other than an investment in index options over the period of a few weeks. As soon as I read this, I knew exactly what happened. The lad was hugely overlevered in Out-of-the-Money, short-tenor call option contracts on (probably) the S&P 500. As long-time intelligent option investors will know, any money spent on time value should be considered an immediate realized loss, and OTM option prices are entirely composed of time value. So by levering up, Li thought only of the enormous profits that would accrue to him when the market rose, and failed to consider that the price of gaining access to these wonderful profits was a $57 million immediate realized loss.
I also imagine that in addition to being OTM, the options Li bought were likely very short tenor as well (perhaps a month or less to expiration). I can tell this because Li’s fall was so quick and complete. The time value portion of an option melts away quickly for OTM options and very quickly for short-tenor OTM options. The fact that only about $200,000 of a erstwhile $57 million portfolio suggests strongly that the options purchased were short tenor ones.
It goes without saying that this is the type of investment we would never recommend at IOI. There are three rules of thumb that IOI encourages investors to follow with the vast majority of their portfolios:
- Minimize money spent on time value
- Invest in instruments for which you can reasonably estimate a fair value range, and
- Buy long-tenor options and sell short-tenor ones.
Li violated all of these principals in a single investment decision.
Understanding how Li blew up his fund, though, is not as interesting to me as why he structured his portfolio in such an imprudent way. Quoting from Reuters again:
According to prosecutors, the collapse occurred after Li had lied to his investors by overstating Canarsie’s performance, and misled the U.S. Securities and Exchange Commission about trades he had fraudulently reported to conceal his use of leverage and the size of an investment in Facebook Inc (FB).
While the first lesson deals with option strategy, this lesson deals with what I call a “structural” factor.
Any hedge fund manager that is losing on an important trade will be tempted to make large, imprudent investments to try to make up for lost ground. If the trade goes against you, no big deal – it’s somebody else’s money you just lost; if the trade goes well for you, great – you’ll be hailed as a hero and will receive a nice fat check totaling 20% of the outperformance. Nick Leeson at Barings, Long-Term Credit Management, and the managers of Enron Corporation all fit this model to a “T”.
As a principal investor who might be investing in hedge funds, it is important to understand that hedge fund managers are incentivized in such a way that makes taking large, imprudent risks a rational outgrowth of the manager’s compensation agreement. Having some portion of your portfolio managed in such a way can make sense (as long as it is a very small portion – 1% of your portfolio’s value or less, perhaps), but overallocation to this strategy can be devastating.
From a larger perspective, the most important lesson from this anecdote does not involve the actions taken by Li, but rather the realization that with training and an intelligent, well-conceived framework for making investment decisions, a principal investor – the “Chief Investment Officer” of a family – can do better than Wall Street titans. Think about it, as a principal, you have no structural issues working against you, so with a good collection of investing tools and a sound blueprint, you can make a monkey out of a brash young Master of the Universe.