• • Another hedge fund takes a 10% hit.
  • It sold options or had “short volatility.”
  • Why selling naked options when you’re a retail investor - or even a rich guy - is insane.

I found a lovely little bottle shop that imports Trappiste Rochefort, one of my favorite Belgian ales.  Bully for me!  I recommend both the 8 and 10, but they’ll knock your head off if you’re not careful.  

At my age, even I can’t have too many of those, though, with its high ABV.  I’m getting on a bit and can’t neck them like I used to.

Anyway, yet another hedge fund has succumbed to the WallStreetBets apes to the tune of 10%.  As my son Micah might say, “Ouchy!”

But before we get to them, let me explain naked options selling and why I never do it, myself.

It’s a No For Me

I understand the attraction.  You sell something and immediately collect money (premium) for it.  But that’s not where it ends.

It only ends at the expiry of the contract.

From the time of the sale to the expiry of the contract, you’ve got to pray that the option you sold doesn’t wind up “in the money.”

“In the money” means that there’s intrinsic value to the option.

For call options, that’s when the underlying stock price is greater than the strike price of the option.

For put options, it’s the opposite.  They’re in the money when the underlying stock price is less than the option’s strike price.

There’s no way to guarantee that the options you just sold will stay “out of the money” for the entire duration.

That means shorting options is an insanely risky trade, especially if you have a small amount of trading capital.

Of course, a retail investor may get lucky with his first 10 times selling options.  But the 11th time?  He’d still probably lose all the capital he accumulated to that point.  And maybe more.

Let me explain why.

Keeping Up-to-Date

I still educate recent graduates entering banks during the summers.  It’s a fun job, and as you know, no one loves the sound of his voice more than I do.  So I turned that bug into a feature and became a teacher.  (Yikes, that rhymed!)

It’s up to me to stay current with all the trends in the markets to answer any questions my graduates have with depth and accuracy.

Now, pricing doesn’t change year to year.  A bond is a bond.  An option is an option.  But in my research, I’ve found websites that brag how they can teach you to sell options for a steady income.

Nothing has terrified me more than that.

My Own Bias

I’m not a quant.  A quant is a Wall Street geek with a physics, engineering, or mathematics degree and can solve complex problems in his head.  I’m good with spreadsheets and will eventually get to an answer, but I can’t just look at a stock price monitor and tell you a story like they can.

When it comes to options, there are two types of traders.  They’re either directional traders or volatility traders.  Directional traders are 95% of the market.  If they think a stock is going up, they’ll buy calls.  If they think the stock is going down, they’ll buy puts. So they take advantage of volatility by buying it, but they’re more interested in being right about direction.

Volatility traders - the quants - are another kettle of fish altogether.  They’re not interested in direction but taking advantage of the price of volatility.  (Selling vol when it’s high, and buying vol when it’s low.)

When I first got to Wall Street, I didn’t even know volatility was something you could buy.  I genuinely believe you need an advanced degree in the subjects I already mentioned to do this well.  Most of the guys on Wall Street who do this have PhDs in those subjects.

There are probably no more than 150 people on the planet who trade vol well.  If I’m wrong, it’s because I’ve overestimated how many people can do it.

BTW, read Liar’s Poker, Michael Lewis’s first - and best, if you ask me - book.  In it, he talks about how the quant revolution began under John Meriwether at Solomon Brothers.

That leads me to another famous writer… who wrote about another famous writer...

Malcolm Gladwell, author of Tipping Point and Blink, wrote a famous article in The New Yorker on Nassim Taleb, the philosopher, author, quant, and options trader.  Here’s a choice quote from that piece, which I can’t encourage you enough to read in its entirety:

[Taleb] never sells options, then. He only buys them. He's never the one who can lose a great deal of money if G.M. stock suddenly plunges. Nor does he ever bet on the market moving in one direction or another. That would require Taleb to assume that he understands the market, and he doesn't. He hasn't Warren Buffett's confidence. So he buys options on both sides, on the possibility of the market moving both up and down.

Let’s make a rule out of this: If Nassim Taleb isn’t smart enough to sell options, then neither are we.

Selling Naked Calls

Let’s start with unlimited insanity.

Let’s say you’re bearish on a stock.  You think it’ll lose considerable value over the next few months.  If it were me, the best way to express this view is to buy puts.  But if you listen to any of these “gurus,” they’ll tell you no one makes any money buying puts.

Of course, Bridgewater made a boatload of cash buying March 2020 SPX puts, but that was just lucky, right?

What they’ll tell you to do instead is to sell calls.  Here’s the reasoning.

In our example, let’s use Square, @jack’s “other” company.  SQ is a payment processing software company.  Let’s say we’re a Square bear.

If SQ is trading $215 at the moment, shorting the stock is expensive.  So if you sell the $225 calls instead, you take in $5 worth of premium per share.  For one contract, that’s $500, as the options represent 100 shares.

Say you sell 10 of these contracts. You bring in $5,000.00.  Instantly!  Wow, your account has just swelled a bit.

You’ve got to watch, though, as you breakeven at $230.  That’s the strike price of $225 plus the premium of $5.

But here’s the thing: if, say, @jack announces that they’ve got a new solution that’ll bring in billions of revenue, and the market believes him, SQ shoots to $250.00/share.

That means you just lost (250-225+5) or $20 per share.  On 10 contracts, that’s $20 x 100 shares x 10 contracts, or $20,000.  “Ouchy!”

And you’re not done yet.  Let’s say the momentum traders’ system alerts light up.  Now they’re all buying SQ!  It rises to $270.

That’s another $20 x 100 x 10 contracts or $20,000.  You’re down $40,000 in two trading sessions.

It doesn’t end until the contract expires.  But by that time, you’ve lost your car, house, and wife.

Why?  Because the maximum loss is unlimited.  Literally, actually unlimited.

Just imagine how all those TSLA shorts felt when it shot to $900/share!

Shorting naked calls is insane - even if you’re worth millions.

Let’s look at the “less risky” shorting of puts.

Selling Naked Puts

Another act of lunacy is selling naked puts.

Let’s stay with SQ.

Say you’re bullish on SQ.  You think it could go to $300/share by the end of the summer.

Common sense says to buy calls as cheaply as possible, but still within the realm of the calls possibly expiring in the money.

Not so, say the gurus.

Sell puts, instead, they say.  They’ll say, “You may be right, but collecting premium is a surer way of making money on this trade.”

Hogwash.

So SQ is trading $215, so what you do is sell the $205 puts instead.  “There’s no way the stock will trade down there.”

How many ruined traders have uttered that question?

So you collect your $5 again per share.  So if you sell 10 puts, that’s $5 x 100 shares x 10 puts, which equals $5,000 again.

Only this time, SQ issues an earnings guidance that tanks the stock.  Suddenly, it’s trading $180 per share.

That’s a loss of (205-180+5) x 100 x 10 = $20,000.  Ouch.

Although the downside isn’t “unlimited,” theoretically, you can lose $200 per share.  That’s the difference between your breakeven and the stock going to $0.

In the extraordinarily rare case that SQ goes to $0, you’ll have lost $200 x 100 x 10 = $200,000.  So you’ll have risked $5,000 to lose $200,000.

So the loss is “limited,” but does it feel like it?

I bet not.

Again, the chances of that happening are a non-zero number awfully close to zero.  But that’s the risk.

Why Are We Talking About This?

Mudrick Capital - someone needs to start a business giving hedge funds good names - just lost a boatload sell options.  Yes, even the pros get smacked in the mouth doing this.

If the pros are getting hammered, you can only imagine how many day trading Populi are getting wrecked shorting options.

Don’t do it.  It’s not worth the risk.

Mudrick Capital dropped 10% of its flagship fund shorting call options on AMC, which has rocketed lately.  It’s a hubristic strategy.  Let the hubristic hedgies suffer for it.

When people ask me, “Sean, why don’t you short options?” I say there are two reasons.

1. 1. I’m not smart enough to short options.
   2. I’m not dumb enough to short options.

They are the only two reasons you need.

Stay safe out there, and have a great week ahead!

All the best,

Sean