Too Good to Be True

The Wall Street Journal reported on a firm that went belly-up due to “bad bets on energy prices.” The firm, OptionSellers.com, sold options on future contracts and they suffered a “catastrophic loss” on their trading strategy.[1]

As a result of the firm’s trading losses, some of their clients lost 100% of their capital and they were still required to add money to their account because their accounts went negative. One individual in the article had $470,000 invested but is now $150,000 in debt.[2]

Investors were attracted to the firm’s “double-digit gains” and income from selling options. It appears the firm sold naked calls, or short calls, against energy positions. When you sell a naked call, you don’t own the underlying asset - the most aggressive option strategy you can employ. For example, if you sell a call option against Apple at $150 per share and it rises to $200, you’re required to sell your shares at $150 and buy them at $200. In this example, you lost $50 per share minus the tiny income you received from selling a call option.

Unfortunately, greed and envy are two magnets some investors can’t ignore. The lure of double-digit returns is too much for individuals to overlook. Envy of what others are doing is a catalyst for investors to do dumb things with their hard-earned dollars.

High risk, highly leveraged strategies work in a raging bull market but when stocks fall risk in these portfolios is exposed. As investors in this firm found out it was too late for them to recover their assets. Everything works until it doesn’t. Too much risk can vaporize your wealth – quickly.

During the Tech Wreck from 2000 – 2002, I managed a branch office for a major Wall Street firm. One of our brokers worked with a client who aggressively traded options. When the stock market corrected, his client lost 100% of the account balance. Due to his margin balance, he still owed $20,000 after his account was liquidated. I called his client to let him know his account went negative and that he still owed the firm a balance. He was cooperative because he knew the level of risk he was taking. Thankfully, he sent us the money.

A globally diversified portfolio of mutual funds is boring, very boring, when compared to an exotic trading strategy using options and futures. A portfolio of mutual funds is like a slow moving, meandering river snaking its way across the country. The river is in no hurry to get to where it’s going but it will eventually arrive at its destination.

When I present a diversified mutual fund portfolio to potential clients some of them are less than thrilled. I get comments like: “That’s it?” or “I’m doing better on my own!” or “I want to be more aggressive trading individual stocks.” Some people want the sizzle more than the steak.

A diversified portfolio of mutual funds is based on your financial goals, identified and quantified through your financial plan. Your portfolio is built for the long-term with a main goal of asset preservation through rising and falling markets.

If you’re attracted to shiny objects and feel the need to speculate, limit your trading dollars to 3% to 5% of your investable assets. Do not speculate or trade in your retirement accounts.

Markets fluctuate, and losses are inevitable, especially in the short term. One of the best ways to protect your portfolio against permanent loss is to own a globally diversified portfolio of low-cost mutual funds and review your financial plan often. Over time, markets recover and appreciate.

“The stingy are eager to get rich and are unaware that poverty awaits them.” ~ Proverbs 28:22

November 20, 2018

Bill Parrott is the President and CEO of Parrott Wealth Management firm located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process.

Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog.