In what should come as not much of a surprise at all, the reported blowup of the commodities-based hedge fund over at OptionSellers.com was likely the result of none other than - wait for it - selling naked options on natural gas. Media reports and a YouTube video of the fund's founder sobbing and apologizing started to make their rounds last weekend after an unprecedented and unexpected spike in natural gas futures. Bloomberg recently confirmed the details.
The hedge fund's founder, James Cordier, has been a long time advocate for selling naked options to trade. He wrote a book about it and even touted selling naked options as an investment strategy on Seeking Alpha. Of course, like anybody shorting volatility, which has become popular over the last decade, options writers are hoping to quickly scrape up a premium while the underlying stays calm and parked. In this case, Cordier got a lesson on why managing that risk is important - and exactly what can happen when unexpected volatility strikes.
Jack Scoville, vice president at Price Futures Group in Chicago, put it a different way: "People like to sell options rather than buying options because the odds of making money are better. However, as we saw with natural gas, that’s not always the case. You can get into a situation where the market is getting away from you pretty quickly."
A nicer way to say it is that shorting options carries theoretically unlimited risk, which Cordier took on, and then passed on, to his clients. According to the article, Cordier's clients not only lost 100% of their account values but now also owe money to the fund's clearing broker. According to a Bloomberg article, the firm had its accounts liquidated by its clearing broker, FCStone Inc.
Jason T. Albin, a lawyer at ChapmanAlbin LLC, confirmed to Bloomberg that some of the accounts held naked options positions and he estimated that losses from the failure of the fund could run in excess of $150 million.
Albin told Bloomberg: "FCStone borrowed on margin against their clients’ accounts to cover, which caused them to not only lose 100 percent of their account values, but now they also owe FCStone for the loans."
A video of Cordier apologizing and sobbing (though not really explaining the blowup) likened his fund to a shipwreck and went viral within the investing community last weekend. The video can be viewed here:
Cordier once wrote in his book:
“While writing naked options may sound outrageously aggressive and even frightening to some, if it is done correctly, one should be able to sleep very well at night. The downside, of course, is that the market potentially can exceed your risk parameter."
Wouldn't the thought of the market exceeding your risk parameter be the last thing that would have you sleeping well at night?
Naturally, financial Twitter poked fun at the video.
Proof we're in a simulation pic.twitter.com/IeR3oG9z4c
— Trade War Wynne (@Emanuel_Wynne) November 20, 2018
While we'd like to assume that this will be a lesson to investors and that it could mark the beginning of the end of the "shorting volatility" craze that has made even Target managers rich, the unfortunate scenario is that we will have likely learned nothing from this.