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Karen The Supertrader: Lessons Learned?

Summary

Karen the Supertrader is being investigated by the SEC.

Earning excessive returns comes with substantial risk.

When something sounds too good to be true, it usually is.

Karen the "Supertrader" has generated a lot of curiosity in the trading community. She has been interviewed on TastyTrade few times. The title of the last interview was "OPTION TRADER makes $105MM PROFIT in the NDX, SPX and RUT.

As a reminder, Karen claimed to make 25-30% per year by selling naked options on indexes.

The highlights of her strategy, based on the information she provided in her interviews:

  • She mainly trades the S&P 500 Index (SPX).
  • Sells calls and puts (strangles) at 56 DTE (Days To Expiration) and keeps the trade on for a few weeks.
  • Calls are about 10% OTM, puts about 12% OTM.
  • Karen commits around 50% of her capital, though sometimes she will go as high as a 70% capital commitment.

Karen was an inspiration to many retail traders who hoped to reproduce her success. What most investors didn't realize was how much risk she is taking to achieve those returns.

Over a year go, I warned that her story sounds fishy. According to my calculations and the information available on tastytrade videos, she would make around 11% annually if using 50% of the available margin and all sold options expired worthless. You can read the full article here.

So how was she able to make 25-30%? The only possible way to do it is leverage. With millions dollars of money under management, she had what is called portfolio margin. This allowed her to sell more options than in regular margin account. But it also means much higher risk.

As I mentioned in my article, If volatility spikes like it did in 2008, her account will be gone in matter of days.

Well, it didn't have to go to 2008-like volatility. All it took was a minor pullback in 2014. Between October and December of 2014, Karen took some heavy losses selling her options.

But to keep the incentive fees coming in, she organized a sophisticated options roll at the end of each month. My fellow SA contributor Macro Ops described here how she did it, and this is the main reason for SEC investigation.

What are the main lessons we can learn from this story?

Our contributor Jesse wrote over a year ago:

"All trading has risk. It's not the strategy that determines if something is risky...it's the position size (amount of leverage) and risk management that does (and then the discipline of the trader to follow the plan which often means taking a pre-defined loss before it gets out of control)."

Is selling naked options risky? That's the wrong question - ask better questions, and you'll get better answers...Is selling excessively leveraged naked options that aren't cash secured risky? Yes, eventually. Short strangles on SPX and other index products are money making trades over the long term, you just have to use sensible position size and sensible exits. Just don't get greedy. Pigs get fat, hogs get slaughtered.

"The point here is not to dismiss all volatility and option selling strategies as useless and blow up prone. The short volatility trade on equity indices is one of the best trades out there. It does very well long-term. "

The point is to understand your risk. In fact, be obsessed with risk management if you want to survive as a trader for the long term.

I suspect that investors will not learn the lesson from this case. Humans desperately want to believe there is a way to make money with no or little risk. That's why Bernie Madoff existed, and it will never change.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.