I remember the day clearly, I received a call from a client, yelling at me, "STOP THE BLEEDING JOSH"
The values of my clients accounts, seemed like they were free-falling for weeks.
My biggest loss as a money manager occurred from being short puts in a stock at one of the absolute worst times.
The stock, British Petroleum (NYSE:BP), the time frame, late June 2010.
For those that don't remember, on April 20th 2010, the Deepwater Horizon oil rig in the Gulf of Mexico exploded and sunk. In addition to killing 11 people, nearly 5 million barrels of oil leaked into the Gulf, taking nearly 3 months for BP to cap the leaking pipe!
It was the morning of June 25, 2010. British Petroleum was experiencing an epic collapse. The stock price dropped from the high 50s to the mid 20s…we were sitting at 52 week lows and no sign of the pipeline leak being capped.
Weeks before, I didn't expect this to go on- for as so long as it did.
Whenever you sell option premium, you're paid to take on risk. Often times, the options market will overestimate the risk and the premium seller is rewarded.
One can look back at the past, and see what type of extreme moves a stock has had, to get an idea of how low or high it has the potential to move.
However, when you're selling option premium naked, you are also taking on risk that potentially has never been experienced in a underlying before or an outlier move.
There are outliers and even high probability trades that will beat you up from time to time.
As a professional, you're taught not to get emotional about every up and down move in a stock.
I was very transparent with my clients, they knew my every single move, along with access to the account. Clients tend to get overly emotional…especially, when things start moving south…and that's what happened in this case.
I understand it and it's normal, but it didn't make things easy.
My clients were able to see everything in real time…they could stare at their profits and losses all day, if they wanted. Instead of being able to focus on the trade at hand…I was playing the role of shrink to my clients.
They called and asked me to stop the bleeding…they were worried that the company would go bankrupt.
With the stock in the news everyday…it was easy to get mislead by the talking heads.
I tried my best to calm them down…explain the situation-the risk involved in the trade, how implied volatility was elevated and that buying back our short ITM put options and selling our long stock now, would be a poor decision.
Even weeks of stating my opinion to them, that the company wouldn't go bankrupt, and this would eventually blow over. However, as time passed, I also started to worry and felt that I might have misread the severity of the situation.
Things seemed to get worse, BP was despised, at the time, by nearly everyone. One of my clients wanted out because he had another position in BP-not affiliated with our account. Basically, they were long BP in another account.
I didn't have control of the other account…but you can probably understand how this caused them greater stress and pressure, which was passed on to me.
I'd receive frantic calls nearly every hour, asking for updates. Now, this isn't an excuse on my part… and I will explain the mistakes I made with the trade a little later on. However, this complicated what I was able to do.
For one, I didn't fully understand the complexity of the BP oil spill and it's consequences.
Let's break down some of the mistakes I made during the trade:
- Being sized too much- too early. As the stock price kept declining, the risk grew… as more margin was required to keep the position on. Within a two month time frame, BP lost more than half of its stock value…trading from the high 50s to the mid 20s. Not only that, but BP became one of the most hated companies in the world.
What I learned:
In What I Learned From A $150,000 Loss Trading Options (Part 1), this was the same mistake I made, that came back to haunt me. It's important to size your trades accordingly-especially in a highly volatile situation like the one mentioned.
The noose quickly tightened around my neck and I couldn't catch my breath.
The problem was I didn't fully understand how all this would affect the company and its stock performance. My initial trades started off a little aggressive and when the stock started rapidly declining, the exposure grew quickly, more than I expected.
It's hard to imagine that anyone would have been able to predict how volatile BP stock options would get, but this is why you want to keep your trades small. Of course, this is something I preach a lot now.
Selling option premium in periods of absolute fear and euphoria are often the best opportunities… but you also need to make sure your risk doesn't get out of control.
- I started selling premium after a pretty big decline in the stock. However, there was a lot of stuff I was unaware of, regarding what would happen to the company, if and when the leak would get plugged etc.
The environmental damage from the oil spill had the country in an outrage. Everyday we would get updates on the leak…and whether or not BP would figure out how to seal it up and stop further damage. Images of the wildlife affected was disturbing to see on TV.
What I learned:
Selling premium, when volatility is elevated, is a good first step. However, that is not enough. You've got to put context behind your option strategy. If you don't understand the headline risk, it's possible that the high implied volatility is justified.
Selling option premium is most effective when there's high implied volatility driven by uncertainty because it's likely overstated. In this case, implied volatility continued to rise and prices continued to decline, which are the two worst scenarios that can happen, if you're short puts.
No one knew what the overall damage was going to be, what kind of lawsuits and fines BP would be facing and how large they would be. Not to mention, they kept showing videos of the leaking pipe everyday on the news.
If you ever find yourself in a trade situation like this, you'll be able to weather the storm…only if you're initially sized correctly. As well as, making adjustments when the time comes. Sure, it might be a very bumpy road, but your chances of the trade working out, are enhanced by following these steps.
Having too much exposure for my clients, and not reacting quickly enough with managing the position…eventually lead to me liquidating the position, for a net loss of around $130,000 on the trade.
This large drawdown didn't happen in one day…it occurred over several weeks. It was my breaking point. This trade exposed a lot of my weaknesses, as a money manager.
- I didn't have full control of the trading decisions.
What I learned:
I now know the importance of why hedge funds have a lock in period and certain dates for redemptions.
I still remember, looking at my six monitor setup….and staring at the BP chart. You know, I was angry at myself…but after speaking with my client-he didn't budge and wanted out of the entire position.
It's strange…because my clients delegated the responsibility of handling their trades. I thought to myself, "I'm in charge" …however, I was beat up…not to mention, that the client had a history of overriding my trades.
Sadly, our professional relationship was becoming progressively worse. The losses started to separate us…similar to a sports team that is going through a losing streak… and players start pointing fingers and blaming each other.
I probably don't have to tell you…but this was a confidence killer for me.
For weeks, I couldn't sleep. I found myself waking up earlier than usual…trying to see if there was any new information about the oil spill…and whether or not BP was able to cap the leaking pipe.
Every tick lower felt like another jab to the face.
When I hit the confirm and send button to exit the position…I felt so sick to my stomach that I was just numb.
Honestly, if I knew what I know now…I believe I would have been able to the weather the storm.
Like many of my other setbacks, I've dug deep…fought and won on my own terms. However, in this case, too much stuff was going on…I didn't know how to adjust quick enough.
Due to my lack of experience, I didn't respect or understand how the risk could get so out of hand…so quickly.
Let's discuss the trade a little more
It was right before they attempted to plug the hole with some kind of mud substance.
I decided to sell some near term puts and collect premium, taking advantage of the elevated implied volatility. My thinking was that this would eventually blow over…heck it had already been in the headlines for over a month.
Looking back at some of the big oil spills…I felt that the news was short lived. However, in this case, there was an underground camera focused on the gushing oil that was coming out of the pipe. Not only that, but it was the biggest oil spill in history.
Predicting when a black swan event can occur is impossible.
If it was predictable, they wouldn't be labeled as black swan events. However, whenever you're selling option premium naked…you've got to play out worse case scenarios out-even the ones that seem unrealistic.
Unfortunately, this is something that cripples most people from selling options. However, think about it, if brokerage firms are aware of black swan risk, why do they still define their overall risk profiles at a two standard deviation level, on short naked options? With that said, why would you let this fear keep you away from some potentially great opportunities?
By going through an exercise of what if analysis-you're able to get a clearer picture of how to set your position size limit.
This lesson has taught me to size my trades much smaller-especially when I decide to short options naked. With that said, there are certain sectors, like pharmaceutical and drug companies that I will never short options naked, because the event risk is too high.
In hindsight, I got in front of a fast moving train. Sometimes things like that happen in trading. Heck, one could argue, it's happening right now in the crude oil market. How many traders have tried to go long crude oil over the last month or two, thinking that the bottom was in?
- I didn't understand that under special situations…high volatility…gets higher.
What I learned:
When more credible solutions started to arise on how to plug the leak…BP would get a temporary price move higher…however, the volatility kept increasing.
I remember the first tranche of puts I sold, the stock price actually moved higher, but the puts didn't decrease like I expected…. they increased because the implied volatility was growing larger.
What I should of done was similar to the MA trade in What I Learned From A $150,000 Loss Trading Options (Part 1).
After being assigned the stock from being short the puts…I should have sold calls against my long stock right away. More importantly, instead of taking on the stock at the time, I should have rolled the short puts into another month.
This would have avoided tying up more capital and also taken advantage of the higher implied volatility.
Even though this wouldn't have saved me…it would have brought down the losses.
Also, if there was really a threat of the company going bankrupt, I could have purchased way OTM puts to define and cap my overall risk.
Again, this was an expensive lesson on option volatility. This experience motivated me to write:
- I didn't get defensive fast enough & adjust for more time
I was short near term puts with implied volatility at extremely high levels.
What I learned:
As I've talked about many times, in several articles and trainings, volatility cycles. Periods of high volatility are followed by periods of low volatility. If I closed out of my near term puts and sold options much farther out in time, that would have given me a better chance to see the volatility revert back to the mean.
Of course, one could argue this in hindsight. But if you look at the chart, I covered my puts near the bottom. When selling option premium, you'll sometimes need enough time for the volatility to normalize. I could have even sold some calls to bring my break-even point closer.
Overall, this took a devastating psychological toll on me. You see, not only was I managing money, trading my own account, I was also running OptionSIZZLE. In fact, I actually just settled a year long battle dealing with OptionSIZZLE, which was emotionally draining.
Two months after this, I made a tough decision, but the right one.
I decided to stop managing money and close StockStar Capital. I wanted to focus my time towards helping more people, create wealth freedom & options for themselves, through OptionSIZZLE.
From my experience in the business of managing money I learned that it's not about delivering superior returns, but it's more about selling and raising money. It helped me realize, how I still wanted to help the individual investor, so they can create superior returns by teaching them strategies that could empower them.
Since then, I've been offered opportunities to manage money again. But I've passed up on them…This experience not only caused friction between myself and my clients…but it also affected the personal relationship I had with my girlfriend at the time.
However, all this has lead me to become a stronger person. No, I didn't recover right away…it took a long time to get over these early hardships in my career.
But you know what?
I can now tell you it was all worth it. Not only did I learn a lot about myself as a person and trader…but I got a proper education on business.
The reason I started OptionSIZZLE, was to create wealth, freedom and options. The relationships I've built within this community have been beyond rewarding.
I've always wanted to trade options, teach people and focus on other business interests (which are not related to the financial markets).
I don't want to be a slave to the market, and hang on every single tick- nor do most of the people I speak with, that want to create success with options.
As you can see, I've been pretty humbled by the business. Longevity is what matters to me. I'm on this journey with you, trying to create long term success from the market-through the use of options.
I believe my background, experience and transparency is what makes OptionSIZZLE different. I still continue to learn and work on my process.
I believe together, we can make our dreams come true in creating wealth, freedom and options….So let's do it together!
I hope you've enjoyed this two part series. This was something I was embarrassed about for several years. Hopefully, you'll learn to avoid these mistakes and learn from them.
What are some of the setbacks you've had before that you thought your world was just over? I've been there before…..and if you'd like to share your story, post it below.