I could not hope for a better start to the year. Within the first two weeks of 2014, I have made US$5+k from options trading. Building on my good results, I was eager to find more opportunities.
I noticed some anomaly in Natural Gas options. Given that the U.S. weather has been unusually cold due to Polar Vortex, Natural Gas (NG) price was poised to rise with the higher demand for heating. The NG price was $4.30 on 15 Jan 14 and I could get very decent premium for call options at strike price of $7, expiring in about 40 days. Seeing a rare chance and that the price needs to pass through several resistances ($4.50, $5, $5.5, $6) before hitting $7, it is likely that the options will expire worthless before hitting the strike price. I went ahead to sell 20 NG contracts.
On the next day (16 Jan 14), NG premiums were still attractive and I sold another 10 call options at strike $7.50, and 20 call options at strike $8. Altogether I had 50 NG options and potentially make another US$4+k to make it to $10k profits for the month of Jan 14!
The price went up and the margin got bigger. On 27 Jan 14, I received a margin call from the broker. He asked if I would top up cash to the account to meet the margin requirement. The price of NG was $5.37 and no where near the strikes. But because my position was too big, I did not have enough margin to buffer the rise in price. I refused and wanted to ask for time to close the position when the US market opened at night (Singapore time), as the liquidity was low during Asian market trading hours and the options pricings were erratic with wide spreads. He said he was powerless to grant the request and the margin team will have to close the positions. And sure they did. They closed all my contracts which wiped out my entire capital. That was US$82k!
How did all these happen? Didn’t I have risk management rules in place? Simple things like stop loss? Yes, I have the rules, but I broke them.
Mistake No 1 – Ignoring Position Sizing (Greed)
As I was making good profits, I became greedy and put on too much options than my capital could take. I was doing 5 times more contracts than usual. If I did the normal size, the margin call wouldn’t happen, and I would have enough margin for the NG options to expire worthless and making a profit, despite the price going against my position. Greed got the better of me and I overrode the rule.
Mistake No 2 – Not Cutting Loss (Ego)
The second safeguard to risk management is cutting losses. The following was what I wrote in an earlier article, after learning from a loss in Gold contracts:
“Instead of rolling trades like what Dave suggests, I prefer to cut the loss fast. And instead of taking a risk-reward ratio of 3:1, I have reduced the risk-reward ratio to 1:0.7.”
I set the rules and I broke it myself. What happened to the promise? Humans cannot be trusted? It was difficult to cut loss because the paper loss was big. The paper loss was big because the positions were big. I was egoistic to hang on to the contracts because I think I was right and assumed I would have enough margin to pull through. The margin proved too much to handle and the broker intervened. Below is a screenshot of the chart and on hindsight, I would have survived because NG closed 5% lower the same day they closed my positions. But that is what a sore loser will say. If I survived this trade, I will do it again in the future. One day I will still blow up. I will take this lesson and move on. Greed + Ego = S$105k
I hear and I forget, I see and I remember, I do and I understand.
I read many scary stories about blowing up and the importance of risk management in the past.
Long Term Capital Management, with a team of Nobel-prized winners and brilliant traders, over-leveraged and could not unwind their positions fast enough.
Victor Niederhoffer bet big in Thai stocks and went bust during Asian Financial Crisis.
Risk management applies to local businesses too. Nanz Chong-Komo was over-ambitious and expanded her One99 shop too fast and ran into cashflow problems which eventually led to bankruptcy.
I thought I knew all these lessons after reading all these stories, but I never understood until it happened to me. I knew the importance of position sizing and cutting loss but I didn’t do them when situation calls for them. Knowing and doing are different.
I was my own Black Swan
I didn’t blow up because of an external Black Swan event. I feared the Black Swan but I didn’t know what it is. No one does. Only on hindsight we know what the Black Swan is. I was my own Black Swan – the real me deviated from the perception of myself.
I perceived myself as a very disciplined trader and person in life. I adhere to rules and routine very well. But when I really think back, I do take shortcuts sometimes and I bend the rules a little, believing everything will be fine. Bending most rules were inconsequential. Bending rules when stakes are high is a killer. I always thought I will position size and cut loss properly but I didn’t in this case. It is good to revisit what I wrote last year:
Jon is the biggest Taleb fan I know. He doesn’t believe in options selling totally. I told him I am going ahead to sell options even if he disagrees. I am going to do it even though I agree with what Taleb said. I explained to Jon that all forms of trading and investing are all about risk management.
Yes, options payoff are non-linear which is unlike traditional linear payoffs from long-short equity strategies. However, it does not mean you will not blow up your capital if you long or short shares. Every trader and investor needs to practise risk management because there is one trade out there that will wipe you out, regardless if you have total conviction about being right.
So what is the difference between selling options or any other strategies? I see one similarity rather than differences – all are risky. I agree with Jon I am picking pennies in front of the steamroller. But this is similar to scalpers, swing traders and trend followers. I will try to jump away from the steamroller as fast as I can so that I can continue to pick the pennies. Jon questioned my overconfidence in jumping off in time and I admit I stand a chance to blow up, without a doubt. And if I do, I hope he will pick me up from there. 🙂
Human Factors in Financial Markets
Along the journey the market will test you. You need to be following your risk management strategy 100% of the time, otherwise you can blow up too. If you trade or invest for next 10 years, you need to be consistently keeping to your rules for a good 10 years. We know it is hard because we are all emotional. Can you guarantee you won’t be swayed or affected by the market movements for the entire 10 years? It isn’t easy. This is why blowups happen time to time. It is because humans failed themselves, not the market and not the strategy.
I find that the following quote most suitable for traders in this context. After the failed attempt to assassinate British Prime Minister, Margaret Thatcher during the Brighton Hotel Bombing on 12 Oct 1984, the Provisional Irish Republican Army said this,
“Today we were unlucky, but remember we only have to be lucky once. You will have to be lucky always.”
We can break our rules and hope that we are lucky enough not to be caught. And this apply to our everyday lives too.
Driver error accounts for about 80% of the causes of accidents. A taxi driver puts his life at risk every day he drives. He can drive safely for 5 years but the moment he has a slip in safety, he may just get into an accident. This is how vulnerable our exposure to risk is. We can be disciplined for a long time but it takes just a moment of carelessness to get punished real bad. That is why our airline pilots follow a set of procedures to check and fly the aircraft, no matter how experienced they are. We hope they do not skip any of it just because they feel moody that day.
In case you do not get the point, it is very difficult to be consistent with our behaviour because we have emotions. Our emotions can bend risk management rules which can be very costly. We can be lucky to escape punishment sometimes, but one day it will get us. Since humans cannot be trusted all the time, we should minimise our involvement to execute risk management procedures.
You see and you understand
My friends were shock when I told them about the loss. One of them admitted he was breaking his trading rules too. My case reminded him of the consequences. The lesson definitely has more impact to people close to me. Maybe those failure stories that I read were too distant and I didn’t feel afraid at all. I hope you can take the value from this lesson as much as possible.
This lesson will stay with me forever and bring me a long way. I am sure this won’t be the last lesson that I will learn. I can lose money, but I cannot lose my will or my ability to make money. Even though I broke the rules, there was one rule that I kept to it and I want to thank my teacher for it,
“If I am wrong, will I be financially ok?” ~ Dennis Ng
The saving grace was that I did not have all my money in this account. I have 4 other accounts for stocks trading and value investing which remain intact. My lifestyle remains unchanged too. Nonetheless, it will take some time to make the money back. A painful but necessary lesson.
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CEO of Dr Wealth. Built a business to empower DIY investors to make better investments. A believer of the Factor-based Investing approach and runs a Multi-Factor Portfolio that taps on the Value, Size, and Profitability Factors. Conducts the flagship Intelligent Investor Immersive program under Dr Wealth. An author of Secrets of Singapore Trading Gurus and Singapore Permanent Portfolio. Featured on various media such as MoneyFM 89.3, Kiss92, Straits Times and Lianhe Zaobao. Given talks at events organised by SGX, DBS, CPF and many others.