Fund loses 600mil (15%) doing spreads

[Stymie]

This guy was doing synthetic short naked options. He traded too big for his account size.
The small Delta he was short became large Delta with the market rally which is equivalent to a large position relative to his account size. Volatility is near all-time lows and his strategy was to sell volatility so no surprise. If selling naked puts in ratio spreads he would've at least had the vol skew in his favour but he did not do that. I'm a vol buyer so I'm grateful for these people to come along and try their luck.

 

[Pekelo]

They were betting on a down/sideways market in an election year. Election years are almost always positive...

 

[tradelosses]

what a horrible strategy sold to high net worth suckers

even worse when you include the 2% annual fee .

 

[ironchef]

Moreover, I am reasonably certain, based on what I've heard in the mkt, that the culprit was a very large 1 x 3 call spread position, rather than a fly.

The not-so-stupid reason to do these is the idea that vol and mkt direction are correlated. There are all sorts of clever terms for these phenomena and they can get kinda complex (ask sle, if you want the gory details), but the basic idea is that, at least in the case of, say, SPX, vol tends to decline when the mkt rallies. So it could be that this was the reasoning here, which would make this a bit less of a silly bet. However, it still might have been at least somewhat silly, because of the leverage (a drawdown of 18% in a week is nothing to sneeze at) and the not-so-great entry level (vol already being so low).

I really appreciate your explanation.

Let me take this opportunity to analyze the trade so I can learn something about spreads:

1. A "normal" call credit ratio spread is 1x2 ratio, similar to a ratio write (a covered call + 1 naked short call). The reason for ratio spread is to reduce the cost of the position as a covered call requires substantially more investment? There is also no downside risk as the net initial cost is positive (receiving a credit). So, what is the disadvantage?

2. A 1x3 call credit ratio spread has more naked short calls. The initial credit received must be more than the 1x2 but with higher risks if SPX rally. So, they might feel strongly that SPX will not rally in that duration. In that case they could create a delta neutral spread? This way, the position is neutral to movement of the price of SPX within a range?

3. One way or another, this is a neutral to bearish bet?

How should they manage the trade when it moved against them? Do you have any suggestions that can help me if I were in that situation?

Regards,

 

[ironchef]

If selling naked puts in ratio spreads he would've at least had the vol skew in his favour but he did not do that. I'm a vol buyer so I'm grateful for these people to come along and try their luck.

Can you please explain. He was net short calls, so his was a bearish/neutral bet. If he sells naked puts in a ratio spread, won't he be making a bullish bet instead? That would be against his judgement of the market direction?

Thanks.

 

[Martinghoul]

I really appreciate your explanation.

Let me take this opportunity to analyze the trade so I can learn something about spreads:

1. A "normal" call credit ratio spread is 1x2 ratio, similar to a ratio write (a covered call + 1 naked short call). The reason for ratio spread is to reduce the cost of the position as a covered call requires substantially more investment? There is also no downside risk as the net initial cost is positive (receiving a credit). So, what is the disadvantage?

2. A 1x3 call credit ratio spread has more naked short calls. The initial credit received must be more than the 1x2 but with higher risks if SPX rally. So, they might feel strongly that SPX will not rally in that duration. In that case they could create a delta neutral spread? This way, the position is neutral to movement of the price of SPX within a range?

3. One way or another, this is a neutral to bearish bet?

How should they manage the trade when it moved against them? Do you have any suggestions that can help me if I were in that situation?

Regards,

1. Whether one receives credit or pays when doing a 1x2 depends on the strikes (hence I dislike the whole "credit/debit" terminology). And no, forget covered calls. As to there being no downside, you're wrong. Just plot a payoff diagram and you will see.

2. Like I said previously, if their particular strategy is based on them 'feeling strongly' about what SPX will or won't do, their investors deserve our most heartfelt sympathy. What is a "delta neutral spread"? I really don't understand what you're trying to get at here...

3. Well, you should plot the payoff diagram and you will get a sense of what sort of bet it is.

As to how to manage the trade, it all depends on precisely what goes wrong. If it was a stupid trade, the best way to manage it is to just get out. If it was a not-so-stupid trade but something went wrong, you need to examine all your assumptions carefully to figure out the best course of action.

 

[ironchef]

2. What is a "delta neutral spread"? I really don't understand what you're trying to get at here...

The sum of the delta of the 1 long and 3 shorts equal zero and you can dynamically hedge to keep it delta neutral? This way the trade is immune to change in SPX prices? I am not sure if I am making any sense.

 

[Martinghoul]

The sum of the delta of the 1 long and 3 shorts equal zero and you can dynamically hedge to keep it delta neutral? This way the trade is immune to change in SPX prices? I am not sure if I am making any sense.

Well, sure, but, again, look at the payoff diagram... What happens to the delta of the position as you go through the strike you're short?

 

[Chuck Krug]

So based on this we can expect the market to correct deep next week because the trade is closed? Just skeptical that a $600m loss in a fund can drive the market for a week.

You got to take zerohedge with a grain of salt (Preferably a large one)

What did Warren Buffett say? Bull markets are like sex. It feels best just before it ends.

 

[fordewind]

So based on this we can expect the market to correct deep next week because the trade is closed? Just skeptical that a $600m loss in a fund can drive the market for a week.

Based on this,your timing is so poor.