Another Example Of Selling Naked Options
On Thursday, Deutsche Bank AG, the largest German Bank revealed details of a losing trade that was one of the biggest bets gone bad in the banking world in the past ten years. The trade was a whopper, around $1.6 billion or roughly the banks earnings for the past four years. The executives admitted that the trade had been buried in their books for almost ten years as they tried to unwind it.
What they did is very simple. They combined municipal bonds with various yield curves in the bond market both in the USA and abroad and used naked options to finance the trade. The only problem was that the naked options came back to haunt them. Trying to correct a trade involving naked options is like trying to herd cats. You constantly chase them but very rarely catch them.
How did Deutsche Bank hide the trade for so long? It is simple. They lied to the authorities about the total value of the trade. What they did was to break down the trade into several parts. The ones that were winners were shown to the bank examiners. The losers were shuffled away while the bank waited for the market to “return to normal”. As Joe Pesci said in the move classic Casino “You know when something like this comes down someone is going to get whacked.”
Someone did get whacked and it was the CEO, John Cryan. More heads are sure to fall as the details of the transaction come to the front. The traders responsible for the trade will probably be flipping burgers or asking if you would like olives with that Martini. That is the way the world works. If you have followed me for any length of time you know that selling naked options will eventually come back to haunt you. It put Bear Sterns, Lehman Brothers, Wachovia and AIG into bankruptcy. The FED let Bear and Lehman fail and bailed out the other two. However, when you go bust selling naked options, I can assure you that the FED will not be there to bail you out!
Ask Mr. Seifert
I am constantly asked questions about trading and how to exploit certain market factors to insure success. Each week I will answer one of those questions with a short paragraph which will cover the trading subject.
Question: My broker says to buy debit spreads since they have less risk than a credit spread. Is he right?
Answer: Your broker is referring to the fact that the debit spread will always have less premium risk than the credit spread, but that doesn’t mean that it has less risk. In fact it has more risk than a credit spread at the same strike. Here is the reason. For the debit spread to be profitable it must overcome the premium you paid for it plus the underlying must move in the direction that you predicted when you bought it. Even if you are correct in predicting price movement it may not move enough to overcome the debit. On the other hand, a credit spread can win three ways. The price moves in the direction you predicted, the price doesn’t move at all, or the price moves against you but not as much as the credit you sold. For my money, I would rather have three ways to win and take the larger premium risk. In the long run you can’t beat a credit spread.
The Wise Guy Report: The View from The Electronic Floor
Each week I talk about how the Wise Guys (floor traders) find the soft spots in the market and take advantage of price dislocation in three major commodity markets: Gold (GC), Crude Oil (CL) and Long-Term Interest Rates (ZB). On the equity side, I cover MSS which is the Mister Seifert Sez Composite Index. This is a proprietary index that I created which measures the dollar flow of the four major indexes (S&P 500, Nasdaq 100, Russell 2000 and the Dow Jones Industrials) on an unweighted basis. This week Let’s look at how the equities markets have performed since the start of 2019.
Equities Trending (Bullish)
The markets are very calm at the moment, except for the occasional unexpected earnings report that will send a stock either through the roof or see it come crashing down. Volatility is below its 20-year average and as long as we continue the climb off the December lows, there is no reason to suspect that VIX is going to suddenly take off. At some point an event will occur and the market will suddenly lose ground but that is inevitable as markets never change. But for now, the longs are certainly the strong hands and as they maintain that position the equity world will be safe and sound!
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“Don’t Buy Them – Sell Them”.
Mr. Seifert