Actual trading events where things went very wrong - and how to avoid them
The Six Sure-Fire Ways to Fail Trading Commodities:
3) Trade In Illiquid Markets
A broker friend of mine related this story to me. He was working at a high commission option firm in 1997. This firm came out with a buy recommendation for out-of-the-money natural gas call options. At the time, natural gas options were very illiquid (and still are at times) and difficult to enter or exit without paying through the nose. Natural gas was still a relatively new futures and options market at the time.
Natural gas was a big winner the previous year. It ran from 1.73 to 4.60, a $28,700 move in the futures contract market. The firm figured on an easy slam-dunk for a repeat move. They wanted all the brokers to aggressively solicit clients by loading up on call options. The firm had a policy of placing stop loss orders on all options. They liquidated positions if the loss exceeded 50%. If you paid $1000 for an option, at $500 you'd be out.
The huge option buying campaign finally ended and the firm's hungry clients were now stuffed and satisfied. They had all the gas they could hold. However, a few weeks passed and things didn't work as expected as natural gas dropped about 40 points and went quiet. The option premiums eroded quickly due to the decreased volatility.
Normally, stops are triggered only if price trades at or below the stop loss order. The natural gas option market was so illiquid that even when the stops were hit on thousands of these options, there was no market below to absorb them. They sank even lower. This situation lasted for weeks with no trades to trigger the stops. The published bids kept sinking way below the stop loss orders. Many of the options bought at $1000 were now under $100 and still no trades. Clients were frantic, demanding executions, but to no avail.
Who would come in to save the day, by taking the other side? Someone had sold these clients the options in the first place by sticking their hands in the fire. Someone had assumed tremendous risk in an uncertain winter gas market when everyone else was buying. The firm's clients were the option buyers - the "safe" ones and were comfortable in the beginning. Now the pendulum had swung the other way. Which side has the market favored...the ones who took on risk and added liquidity...or the ones who played it "safe" and took liquidity away from the marketplace?
After a few weeks, a strange thing started happening. Little by little, buying started coming into the market across all option strike series. The original sellers were now covering their positions and taking their hard earned profits. This trading triggered all the stops and the firm's clients lost all their call option positions for $50-100 each.
To add insult to injury, the market then went on to have a tremendous rally, exceeding the firm's original forecast. Many of these same options hit $8,300 each! There was little an option buyer could do to exit this illiquid market once it started declining. A "smart" trader could have sold a futures contract to hedge the option market's decline, but that may not have worked due to this unique series of events. The more liquid futures market didn't participate in such an extreme manner like the option bids.
New markets, especially option markets, are almost always illiquid. They are prohibitively risky since they have not had time to mature and develop a deep following of participants. Always check the open interest and volume of the futures and option contracts. Looks for the listings to have many thousands of contracts, otherwise the bid/ask spread is probably excessive, making trade executions too difficult. Plus, when the market is going against you, it's almost impossible to liquidate, as in this case.
The moral is to stay away from illiquid futures and options markets. Options, as an eroding asset, magnify this problem even more. You may still lose in the option even if the futures contract market does what you think. Getting in and out when nobody wants the other side can be financial suicide. It’s the same old question - would YOU take the other side? Then why should anyone else?
The important lesson is the ones with the nerve to step up and take the scary side usually win in the end. The clients were in so-called, “safe” trades. You will see this theme occur over and over in real life trading. The one who puts his hand in the fire almost always comes out on top in the end. It must be this way. We are paid for providing market liquidity - not for taking it away... always remember this!
SOLUTION: Simply stay away from illiquid markets. But if you MUST participate, risk less than 10% of your account.
Part Four of Seven Parts - Next
There is substantial risk of loss trading futures and options and may not be suitable for all types of investors. Only risk capital should be used.
