Only trade what you can understand

One key rule in investing – only trade what you can understand. It pains my heart when i read about the suicide ofa 20 year old newbie investor. He committed suicide in despair after losing a huge sum trading options.

The young trader traded Bull-Put Spread on Amazon. When the market moved against him, he thought he had lost $730,000. His final note mentioned he had “no clue” what he was doing.

Before we draw some lessons from this unfortunate case, let’s take a look at the options strategy mentioned in the article.

What is a Bull-Put Spread?

• A bull put spread (BPS) is an options strategy used when the trader expects the price of the underlying asset to increase.
• Let’s look at an example of a BPS on Amazon with following parameters:
  • 1 option controls 100 Amazon shares (current price $2675)
  • Sell put option at high strike of $2670 receive premium of $3
  • Buy put option at low strike of $2665 pay premium of $1.12
  • Combined net premium of $1.88 ($3 – $1.12)
• The strategy pays a net premium upfront ($1.88 in the example above). It uses two put options to form a range consisting of a high strike price (sell put option) and a low strike price (buy put option).
• The maximum loss is equal to the difference between the strike prices and the net premium received [($5 – $1.88) x 100 = $312]
• The maximum profit, which is the net premium ($1.88 x 100 = $188), only occurs if the stock’s price closes above the higher strike price at expiry (> $2670).
• If the stock price is in between the two strikes ($2665 – $2670), the brokerage will automatically close your position. You may make or lose money, depending on whether you’re above or below your break even price.
  • For example Amazon ends trading at $2668, you will lose $12 [($2670 – $2668) x 100 – $188 = $12].
• Illustration of a Bull-Put Spread payoff diagram:

Source: Think or Swim

What happened to the young trader?

Although Robinhood did not release any details due to privacy, the article explained that the young trader probably did not fully understand the risk and settlement mechanism. When the stock price ended in between the 2 strike prices, he thought he had lost $730,000. Therefore he freaked out and ended his own life.

Lessons from this tragic incident

• Options trading is for advanced investors and you need to be well equipped with the skills to manage the risk.
• Leverage is a double-edged sword. Hence, only use it if you are able to manage the risk and always trade within your portfolio allocation rules.
• Only trade what you can understand. As the saying goes – if it seems too good to be true, it probably is.

Emrich Investors provides financial education to equip investors with the know-how to invest safely. If you are interested to learn more about options, please contact us.