In December 2019 a friend of mine started shorting S&P 500 by buying put options (he had no previous experience with options trading). In other words, he was betting that the US stock market will go down. He believed that COVID-19 will spread around the world and the US economy and the stock market will suffer as a result.
It turned out he was right. COVID-19 affected the world’s economy and the US stock market crashed. He started with roughly $15,000 in his trading account and made more than $200,000 in just a couple of weeks. Not a bad return right?
Shortly after, the GDP and unemployment numbers came out – they were terrible, to say the least. On top of that, many large companies announced that they will close their factories. Countries imposed strict lockdowns and the future didn’t look very bright.
All In – Chasing $1,000,000
I remember our talk when he made the $200,000. We both agreed that the best decision is to lock in $100,000 in profits and risk the remainder by betting against the market. Even I thought the market is heavily overpriced given the economic recession and future uncertainty.
A week later I found out that he had shorted the market with all of his money. He knew that such risk-taking is against any financial advice. However, he was convinced that there is no way the markets can go up if the economy and people are doing so bad.
And guess what happened? The markets went up.
In one week, he lost more than $150,000, which was almost all of his profit. His stress level was so high that he even got sick. It’s not very surprising since losses create a stronger emotional effect than gains according to the Prospect Theory.
But how is it possible that the markets went up if the US GDP dropped by 31.7% in Q2 2020?
The Markets Are Not the Economy
It seems that right now the stock market is more disconnected from the economy than ever before. Although the S&P 500 dropped sharply in March 2020 due to COVID-19, it rebounded back very quickly and reached an all-time high of 3,580 on September 2, 2020.
The reasons for the disconnect could be many, such as:
- The stock market is forward-looking and expects a sound recovery from COVID-19
- S&P 500 consist of many large tech companies, which were not affected as much as the overall economy
- Shares are more attractive when interest rates are low
- Drop in the stock market represented many “buying opportunities” to buy stocks cheaply
- Many investors believe governments and central banks won’t let the stock prices fall too far
- And more…
But I am not going to guess which theories are the correct ones.
Given the recent changes in the world’s economy due to COVID-19, Wall Street has shown a shocking amount of resilience when almost every other economic indicator has tanked and we should be aware of it when investing or speculating and manage our risks accordingly.
This confirms once again that the stock market is not the economy.
The market can stay irrational longer than I can stay solvent John Maynard Keynes
How Does It Feel Making $35,000?
If you followed the story closely, you will know that my friend actually ended up making a profit of $35,000.
But losing $150,000 of paper profits hurts, and it hurts bad (think about the car or the apartment that you could have bought). Even though he made a profit in the end, he was very stressed afterwards and couldn’t stop blaming how stupid the markets were.
His work also suffered as a result. He was gambling with large amounts of money relative to his overall wealth. Because of that, he spent many working hours staring at his trading positions, being afraid of missing on major market moves instead of focusing on his job.
This just shows how emotional trading can be. Not only you can lose money, but you can have serious negative effects on your life if you take risks that are above your tolerance level or more than what you can afford to lose.
Don’t invest anything you aren’t prepared to lose. You may lose it ALL, including the money.
Don’t Revenge Trade
After the huge losses, for a brief period, he tried to win back what he lost by entering into very risky trades. He felt that he still had an edge and that he was good at trading options (even though just a month ago he had never traded a single option).
Luckily for him, his further trades didn’t generate any major losses nor gains and he stopped trading for now.
This part of the story is very important since revenge trading is driven by fear and frustration, and it can have devastating consequences. It can lead to rushed, unplanned trades that are almost guaranteed to result in further losses.
In the world of speculating, the ultimate wallet destroyer is loss chasing.
Key Takeaways
So what can we learn from my friend’s recent experience trading options?
- The markets are not the economy. Don’t expect them to move the same way.
- Don’t risk more capital than you can afford to lose. If you really want to trade or invest, risk only so much you can afford to lose relative to your overall wealth.
- Take profits and don’t chase values. If you happen to make $100,000 by pure luck from trading options, take the majority of profits out of your trading account and put them into something useful like paying off your mortgage. Keep speculating with profits only.
- Do not revenge trade! If you are feeling unwell, just walk away.
- Trading can be very stressful. You will experience losses now and then, and they will hurt like hell. Be prepared for that.
- Losing a trade is inevitable, it happens to everyone. The sooner you come to terms with this truth, the easier it will become to move on from unsuccessful deals.
- Don’t trade if you have no idea what you are doing. Options are complex financial instruments and if you don’t understand how they work, stay away from them. You will only invite trouble if you decide to travel to the unknown territory.