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Option Fanatic, RIA (Part 11)

Today I will tie together a couple loose ends from previous posts about the value-added benefit of my trading experience.

In Part 8 I wrote:

> …there is nothing new or unique to my trading strategy.
> The only thing “proprietary” may be that I understand
> it so well. That understanding comes from… my years of
> live trading experience… None of this should be a big
> deal to financial professionals who… do this full-time.

It’s not true that any full-time financial professional can get the live trading experience that I have. As I wrote in Part 5:

> Unlike most representatives of the financial industry
> who do little more than sell products, I actually
> trade. Trading experience gives me knowledge of how
> markets really work: details most “financial advisors”
> don’t [need to] know because they are generally
> specialized salespeople with a glorified title.

I am quite convinced that most financial professionals don’t know much about live trading. Here’s one article detailing potential jobs in the finance industry. If you look closely then you might see the word “trader.” Then again, you might not.

I view this as a significant disconnect in the financial industry. Most clients think they are dealing with the people who can make them money. In fact, they are dealing with salespeople who are limited in knowledge about the precise mechanics by which money is made. Put another way, the salesperson you’re working with may know many details about your personal history and financial needs. The trader who actually handles your money knows nothing about you. Who knew?

I still go back and forth about whether this matters.

I do know that what I would do as an RIA is all about the live trading. Details about working the bid/ask, watching volume and open interest, being cognizant of slippage, implementing limit vs. market orders, how to manage contingent orders, etc., are critical for success. If only for this reason alone, I will not be worried about transparency and the potential for clients to copy and adopt my trading strategy.

Option Fanatic, RIA (Part 10)

Today I continue discussion from the last few posts regarding trade transparency.

My original thought was that seeing option positions in the account was much more transparent than seeing a listing of funds. Mutual funds are not transparent because knowledge of their holdings is only available in retrospect. I therefore cannot replicate those on my own. Furthermore, some institutional funds (e.g. Dimensional Fund Advisers) may only be bought/sold by affiliated investment advisers. The typical client does not even have access to these.

What makes options so “opaque” is the typical ignorance that surrounds them. A typical client might see stocks in an account and be willing to go purchase or sell a stock. I believe the Average Joe/Jane may know a thing or two about stocks (but not enough to actually invest). I think most people know nothing about stock options and many have never even heard of them.

Besides knowing what they are, there is a great deal to know about how to physically trade these vehicles whether they be stocks or options. My concern suggests one could determine a pattern for what positions I get into and out of at different times. That’s just not true. With stocks and options there are criteria used to select which ones to trade (e.g. technical analysis, fundamental analysis). On top of that, much is to be known about what to look for and how to handle order entry to make sure reasonable prices are attained. Without this, any trader can get hosed by the middle man.

Did you know there was a middle man? I’m quite sure that many people do not.

Option Fanatic, RIA (Part 9)

In the last post I talked about my concern with investment transparency as a consequence of clients maintaining control of their funds in personal accounts. What if they figure out my trading and no longer need my services?

I suspect a lot of people hire investment advisers because they simply have no interest in doing it themselves. I think of it as analogous to installing new brakes. A mechanic friend could show me how to do that. I could get the parts from an auto supply store, jack up the wheels, remove the tires, and I’m off! I might get a little greasy but it could save me a few hundred bucks. The problem is I’m just not very mechanically inclined these days. Taking on this task would probably cause more pain, in the form of mental anguish, than money saved.

Besides the lack of interest, another reason clients might not try it themselves is because it’s flat-out dangerous. With the brakes, there’s the risk I might do it wrong. That could pose a danger to myself or others riding in the car. With option trading, mistakes will be made. A beginner needs to start small rather than trying to manage an entire account. If large sums of money hang in the balance then look out below!

For my concern to be realized a situation even worse than the brake installation would have to take place. In the analogy, the mechanic at least shows the other person how to install the brakes. If a client were to copy me then it would be without the “how-to” steps. My job as an investment adviser isn’t to teach people to trade. Lots of fine details go into trade design, trade entry, and trade execution. Whole classes could be done on these topics alone.

I’ll continue with more thoughts on trading transparency in the next post.

Option Fanatic, RIA (Part 8)

In the last post, I discussed some pros and cons to trading others’ accounts in a discretionary manner rather than having direct access to their funds to place in a tradable account that I manage.

I love the idea of not having direct access to clients’ funds. By maintaining control of their own accounts, clients would always be able to see how much money they have. I would not be running a Ponzi scheme or Madoff fraud where I take possession of funds leaving only my word to report investment performance. They would be able to see in real-time, online, how their accounts are doing. They would still get monthly statements from their brokerage–not from me or my company.

And yet–the prospect of offering complete transparency bothers me somewhat because others may copy it. I will be the first to say there is nothing new or unique to my trading strategy. The only thing “proprietary” may be that I understand it so well. That understanding comes from hundreds of hours spent backtesting and through my years of live trading experience. I also understand it through the thousands of hours I have spent to learn and understand options. None of this should be a big deal to financial professionals who also do this full-time.

Maybe I’m letting too much paranoia get to me. My trading strategy will suffer losses. If the losses occur sooner rather than later then clients probably will not be as eager to fire me and do it themselves (they may even choose to quit altogether and find another investment adviser). If the losses occur later rather than sooner then clients may think it simple enough and leave me to try it on their own. This may bite them hard in the rear, though, because when those losses happen they will have no experience with managing them. I strongly believe that in tough market conditions I’m going to do better than someone with little-to-no options trading experience.

I’ll talk a bit more about this transparency in the next post.

Option Fanatic, RIA (Part 7)

Comment [2] from my last post was particularly useful in bringing to light issues in need of legal review.

As mentioned, I love the idea of not having direct access to clients’ funds. Madoff-like frauds and Ponzi schemes succeed because clients give their money to a trustee. Good rapport with the nefarious trustee blocks any thought from investors’ minds about being swindled. Suspicion is held at bay through periodic financial statements from the trustee [or trustee's business entity] with varying degrees of apparent authenticity.

Quite often when investors get duped, the money isn’t there but they think it is. If they could log into their own brokerage account and see real-time balances then this would never happen. The scary exceptions are brokerages that have gone bust. Those are supposed to be SIPC insured but I have no idea how long it would actually take to recover damages, how much I would end up recovering, etc.

As I’ve mentioned a few times before, remember the asterisk. Allowing clients to keep funds in their own personal accounts will separate me out from many investment advisers.

At the same time, though, I can see one potential problem with doing business this way. Would managing funds in this manner provide complete transparancy with how I do my trading? If so then why could any client not watch what I do for a year or two and then fire me as an adviser in order to trade for themselves? Doesn’t any successful business need a moat of some sort to stave off competition? If there were nothing proprietary about a solid profit generator then others would rush in to start doing it themselves.

I’ll discuss this further in the next post.

Option Fanatic, RIA (Part 6)

Today I will continue responding to Internet posts about managing OPM.

       ”There is a massive difference between setting up [a] business offering…
       trading services and doing it for a friend… tax and regulation are
       not matters that concern you if it is an informal agreement between you
       and your mate… it is a very simple process, you just need to trust your
       friend to pay up when/if you make him money.” [1]

I interpret this to suggest agreeing to trade money for a friend or family member in exchange for “under the table” payment.

One benefit to this would be forgoing the need to hire an attorney, to verify and maintain compliance, to get registered through FINRA, etc. I could save money in overhead, too.

I worry about liability, however. Emotions may turn sour if money is lost. People who are friends or family today can become vengeful enemies tomorrow. Nobody would think twice if I had official legal documents to sign as part of the investing process. I think they would even feel safer and more protected.

       ”Your friend sets up a [brokerage] account. When activated he
       requests a power of attorney form… now [you]… have the power
       to place… trades… money can only go in and out from… [your
       friend's] bank [account]… agree [on] a [payment plan] and make
       sure your mate understands that there are risks involved. [Your]
       friend can’t sue… as… both signed a legal… agreement for [you]
       to place trades on his behalf… the account holder can withdraw
       money [to pay your fees]… the key issue here is that they are
       friends. They don’t need to set up a hedge fund…” [2]

I love the idea of not having direct access to clients’ funds. I am not setting up a [hedge] fund and I am only looking to trade as many accounts as I can log into individually. While the power of attorney may therefore be part of the arrangement, I still think this could still leave me open to additional liability if I don’t go through legal channels with compliance mandates, registration, and consent forms.

These comments give me very useful content to discuss with a lawyer. I don’t fear clients would sue me because I traded for them. I fear they might sue trying to claim that I was not qualified and/or that they did not understand something.

Option Fanatic, RIA (Part 5)

Today I continue with a second reaction to [1] from the previous post that involves detachment.

I find it interesting how calm trading educators, the financial media, and many financial advisors remain when the market gets volatile. I am sometimes jealous of their calm because I usually get scared! More than once I have reached the conclusion that had I simply walked away when the market started acting crazy then by the time I got back the market would have calmed down and/or reversed. Doing this could have prevented exacerbated losses.

I do not have the monopoly on fear in volatile markets, either. Robert Lang’s words in his Real Money article “On Human Nature and the Markets” (February 2, 2014) are echoed by psychologists and commentators aplenty:

> Human behavior never really changes and, as I’ve often discussed, in the
> stock market this plays out along a very specific emotional spectrum —
> one with fear on one end, and greed on the other. As traders vacillate
> between these two extremes, their behavior reveals itself via the charts…

How can I possibly manage OPM during crazy market environments when I am fear-stricken and on-edge for myself?

The solution is to insist my clients invest no more than a reasonable percentage of their total net worth. If I am trading reasonable size then I will not worry for myself. Knowing my clients have committed to investing reasonable size means I will not worry for them, either. If I have adequately explained the risk and my clients have understood the message then I should never be receiving emotional phone calls at the end of a trading day.

As a marketing point, my wife suggested it may be a good thing that I am never one to calmly sit back and say “everything will be fine” (remember the asterisk). Unlike most representatives of the financial industry who probably do little more than sell products, I actually trade. Trading experience gives me knowledge of how markets really work: details most “financial advisors” don’t [need to] understand because they are generally salespeople with a glorified title. Furthermore, having skin in the game means I will be more vigilant and able to do what it takes in the critical moments to manage risk.

Option Fanatic, RIA (Part 4)

Today I continue with discussion of Internet posts on the subject of trading OPM.

Another voice in the crowd writes:

       ”From what I have read over the years, managing OPM… has been the downfall
       of many a good (profitable) private trader… this game is psychologically
       very difficult without the added burden of worrying about losing your friends
       and/or relatives savings and having them ask you every couple of days/weeks,
       ’how’s my $10K doing? Have you doubled my money yet?’” [1]

I have a dual reaction to this post.

First, my goal is to make money consistently. My goal is not necessarily to make money fast.

I aim to hit singles rather than triples and home runs.

All this sounds very cliche to me and I hate (remember the asterisk) that I echo outward sentiment held by many in the financial industry (i.e. “slow and steady wins the race”). This is one cliche with which I, for the most part, agree. Presentation of my trading approach will thoroughly emphasize this goal. Should I include a written test of some sort as part of the application process, I may even include a question about this concept.

Yes, I believe it possible to make money fast trading the financial markets. I also believe this greatly accelerates risk of Ruin (going bust). I might be stupid to do this with my own money but I’d be criminal to try it with others’.

I will discuss my second reaction in the next post.

Option Fanatic, RIA (Part 3)

I left off discussing some potential disadvantages to the business of trading OPM. My ultimate goal is to decide whether this is the next logical course of action for my personal trading.

Another post I found through my Internet research follows:

       ”Unless you are dealing with very sophisticated people who understand
       risk… evaluate your friends and family. How will they feel about a 30-40%
       drawdown… in at least 95% of the instances, you will reach the conclusion
       that they are incapable of understanding and bearing risk… it is not all
       wine and roses.”

I feel strongly that concern over how others will react cannot guide my thinking. I set the bar at being true to myself. I can do this with a comprehensive presentation that accurately describes my understanding of the risk. I would strive to educate why this is about probabilities and not about certainties. An instructor used to say, “as with the markets, as in life: there is no free lunch… only pluses and minuses.” My job is to explain these completely. Provided I do this, I will not have blame on my conscience should clients later determine it was worse than expected.

       ”I bet your friend has NOT asked you to show him… trading plans, money
       management plans, max drawdown… Did he say something like… ‘I heard
       you doing well… trading… I have $100K… you trade it for me and I’ll look
       after you…’ golden rule… in managing OPM… get the right client… they
       have to understand what you are ‘selling’… You got [sic] to also
       understand what you [are] getting yourself involved in, its a huge
       responsibility. If it’s not crystal clear and planned out it will cause… more
       trouble than you ever imagined.”

Many points here follow nicely from above. My goal is to be crystal clear about risk to the best of my understanding.

I’m not sure what the “right client” is… someone who actually understands what I say? I could follow-up my presentation with a test to make sure they understand. Although strange, I like the idea. Remember the asterisk. I want something to set me apart in order to escape the greed and sociopathy that I feel inundates the financial industry.

Option Fanatic, RIA (Part 2)

I left off presenting the logical question why I don’t attempt to make money for others if I have been successful making money for myself.

Many points for debate come courtesy of the Internet through my research. In no particular order, I am going to include some posts to guide my deliberation. After discussion of these posts, hopefully I will be a bit closer to making a decision.

       ”You have been trading successfully recently and you have talked to some of your pals
       about your success and they want the same success and don’t know the risk or at least
       they cannot understand the pain of losing money so they have decided to ask you to
       take their money which is sitting in 1% CD and generate 20% a year. I am one million
       percent sure that if you lose just 1% of their money they will be mad at you like hell.
       They won’t tell you this now because they are so sure that you won’t lose money so
       they don’t want to talk about impossibles.”

I would want to make absolutely clear to my clients what kind of risk my trading involves. I have done some rather unique backtesting that will offer a comprehensive answer to this question. This is never a game of certainties but rather one of probability. For that reason, I will insist committing a limited percentage of total net worth to my trading strategy. Yes it will be likely to generate consistent income–much like a fixed or variable annuity (without the ridiculous fee structure)–but in the event something improbable does happen, catastrophe should never be waiting in the wings.

       ”Politely decline and thereby retain them as pals.”

I wonder if many of these comments aren’t directed at those people aiming to sell snake oil. If the product is fraudulent then one can expect loss of friendships.

I don’t want to sell my trading strategy as much as I hope to educate people about it and have the strategy sell itself.

I will continue with more discussion in the next post.