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Last week, we learned that Andy Zaky, proprietor of an "Apple-only" hedge fund, had lost nearly all of the $10.6 million of investor capital in the fund after Apple(AAPL) shares started falling in late 2012. He also had a large subscriber base, and those clients reportedly lost at least another $92 million following his advice. The reason Zaky's fund crashed? According to the story in Fortune, it sounds like the fund used the maximum leverage possible to get into short-term bullish call spreads.

The problem here has nothing to do with options and everything to do with extreme leverage. Zaky apparently had customers and clients buying vertical call spreads in such large size that it only took two months of those spreads expiring worthless to wipe out all of their capital: "I can distinctly remember his urging members to deploy 'any spare cash' they had into the $655-$705 call spread."

Bullish Cross Model Portfolio and AAPL Returns

Source: Fortune

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I don't have a problem with leveraged trades as such -- with the idea of pressing your advantage when you find a reliable edge. Some commentators don't understand this, and missed the point:

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"Zaky, it turns out, was a truly dreadful fund manager: the kind of guy who not only put all his eggs in one basket, but the kind of guy who would also desperately double down upon incurring trading losses. With that kind of a trading strategy, even someone who's right 85% of the time is going to blow up pretty quickly." (Felix Salmon)

There's obviously some problematic math in the above remark: if you're right 85% of the time, and you double down on your losses, then it would actually be rather difficult to blow up quickly in normal circumstances. A bit of extra leverage won't do it, and doubling down on an overly heavy allocation won't do it, either. The only way to blow up so spectacularly is to court what traders call "risk of ruin": positions sized so aggressively that it is easy to see how they could bankrupt an account in just one or two bad trades. You can just as easily court that kind of risk without ever looking at options by buying, for example, shares of a triple-leveraged ETF using all of the buying power in a margin account.

Andy Zaky's Apple investors could have pursued the very same investment thesis and expressed those views with the very same trades, but would still be working with viable accounts today had they followed a simple and intuitive approach to risk management:

The investment analyst and the risk manager in your head should get a divorce. Your special, market-beating fundamental analysis, technical analysis, or quantitative backtest got you to this point; forget all of that now. Assume your next trade will be wrong. You're going to take the trade, but given that it will be wrong, you need to decide how much money you're going to lose. Think about that figure, and about what it will feel like to have lost that amount. If you're okay with that feeling, proceed; otherwise, reduce the size of that loss until it is more comfortable. With that number in mind, you can structure your spread and/or trade the appropriate number of contracts so that you are risking precisely that amount.

For a vertical debit option spread, the task is very simple: your risk is just the premium paid for the spread. Let's use as an example the January AAPL 655/705 call spread that we read about above. It is October 31, 2012 and AAPL is trading at $595. We could have bought that call spread for about $7.75. Trading one contract in each leg of that spread, the minimum size, our risk would have been $775. If we're trading a $100k account, and we couldn't really stomach losing more than 2.5% of the capital on one trade, then the correct number of contracts to trade for that spread would be 2500 / 775 = 3.22, rounding down to 3.

Contrast that with an approach that says "deploy any spare cash to this trade" and advises clients to dump shares in favor of call spreads -- not as a conservative stock-replacement method, but as a willful risk-of-ruin gamble: we would in that case be trading 129 contracts instead of 3.

You can see why Zaky's clients were doomed in advance, regardless of what happened to Apple or the market in any given month; and you can also see why an intuitive, simple approach to risk management will allow you weather any kind of market.

Source: Philip Elmer-DeWitt, "The rise and fall of Andy Zaky," Fortune, March 4, 2013

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