My first trade confirmation arrived in the mail in October of 1987.
I was in the military at the time, and knew I needed to think about my future. So I started investing in the stock market.
But when I opened that envelope, I had no idea what was coming next…
Later that month, the Dow Jones Industrial Average would fall more than 20% in one day. It was, and still is, the largest one-day decline in history.
Within weeks, I’d lost more than 20% of my investment.
I was disappointed, of course. But above all I was intrigued.
This wasn’t supposed to be possible…
What had caused the Dow to plunge double-digits in a single day?
I soon had an answer to my question.
See, S&P 500 futures were brand-new at the time. They’d begun trading in 1982.
Shortly after, salesmen began talking to large funds. They assured them that futures could end the days when markets were risky. They named their scheme “portfolio insurance,” since it insured funds against losses.
Soon, a number of large funds were using futures to hedge their risks. When the market fell, they sold futures. The more the Dow fell, the more they sold.
On what’s now known as Black Monday, insurance selling accounted for almost 30% of the market activity.
The “risk-free” futures scheme had set off the worst one-day crash in history.
This was an important lesson for me. I realized you couldn’t do what everyone else was doing on Wall Street.
And in the years since, I’ve seen popular strategies blow up time and time again…
Wall Street Never Learns Its Lesson
After S&P 500 futures, there was Long Term Capital Management (LTCM) in 1998.
LTCM was a hedge fund run by Nobel Prize winners. They found a way to own $1 trillion worth of derivatives. They used complex models to eliminate the risk of arbitrage trades.
In its first three years, the fund averaged returns of 35%. It paid out large dividends. Investors were begging to get in…
And then Russia defaulted on some bonds and the model was wrong. There was risk after all — and the firm didn’t have enough money to cover the resulting margin calls. Wall Street had to bail out the fund to prevent a full-blown crisis.
Then there were subprime mortgages in the early 2000s. At the time, they were a profit engine for many hedge funds.
I remember that sales pitch. It went something like: “Real estate only goes up. Even if the borrower defaults, the property is valuable. And we’ve used a computer to create a security that can’t default.”
What happened next became the basis of a popular movie, The Big Short. Even if you haven’t seen it, you can guess how it ends…
Subprime mortgages blew up, and started a global financial crisis.
These events reinforced the lesson I learned in 1987. “Safe” investments always have risk.
Many individual investors have to learn this the hard way.
For years, Amber Hestla thought selling puts was safe — until the 2020 crash blew up her strategy, and wiped out six months’ worth of gains.
After that, she questioned absolutely everything about income investing. And, after months of research, she found just a handful of strategies that actually avoid the risk of large losses.
She’ll be sharing one of them with you tomorrow morning. Keep an eye out for more details…
Michael Carr, CMT, CFTe
Editor, True Options Masters