Founder of Stricken Hedge Fund Promoted Naked Option Selling

(Bloomberg) -- James Cordier was a long-time proponent of using "naked" options to trade in the volatile energy market. In numerous articles and even a book, he touted the potential rewards, telling investors they can produce consistent results.

Now it turns out that style of investing may have been at least partially behind the collapse of Cordier’s Florida hedge fund, Optionsellers.com.

The firm, which specializes in writing commodities options for high net-worth investors, had its accounts liquidated, INTL FCStone Inc., the brokerage that cleared the firm’s trades, said Monday. Cordier didn’t respond to requests for comment while Rosemary Veasey, the firm’s office manager, declined to comment on its losses.

While it’s unclear exactly what positions Optionsellers.com was holding before things went awry, Jason T. Albin, a lawyer at ChapmanAlbin LLC, said the some of accounts held naked options positions. He estimates losses from the failure of the fund could exceed $150 million.

An option gives someone the right, but not the obligation, to buy or sell a commodity or security within a predetermined time period. Options are said to be naked when they’re unhedged. If a market moves violently against a naked short options position, it raises the prospect of almost unlimited risk.

When there weren’t enough assets in some of the accounts of a certain type to cover short naked calls, "FCStone borrowed on margin against their clients’ accounts to cover, which caused them to not only lose 100 percent of their account values, but now they also owe FCStone for the loans," Albin said in an interview. FCStone declined to comment beyond its Monday statement confirming the liquidation of the accounts.

Cordier and OptionSellers.com director of research Michael Gross co-authored The Complete Guide to Options Selling. The book discusses the potential rewards of selling naked options, telling investors they can produce consistent results with only slightly increased risk. He has also advocated the approach in articles published in Futures magazine and Seeking Alpha.

Generally speaking, the strategy has someone selling options and collecting a premium. If the underlying futures price doesn’t move that much, the options expire worthless. But if the futures price moves to the point where those options are in the money, the seller can face losses.

"People like to sell options rather than buying options because the odds of making money are better," said Jack Scoville, vice president at Price Futures Group in Chicago. "However, as we saw with natural gas, that’s not always the case. You can get into a situation where the market is getting away from you pretty quickly."

After months of relatively subdued price action, volatility in U.S. natural gas futures returned with a vengeance last week, surging as much as 20 percent on Nov. 14 for their biggest intraday gain since 2010. The price swings in gas, as well as in oil, were a "rogue wave" that "likely cost me my hedge fund," Cordier said in a 10-minute YouTube video late last week.

“While writing naked options may sound outrageously aggressive and even frightening to some, if it is done correctly, one should be able to sleep very well at night,” Cordier and Gross wrote in their book. "The downside, of course, is that the market potentially can exceed your risk parameter."

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