Pyramiding to ruination
Lo herself was determined not to be a punter. Nevertheless, like all traders, she made her share of mistakes early on. One of those mistakes occurred roughly a year after the Black Monday massacre. Lo had begun trading gold stocks once again. To boost her profits she tried a common investment technique called “pyramiding.” Traders using pyramiding increase the size of a position that’s moving in their favour. So, for example, if you bought 100 shares of IBM at 104 and the stock subsequently moved to 108, you might add another 50 shares if you believed the stock was likely to continue rising.
Pyramiding works especially well during sustained bull markets – where you are adding to a long position. Adding to a short position during a sustained bear market is more difficult and far riskier, since the false rallies that are common to bear markets can be steep enough to trigger margin calls.
But with bull markets the technique can nicely augment your gains. Nevertheless, most trading experts advise you to add progressively smaller and smaller amounts to your position – hence the term pyramiding. Your initial position is the largest, forming the base of the pyramid, while any successive amounts are gradually less and less. In that way, each new buy entails successively less risk.
Pyramiding gets dangerous when you add equal amounts to a position – as many traders intent on riding a bull market are tempted to do. It’s all the more dangerous if you’re doing it on margin, as Lo discovered. “If you start with one position, and you double it and double it again, the average price you paid for all those shares very quickly moves up to very close to the market. So just a small setback can totally wipe you out.”
When Lo’s gold stocks pulled back, she was hugely over-leveraged. She counts herself as lucky that she was able to get out with just a $20,000 loss. “Certainly,” she says in retrospect, “if you buy 1,000 shares and you want to buy more on a pullback, don’t buy another 1,000. Buy 300. So your average cost is far behind whatever the average price is now. That way if it bounces or dips you can still get out with a small profit.
Twice burned
A year later, when gold stocks were again on a tear, Lo failed to take her own advice. This time the losses totaled $100,000, effectively wiping out her trading account. Once again, she considers herself lucky that she didn’t owe the firm any money. But as a trader she was dead in the water.
So Lo went into crisis mode. “I figured, ‘I’m not going to let this thing win.’” For six months she worked three jobs: in the mornings, as a broker at Canaccord, which kept her busy until the markets closed on the east coast, which was 1:30 Pacific Time. During the afternoons, she handled the paperwork on the day’s orders from Canaccord’s customers. At the same time she worked as a mortgage broker. Her pager would sound whenever someone needed information on a loan. Then from 6:30 to 11 most evenings she put together take-out orders at a Tony Roma’s restaurant.
The whole ordeal, she says, ended up having a four-fold effect: “First of all, it was good punishment for the sins that I had committed in my mind. The three jobs actually did pay some pretty good money. Third, I couldn’t go out any more, so I couldn’t spend anything. And Tony Roma’s was feeding me ribs every night.”
After many months, Lo amassed a stake of $50,000, enough to get her back into the game. Just as important, she felt confident once again. “If you don’t know what you did wrong and you lose all your money, then you have a huge problem. I had made all that money in the market once before. I figured, if I just don’t make the same mistakes, with some capital, I should be able to make that money back.”
Thus, pyramiding was permanently removed from her trading repertoire. The ordeal also helped Lo further refine her trading strategy. She vowed she’d tune out all the market noise that had clouded her decisions before and hone in on the basics. “The price and the volume never lie,” she said. “And you better just believe what’s on your screen.”
Riding the wild Nikkei
Instead of gold stocks, this time Lo chose an even more exotic instrument: options on Japan’s Nikkei stock index. Options of any sort are difficult for many beginning investors to understand. And to really learn about them you should read a book such as Getting Started in Options by Michael C. Thomsett.
Most people are even less familiar with index options. Very few active traders ever dabble in the ones written on U.S. stock indexes like the Dow or the NASDAQ. Even fewer trade options on foreign stock indexes such as the Nikkei.
For that reason, options require a brief explanation. Options come in two varieties: calls and puts. A call gives you the right to buy a security at a certain price, called the “strike price.” What’s more, you can exercise that right at any time before the option’s expiration dated. A put is just the opposite of a call. It gives you the right to sell a security at a predetermined strike price at any point between the time you buy it and the put option’s expiration date.
If all this sounds complicated, there’s an easy way to remember it: If you’re bullish on a stock buy a call; if you’re bearish, buy a put. Conversely, if you think a stock is going down, you might sell a call. And if you think it’s going up, you might sell a put.
Unlike stocks, which will likely always maintain some value, options become totally worthless if a trader fails to exercise them before the expiration date. If you buy options, any losses you sustain will be limited to whatever price you paid for the option in the first place. However, if you sell options, your losses can be devastating. If the stock rises past the strike price of the call you’ve sold, you’re still obligated to hand over that stock at the strike price called for by the option contract. That means you may have to buy those shares at their current market price and then turn them over to your broker, who will settle the option for you. Conversely, if you sell a put option at a strike price of $50 and the stock drops to $10 per share, you’re still obligated to purchase those shares for $50.
Options on foreign stock indexes are an order of magnitude more complicated. For starters, most trade on the Philadelphia Stock Exchange, a market few people outside the trading profession and outside of Philadelphia have even heard of. The mechanics of index options differ slightly from equity options, too. In certain instances, an index option gives you the right to acquire the entire basket of shares making up a particular index, such as the S&P or the Nikkei. However, in practice people simply sell the options – either at a gain or a loss – before they expire.
Why do people trade foreign index options? One reason: Institutional investors may use index options as a hedge against their foreign stockholdings. For example, if you’re a mutual fund manager with heavy holdings in the Japanese stock market, you might purchase some puts as insurance in case the Japanese stocks in your portfolio crash. Since puts give you the right to sell stock at a specific price, any downward move in the Nikkei Index would result in the put increasing in value. In this way, gains made on the eventual sale of the puts would help offset any losses in the stocks you won. Of course, if the Nikkei were to surge upward, the puts would decline in value until eventually they expired worthless. But remember, you purchased these puts as a kind of insurance policy. If the puts expired worthless, it means that your portfolio as a whole would have grown in value thanks to the increasing price of its component stocks. For prudent investors this is a win-win strategy if executed properly.
By contrast, for individual speculators such as Teresa Lo, index options offer the prospect of fantastic gains or crushing losses. Both result from the huge leverage they offer.
From February to March 1993, that leverage seemed all the more enticing. The Nikkei had bottomed out. And Japan was wallowing in a recession that would last the remainder of the decade and beyond. With