Option Investor
Educational Article

Optical Illusions

Printer friendly version

Optical Illusions
By David Popper

About 12 years ago, I defended a businessman that caused the collapse of a small bank. "John" owned ten fast food restaurants, each of which was extremely successful. Each restaurant was a separate corporation and each restaurant had its own banking relationship with a separate bank. John also had a central bank account from which all monies from all of the ten satellite flowed. This way, each restaurant stood on its own but through the central bank, money could be transferred to one restaurant or another as needed. It really was an efficient system.

Sometime around late 1989, John developed an extremely extravagant lifestyle which was beyond his means. John began draining one satellite account after another and covered the overdrafts with a check from another satellite bank. Eventually money from all of the satellite banks were empty so John began to kite checks from one satellite bank to another and cover that bad check with a bad check from yet another satellite bank. John actually got away with this for several months, not realizing the geometric increase in the debt that he was creating. Eventually John contacted the president of the central bank and explained that from time to time he would need from one to two million dollars in checks covered. The president agreed and for his kindness he received a $100,000 gift of "appreciation." Well it all fell apart when John and the president went away, together with their wives one weekend. Checks that were normally personally cleared by the president bounced and a chain reaction was initiated, which led to the conviction of John and the bank president. The bank itself collapsed due to this bad loan. The FDIC examined the issues and issued a report. The FDIC concluded that the cause of the bank's collapse was that the rule of concentration was violated. This rule requires the bank to limit its exposure to any one client to a small percentage.

Isn't it funny how rules related to everyday life and to business situations apply equally to the market. You can learn a lot about life from the market. It is just common sense for a bank not to overload its lending portfolio with too much risk from any one customer or type of customer. Too much concentration in one customer or sector can lead to collapse. This explains in part the savings and loan debacle of the late 1980's. Sure the tax reform act played a role, but the simple fact of the matter is that overexposure to a sector places you at risk to suffer from the unexpected.

Lately, the same lesson was visited upon traders who were overextended in the optical sector. As I recall, one month ago, the projections for the optical sector were of unlimited growth. Yeah September was bad, but the analysts said just wait until earnings season, the numbers will be tremendous and the stocks will rocket. Traders piled into calls and fortunes were ready to be made, but someone forgot to tell NT. NT reported a chink in the armor of the optical sector and you know the rest of the story. Fortunes were lost by people, who let greed blind them from the common sense rule of avoiding excessive concentration.

Now for the really tough part, the optical sector is still a great sector with growth projections that most sectors would die for. It will take off again, just not in time to save the day for the holders of expired October calls. The sector may very well be a buying opportunity now or in the near future. What a shame not to have some cash on hand now to take advantage of the dip. What a shame to have too much of a portfolio in a sector that took a fall. I have been there and it is painful. Are there any solutions? Probably a million of them.

My solution is to adopt a business attitude to my portfolio. I am not in it to make a killing this month, rather I am in it to make steady growth each year. Therefore, I don't have enough invested in any one sector to inflict serious long term damage to my account should the unexpected happen. If there are not enough stocks that I like, I still don't overbuy, instead, I simply wait in cash until things become more attractive. No, this approach may not be as dramatic, but it keeps you in the game. By maintaining a cash position, you can buy LEAPs on great stocks when they are down. By maintaining some cash, dips are no longer feared. Instead they provide the opportunity to exploit a buying opportunity. Besides a little bit of a volatile stock can go a long way. For example, QLGC has recently rebounded 50 points as did VRTS and SUNW. There is value in being patient and in not violating the rule of concentration. For me, it's just all part of my maturation as a trader. Now if only my trading can match my rhetoric.

Options 101 Archives