Quora Answer: Can Clients Lose More Than 100% of Their Investment & Owe the Broker?

The following is my answer to a Quora question: “Can clients lose more than 100% of their investment and owe the broker money, when a professional money manager blows up the fund with leverage and owes the broker money, and does this apply for all funds that use leverage?”  He cited this article: A Risky Natural Gas Bet Gone Awry Leads to Weepy YouTube Confessional Video. 

In an ordinary collective scheme or mutual fund, no.  They only take a position based on their capital, and have no mandate to borrow on that to increase a position.  In any case, since these funds grow their position over an extended investment horizon, it makes no sense for that them to borrow on their positions.  In the case cited above, it was a hedge fund practising a ridiculous fringe investment strategy known as naked options trading.  In short, this was a hedge fund that did not hedge.  Instead, they doubled down on bets and prayed to whatever god they believed in that the inevitable volatility does not blow through their parameters and their capital.  This leverage failed them. 

Also, they are trading in options, a type of derivative, not the actual equity or debt instrument.  Derivative trading allows people to take a position without putting down the entire cost of the trade.  Sometimes, as in this case, they did not have the capital to cover the trade anyway, beyond the “downpayment”.  As long as they made a profit, there were no consequences.  However, in this case, there were consequences, and that involved the loss of not only their capital but the amount borrowed against that capital.  This is not investment; this is just gambling. 

To compound this perfect storm of idiocy, the bets were in energy, which is one of the most volatile of commodities.  Commodities trading involves a lot of guess work since there is no clearly defined means to calculate the value of a position against the market.  There is no cash flow or income stream to calculate yield.  To reiterate what I said earlier, this is no different from gambling, except that most people involved gamble with other people’s money.