“The Santa Monica Technique”

By Travis Johnson, Stock Gumshoe, January 1, 2008

Let’s start out the new year with a look at another new investment teaser that gives a mysterious name to a commonplace investment — and thereby makes the strategy seem much more complex, exciting, and secret … perhaps leading to an impulsive newsletter subscription purchase.

This is for a newsletter called the Strategic Short Report from Agora, edited by Dan Amoss, which they’re launching soon at a price likely to be above $1,000 a year. It mentions his past successes in shorting mortgage insurers and Hansen with pretty good profits.

But the teaser part of this email, which is all about a trading technique, not a particular stock, is wrapped in mystery …

“New options research service uses the covert Santa Monica Technique that made what the Financial Times calls “the most profitable single trade of all time”

And what was the “most profitable single trade?”

Another quote to tantalize you:

“A tiny, little-known fund in sunny Santa Monica has just cranked out a 1,000% return. Here’s how the hidden fund did it. It used a secret technique — what I call the ‘Santa Monica Technique’ — to bet against crummy mortgage loans.”

And if you want to hear a little more to get your juices flowing, here’s the full quote from the Financial Times that the Agora folks share with us in the teaser:

“The decision to use [the ‘Santa Monica Technique’] to short, or bet against, low-quality U.S. home loans taken by a select group of hedge funds last year appears to have become the most profitable single trade of all time, making well over $20 billion in total so far this year.”

OK, so … I don’t have a company to share with you this time around, but the Gumshoe can certainly tell you that this “Santa Monica Technique” is a wholly invented term for …


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OK, they’re being a bit more specific than that — They’re mostly talking about trading options, probably mostly buying puts, since they’re talking about making bets on the downside.

But I read that Financial Times article, and the word they’ve obscured is simply “derivatives.”

For anyone who doesn’t know, derivatives are just financial instruments whose value is based on some other instrument. Options, for example, are derivatives, because their value is based on the price of the underlying stock. Futures contracts are more complex derivatives.

The hedge fund that got the 1,000% return from betting against subprime mortgages was Andrew Lahde’s Lahde Capital, which is indeed based in Santa Monica, and did indeed have that spectacular return for 2007 as of about a month ago. There are several other hedge funds that are reporting returns of more than 500% from very similar strategies.

There are also, of course, many more hedge funds that were holding huge piles of subprime mortgages and went under, lost lots of money, or had to be bailed out by investment banking partners or parents (as with the Bear Stearns hedge funds several months ago). The point being, even with those 1,000% or similarly outsize returns from a select few hedge funds, I wouldn’t be surprised if the overall performance of hedge funds — and most hedge funds use derivatives or short stocks — was negative for the year (though I don’t really know).

For most individual investors, derivatives are a loooong way out of their wheelhouse, and simply a way to lose more money, more quickly. That’s why trading services that use them are so popular and so expensive — the mysterious nature of derivatives for most people, and the promise of truly outsize returns, are enough to get divers to jump in the water even when they can see the sharks circling.

This new Strategic Short Report seems to be well-timed, launching just now as investors are incredibly skittish about the stock market and worried about how they can make a profit when pundits are almost all predicting a slow start to 2008 (and those are the optimistic ones).

I have never heard of our new adviser, Dan Amoss, though apparently he did make several good short recommendations and if you’re in to this kind of thing, it’s certainly possible that he’s as accomplished as any other bearish newsletter advisers or options or shorting service gurus.

But just to give you a couple things to think about, when you’re tempted to use options trading, other derivatives, or short selling to profit from a falling market (for those of you who are already experts in all this stuff, please forgive the Gumshoe for starting the year on his soapbox):

1) The current, though uneven, is against you. A regular “long” investment in a common stock or in the overall market has good odds of benefiting over time from the fact that the tendency of the market is to go up over time — there are certainly bad years, but the average return is a positive 8-10% annually, so that means you’re fighting the overall market in the long run. Given an average day, week or month in the market, you’ll be better off owning stock than shorting stock — so you need to be sure that you’re smarter than average, or have better than average timing.

2) Pundits are not, on the whole, any better at predicting a great market than they are at predicting a bear market collapse. The fact that we are in a credit crunch means that the investing programs and magazines are filled with people telling you, often in frantic, high-pitched voices, how you have to prepare for a crash … but it does not mean that there’s going to be a crash, or even a prolonged bear market … or that it will begin and end when it’s most convenient for you or your trading strategy.

3) Derivatives are usually tied precisely to time periods, and are much more likely to become worthless than are common stocks. Derivatives, especially the most common ones like futures contracts and options, do often expire worthless — that’s why that other strategy recently teased as the “California Overnight Dividend” works pretty well for many individual investors, the people that sell derivatives, on average, probably get a much more stable return than those who buy them.

4) Any kind of short, whether a put option or a genuine short sale, has a ceiling — there is a maximum amount of return that’s possible. That’s especially true for shorting a stock — the most you can make without borrowing money is the full price of the stock, a 100% return (that’s a simplification, but generally true). Just to give an example using Research in Motion — if you had shorted the stock a couple years back when it was at $50 and everyone said it was overvalued, the most you could have possibly made if you were right (which you were not) would have been $50 a share if it went to zero. Upside potential is, however, unlimited — even if doing better than 100% is unusual. Buying RIMM shares would have gotten you a couple hundred percent return by now, and there’s no mathematical limit on how high a stock can go.

5) One point in favor of derivatives: You can easily choose a maximum amount you’re willing to lose. If you’re going to bet against the market, put options are generally a much more palatable strategy for many investors than are regular short sales. Selling a stock short has a defined and limited upside (potentially the stock could go only as low as zero), but an infinite downside (there’s no limit to how high the stock could go if you’re dramatically wrong). Since a short seller has to buy the stock back someday, if the stock goes up 500% before you buy it back you could lose far more than the stock was initially worth (in practice, most short sellers would sell before it went that far — but I’m sure some hold on stubbornly for ages, just like long investors do, and some stocks, especially microcaps, could potentially move a hundred percent on a single piece of news before you can cover your short). With put options, however, which give you the right to sell a stock at a specific price before a specific date, there is no way to lose more than you invest to buy the option — if it expires worthless, it just goes to zero. And on the plus side, put options represent significant leverage, too, so if you buy a $50 put on a $50 stock (the right to sell the stock before a set date for $50, regardless of what the stock price actually is) for $10, you could potentially get a 400% return if the company goes bankrupt and the stock goes down to zero.

(Just to further explicate … or perhaps confuse: in this case the stock would have to go below $40 by the expiration date for your put option to be “in the money” or break even … but if it did go to zero, that whole move from $40 down to zero would be all profit for you. If it only went down to $45, you’d lose $5 of your original $10 invested, if it went up instead of down you’d lose all $10 but no more. For a short sell in the same situation, you would borrow shares when they were at $50 and sell them. If the shares fell to $1 you could buy the shares and use them to repay your loan, thereby getting a profit of $49 a share. Since you don’t actually buy the shares in the first place this is theoretically a massive return, but you did incur a liability when you borrowed the shares so you are tying up that money — and if the price goes up, you still owe the owner of the original shares their shares back, so you’ll have to buy them at whatever price the market charges you.)

OK, so no real exciting stock teaser this time, just an email ad for a trading service that caught my attention because of their clever “Santa Monica” name. I’ll get back to finding interesting stock ideas in the teasers shortly, I hope.

Oh, and let me take this opportunity to wish all the fabulous readers in Gumshoe Land a very Happy New Year. Thanks for giving me the opportunity to blather on about newsletters, teasers, scams and investing ideas … and special thanks for those who have sent in teasers, contributions, and ideas, or otherwise shared their experiences with the community.

I hope you’ve got the patience to put up with me for another year of bloviating and sleuthifying — I think it’s going to be an interesting one!



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January 1, 2008 8:45 pm

Interesting read. I like the old rule of if you don’t understand it well enough to explain it, you shouldn’t invest in it. The company I work closed a significant acquisition this year. Leading up to it we hedged the interest rate with derivative instruments. Even our high-priced investment bankers were surprised at the outcome – one in which they had not contemplated and resulted in us writing an 8-diget check. Investor beware!

Best Wishes,

January 2, 2008 1:45 am

Well wishes for a New Year! May the trade winds favor you & always sell at the top!


January 2, 2008 9:27 pm

Since we are taking options,a strategy I have used with success is buying options at the same strike price, yes,going long and short at the same time. This allows you to trade both sides of the market at the same time.The biggest risk is a flat market.Trade this pattern 6 months out. Try it on paper first.If your short options and long futures,use a stop loss to exit the future at the strike price,and your in position to make money on the downside. Ignore this trading pattern if you have no stomach for risk and have a long term investor mentality. Had Amaranth used this technique in the nat gas market,they wouldnt have gone bust.

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February 17, 2009 11:46 am

Yes, I agree ..In this market climate
you must be on both sides of market..

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