My junior year at Eastern Illinois University I took a course called “Financial Markets: Commodities, Derivatives, and Securities”. Riveting stuff.
Our professor, Dr. Crystal Lin, asked us to participate in an enhanced version of the “stock market game”. The stock market game has become pretty common in high school consumer ed classes across the country, where each student gets a sum of fake money and has to invest it in stocks of their choice. After a month or two the teacher calculates which student would have had the best performance off their stock picks and they are declared champion/finance guru/Jim Cramer Jr.
Dr. Lin added a twist onto this game. We had to pick one company and the company’s name had to start with the first letter of our last name, so I was limited to companies that started with “M”. Further, we were not buying the stock but a derivative of the stock via a “call option” or “put option”. Investors buying call options are bullish and expecting the stock price to go up, and put options would take the opposite position.
You can utilize significant leverage using call and put options, and it is not uncommon for options to gain or lose significant value in a short period of time.
We were allowed to hedge, which of course limits the upside potential. It was fake money though. Being a poor college kid, I was in a good position to risk a lot of fake money.
In my search for companies that started with the letter “M” with potential to have a sharp price movement in a short time span, I came across one called Massey Energy Company. Massey was the fourth largest producer of coal in the United States, had strong fundamentals, traded at a lower valuation than its peers, and was reporting earnings at the end of April.
I decided to bet the farm on a sharp gain before options expiration, and put everything in out of the money call options. If Massey reported a nice earnings surprise, I suspected I would make hundreds of percentage points in return.
From what I remember the project started in mid-March and ended at the end of April. I saw the shares or Massey Energy rise nearly 10% from the middle of March to the start of April. My call option was now in the money, big time (we weren’t allowed to sell though until the options expired).
Then on April 6, 2010 I went to my computer to record Massey’s opening stock price and noticed a steep decline. Then I saw a headline like this:
The most tragic day in the history of the company occurred and 29 miners lost their lives. The stock price plunged and my options were now worthless, but none of that really matters. 29 people never returned home to their families.
None of this could have been forecasted by an investor. If it could have, 29 people wouldn’t have died.
If you think this is an extreme outlier and unlikely to happen to any individual stock you own, you are mistaken. 14 days after Massey’s mine explosion, BP spilled 4.9 million barrels of oil into the Gulf of Mexico. The stock fell more than 50% over the next 10 weeks, and its share price is still 35% lower than it was in April of 2010.
In February of this year a little company called Kraft-Heinz lost $17 billion in market cap instantaneously. Here’s a chart, see if you can spot where they announced they were under SEC investigation for accounting practices and cut their dividend by 36%.
As you may tell from the chart, the market interprets news rather quickly. The stock is still down over 70% from its 2017 high point.
While I didn’t win the stock game with fake money, I choose not to play the game with real money. A permanent loss like the ones listed above could be severely disruptive to your lifelong endeavor of compounding interest. Broad diversification amongst different asset classes does limit your short-term upside, but can still build significant wealth over time.
By the way, I did get an “A” in the class.