NFA Reveals Commissions Chaos in Churning Case
By Paul Springer
It’s easy to lose your shirt — and everything else — trading derivatives and currencies, but your loss may well be the broker’s gain. Brokers are entitled to make an honest living on commission regardless of how the trades turn out, but the National Futures Association recently painted an ugly portrait of brokers that didn’t turn out to be very honest.
The NFA permanently barred 20/20 Trading Co., and its principals Sharief McDowell and Bharat Adatia for five years, in an enforcement action that accused the parties of “failing to uphold high standards of commercial honor and just and equitable principles of trade.”
That’s a pretty pale rendering of what attracted the NFAs attention. The CFTC referred a customer to the NFA, which learned that within two days of the customer opening an account with $31,000 in 2007, 20/20 recommendations led to 144 trades that generated commissions of $13,000.
The NFA reviewed additional accounts and found that when it came to trade ideas, 20/20 often recommended the losing kind:
The spread strategies that 20/20 recommended generated large commissions for 20/20 but frequently made no financial sense for customers. In some instances, customers could have obtained similar market exposure with outright futures or option positions rather than the spreads that 20/20 recommended, but this would have meant substantially fewer trades and, in turn, substantially smaller commissions for 20/20.
Traders need to balance potential risks and rewards, but at times 20/20 recommended trades that couldn’t possibly win:
Sometimes the spreads that 20/20 recommended were automatic losing trades from the moment they were placed due to the fact that the commissions and fees charged on the spread exceeded premiums collected. Out of the twenty customer accounts held at [a clearing company] that NFA reviewed, all but one had at least one option spread that was an automatic losing trade on which the customer had no ability to profit.
The NFA says 95% of the firm’s customers lost money in 2006, 2007 and 2008, much of which was incinerated in retirement accounts.
The pair denied some allegations and said they lacked information to evaluate others, but they said trading results reviewed by NFA “speak for themselves” with respect to the NFA’s claim that 95% of its customers lost money.
Anyone interested in how derivative transactions can be structured to benefit the broker at the expense of the trader should take a look at the NFA’s analysis of trades. One example from a review of an iron condor vertical spread trade:
[The client] paid commissions and fees equal to 53% of the premium collected, thus benefitting 20/20 and McDowell more than it did [The client]. Moreover, the call leg of the lron Condor made absolutely no financial sense as the commissions and fees of $1,987.14 greatly exceeded the $220 net premium [The client] collected. As such, [The client] incurred significant additional financial risk while receiving absolutely no financial benefit. In fact, if that leg of the trade had not been executed, [The client] would have saved $1,767.14 and been exposed to considerably less risk.
In another case, the NFA claims, a cold call persuaded a client to open an account with about $50,000, “his entire life savings from his IRA.” The account generated $15,000 in commissions in the first two days, and it had a debit balance of $1,200 when it was closed about a month later.
Even with low fees, the first rule of derivative trading always applies: you can always lose more than you’ve made, and you can lose it more quickly than you made it. Throw in the old adage of caveat emptor and an abusive fee structure, and you’re frankly better off buying lottery tickets — at least there’s a slight chance you might win.
- Greed Isn’t Good: Enforcement RoundupThe wheels of justice grind with proverbial sluggishness, but grind they do. Here is a compendium of recent...
- Street Dodges Volcker with Prop Trading MovesBack in the 1990s, Nasdaq created the Small Order Execution System (SOES) to help the little guy get...
- Flash Crash: A Cold Case?Picked up this morning by Jim Kim over at FierceFinance is a Reuters Article that, as Jim puts...
Short URL: http://www.traderdaily.com/?p=7561