Investment Strategy: Shorting Stock And Joe Campbell’s $144,405.31 Mistake

Joe Campbell, by accounts, is a 32-year-old small business owner from Gilbert, Arizona. On Thursday, November 19, 2015, he became a viral internet news story.

Joe Campbell was doing fairly well in life – well enough that he had a spare $37,000.00 lying around that he could “afford to lose.” With that spare change, he opened up an E-Trade brokerage account, which he used for speculation.

Joe set his sights on a small biotech firm, KaloBios Pharmaceuticals. The company was in serious trouble. Closing at $2.07/share on November 18, KaloBios Pharmaceuticals could no longer afford to carry on the costs of doing business and was headed toward liquidation. Campbell estimated the stock was worth about $1 and saw an opportunity to make a quick return on his investment.

Campbell went to E-Trade and asked to borrow shares of the stock from other investors, promising to return them later. He sold the stock, took cash up front, then figured he would buy the stock back later for a fraction of what he paid, giving those shares back to the other investors he borrowed them from while keeping the difference.

This is what happens when you short a stock. Specifically, Campbell entered into a “naked short” – he held no securities that would have gained asset value if the stock price increased, insulating him from potential losses in the event his short position didn’t go as planned.

Joe went to bed on November 18, 2015, having sold (borrowed) 8,400 shares at an average price point of about $2. What happened next was the stuff nightmares are made of.

 

Overnight, the company announced that a buyer was going to acquire the firm. In an instant, the shares skyrocketed. On November 19, KaloBios Pharmaceuticals opened up at $14.00 per share.

Upon realization, Joe got on the phone with E-Trade. Because KaloBios Pharmaceuticals was such a tiny business with such a small float, there was little opportunity for E-Trade to get ahold of the shares Joe needed to close his position. Joe sat there, exposed, until E-Trade was finally able to fill the order at an average share price of about $18.50.

Joe Campbell’s entire account was wiped out in an instant. Worse, not only was the $37,000 completely gone, the value of the outstanding shares he promised to pay back was in the red. Joe Campbell had a realized loss of -$144,405.31. He now owes E-Trade a debt of $106,445.56.

This information was made public because Joe Campbell, in a move of desperation, started a GoFundMe page that has since been removed (but not before he was able to solicit $5,310 in donations). There, Campbell shared several screen shots from his account, which documented the damage.

 

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The full story can be found here, and documents the devastating series of events, as well as Joe’s transcript from his GoFundMe page. The full account makes me sick to my stomach and I feel tremendous empathy for Joe and his wife.

 

Shorting Stock As An Investing Strategy

Full disclosure: I do not short stock. And this is precisely why. Yes, there are ways you can protect yourself in the event this situation occurs, but know this:

When you are long a stock, the downside is limited to the principle and the upside is unlimited. When you are short a stock, the upside is limited and the downside is unlimited.

I work hard for my money – much harder than I’d like to admit – and I am not willing to subject it to wipeout risk. When you are shorting stock, you enter a binding agreement with your broker that you are borrowing shares of stock from other investors and you will pay those shares back.

 

Lessons Learned From Joe’s Mistakes

1. Joe entered in an agreement he did not understand. He did not realize that shorting stock can result in a greater loss than what existed in his account. He believed the worst case was the account would go to $0.

2. Joe did not understand that a stock can go from $2.00/share to $14.00/share without going from $2.01-$13.99 on the way. From his GoFundMe transcript:

The stock was at $16 and my account was negative over 100k. I figured it was a mistake, Etrade would never let that happen, they must have cut the position when my account got to $0….nope. I immediately called them and they confirmed I still owned all the shares. He says that it got out of hand too fast for them to cover me…Never in my wildest dreams did I imagine that Etrade would NOT have some sort of stop or circuit breaker in place that would automatically cut a position if the account went to $0…..how could they ever let it get to -$144k loss on a account that small!

E-Trade is a discount broker. They are not a dedicated financial adviser. Their job is to sell you shares as cheaply as possible – that’s what you sign up for when you sign up for a self-managed account. Joe Campbell believes that it is E-Trade’s job to watch over his account with paternal guidance, protecting Joe from himself. Not so. Even if he would have had a stop-loss in place, there never would have been time to trigger it because the stock jumped straight to $14. It happens – every day.

3. Joe is in this mess because he began tinkering with things he didn’t understand, and he will probably make it worse by trying to fix it by tinkering with things he doesn’t understand.

From Joe’s GoFundMe transcript:

My plan moving forward is to liquidate mine and wife’s 401k’s and try work out a payment plan with Etrade. I’m also going to ask them to help out in some way…thats a longshot. I will pay them and be back trading….only with set stops this time. What an expensive lesson that was.

This action could have devastating consequences. This debt that Joe owes is very real – it is very similar to credit card debt. Many 401(k)’s have bankruptcy protection. There is a very good chance that Joe will default in this situation. In other words, if Joe’s entire asset base gets wiped out in this situation, he doesn’t have to start over completely. He could start from $0 + 401(k). Liquidating the 401(k), then defaulting anyway, will have him truly starting from $0.

Actually, less than $0. This action will have him triggering taxes on the deferred contributions, plus a 10% early withdrawal penalty. Joe will be adding potentially tens of thousands of dollars in IRS debt to the equation by doing this.

Which brings me to my next point.

4. Joe is assuming E-Trade will work out some kind of installment plan to help pay back the debt.

When Joe shorted the stock, he entered a binding agreement with E-Trade. He borrowed that money as a loan from his broker, taking on risk he could not afford to take on. E-Trade is under no obligation to help him pay back the debt in some type of convenient installment plan, and could sue him into bankruptcy if they so choose. Joe could be facing the E-Trade debt, IRS penalties and lawyer fees.

5. Joe’s credit could be ruined.

Unbearable debt. Bankruptcy. Lawyer fees. And add crippling insurance premium hikes and destroyed credit that come along with bankruptcy.

 

And The Moral Of The Story Is…

Writing this brings me incredible pain. I feel awful further publicizing the misfortunes of this 32-year old kid. I’m a 29-year old kid myself. We could have been high school colleagues. He could have been my older brother. He could have been a friend. But Joe Campbell can teach us all something. Joe Campbell can teach us how to avoid making these mistakes, and through his misfortune help so many others. The moral of the story is this:

Know your risks.

Joe Campbell’s life was ruined in an instant because he entered into an agreement where he did not (and continues to not) understand the risks.

Understand the risks. If you, as an investor, are willing to enter into transactions that subject you to potential wipeout risk and completely understand those risks, that is your decision. But do so with a full understanding. Do not enter into transactions blindly.

Acknowledge the risks. Do not ignore them because the possibility of them occurring is remote. If you honestly cannot acknowledge the remote possibility of wipeout because the acknowledgement makes you uncomfortable inside, walk away from investing in equities. Stick to T-Bills and Certificates of Deposit and accept the low returns. You are doing a disservice to yourself and your family by conducting business this way.

Mitigate the risks. Joe Campbell could have mitigated his risk by simply buying cheap covered calls in the event of this rare instantaneous stock surge. If you do not instantly understand what I just wrote, do not short stock or trade options.

A smart investor is an informed investor. My rule of thumb is that I should be able to explain every one of my investments to a first grader within 30 seconds. And I can. I am by no means a successful investor. I’m a young adult chugging along with most of my money in S&P 500 mirroring funds. There is nothing special about my strategy. But I do not fear wipeout. I have never gone to sleep worrying about my investments. Joe Campbell went to bed fearing his positions, and he paid the price. Be careful out there.

All information found herein, including any ideas, opinions, views, predictions, commentaries, forecasts, suggestions or stock picks, expressed or implied, are for informational, entertainment or educational purposes only and should not be construed as personal investment advice. I am not a licensed investment adviser.

Anthony

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