News of a $2 billion "rogue
trader" loss brings to mind an important subject: How to keep rogue
trades out of your portfolio.
The parallels to 2008 keep
piling up.
Early that year, French bank Société Générale
revealed $7.2 billion in losses (that's billion with a "b") at the
hands of a single rogue trader. The culprit: A 31-year-old trader named
Jerome Kerviel.
The Société
Générale losses came on a massive $73
billion worth of positions, which Kerviel hid by
hacking the bank's computers. After that devastating hit, SocGen
instituted a whole new slew of watchdog rules, such as "be wary of
traders who never use vacation time."
Now, in 2011, another major bank
-- the Swiss bank UBS -- has announced a cool $2 billion in surprise losses.
A "rogue trader" has struck again.
This time it was not Jerome Kerviel in Paris, but a UBS employee named Kweku Adoboli in London, who
did the damage.
The similarities are uncanny:
Both Kerviel and Adoboli
were 31 at the time of their arrest; both worked with "Delta-1"
products (a form of derivative that tracks asset classes); and both appear to
be quiet types who toiled in similar departments.
The $2 billion rogue-trade loss
is another black eye for the banks, which were supposed to have stamped out
this sort of thing with much tighter fail-safes and controls.
"It is amazing that this is
still possible," muses trading analyst Claude Zehnder.
"They obviously have a problem with risk management..."
For individual investors and
traders, one lesson here may be to avoid "black boxes" -- opaque
businesses with complex structures, like banks, where something big could go
haywire at any given time.
But the incident also provides
food for thought. How do these trading disasters come about?
Men like Adoboli
and Kerviel, and other rogue traders like Nick Leeson of Barings Bank (who lost $1.3 billion) or John Rusnak of Allied Irish Bank (who lost $691 million), do
not intentionally set out to blow things up.
Instead, the trouble usually
starts small... an attempt to cover up a modest investment portfolio loss, or
to make a poor reporting period look better.
The goal becomes to make a
little extra money quickly -- enough to cover the small problem -- and then
go back to normal, with no one the wiser.
If the double-down scheme works,
the trader's name never shows up in the news. He (or she) may even earn a
nice bonus at the end of the quarter.
But if it doesn't work, and the
initial loss snowballs, that's when the real trouble begins. As problematic losses
become too big to manage, desperation kicks in. Bigger and bigger bets are
made, until finally it all unravels.
On a much smaller scale, the
same thing can happen to an individual investment account. Not the fraud
part, per se, but the compounding disaster from a "rogue trade."
In this instance, a small loss
is allowed to morph into a bigger one... a bad investment is ignored, or even
added to on margin... and so on. You know the rest of the story.
Here are some rules of thumb for
keeping "rogue trades" out of an investment portfolio:
·
Always know
your exposure.
·
Always know
your risk points.
·
Don't buy
more without a plan.
·
Don't
forget correlation.
Always Know
Your Exposure
This one is simple but
important. How much risk does your investment portfolio actually have? And
how is that risk spread out across positions?
If you are 50% long with all
your money in two stocks, for example, that is a different proposition than
having your money in 20 stocks. If you have short positions or inverse ETFs
to offset some of your long exposure, that changes the picture too.
Tracking exposure levels helps
clarify the danger you might face in a "worst-case scenario." It's
not always fun to think about, but better to be prepared than unprepared.
Always Know
Your Risk Points
Next: If a position goes against
you, where is the risk point? That is to say, at what point will you sell it
(or cover if short)?
There are many possible
approaches here: A trader might prefer a tight stop-loss based on a chart
pattern. An investor might utilize a general risk point, like a 25%
stop-loss. An aggressive value investor might say, "I like this position
so much it could go down 50% and I wouldn't sell."
The key thing is having a risk
plan beforehand -- and then sticking to that plan. If you buy a stock with no
sense of where you might sell, you secretly imply a willingness to hold to
zero.
And if you really are willing to
hold on no matter what -- assuming the fundamentals still look OK -- then
clarify that to yourself up front. It will push you in the direction of
smaller position sizes, and encourage treating the entire holding as your
risk amount.
(For example: "I have 5% of
my investment portfolio in XYZ, which I will hold... so even if XYZ goes
bankrupt, the most I can lose is 5%").
Don't Buy
More Without a Plan
There is a great divide between
traders and investors when it comes to "averaging down" -- the
process of adding to a long position as price declines (or adding to shorts
as prices rise).
Most traders rarely if ever
average down. Some value investors swear by it and do it regularly.
For the trader, a position
moving too far the wrong way is a clear sign the timing was wrong. For the
value investor, it is just a sign their cheap investment pick is getting
cheaper! Traders and investors are also willing to add more as a position
moves in their favor. This is often known as
"pyramiding."
No matter the circumstances, a
decision to add to the position (via pyramiding or averaging down) should be
planned out in advance, before emotions get involved.
This is what the rogue traders failed to do; they let
emotion get in the way, and then they lost control.
Don't
Forget Correlation
And finally, don't forget
correlation risk. The more capital you have committed to a single industry or
group, the greater the correlation, in terms of price moving up or down on
the same drivers.
For example, seven different
steel stock positions may actually act like one steel stock position,
seven times as large. Three bullish grain trades
may act like one bullish grain trade three times the size, and so on.
On top of that, it takes little
reminding these days that risk assets have become more correlated in general.
This is the idea behind "risk on" and "risk off" market
conditions, in which the thundering herd runs full blast in one direction or
the other.
With those basic rules at hand, your trading and investment portfolio should happily stay
"rogue free."
Justice
Litle
Taipan
Publishing Group
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