London’s “Whale” got harpooned.

After being in the press for taking outsized positions in the credit derivatives market, it finally ended for Bruno Iksil, aka the Whale—and badly.  JP Morgan’s recent multi-billion dollar trading loss caused a huge amount of angst in the financial press over its prop trading activities and risk controls.  As traders, we should pay attention – not out of schadenfreude but to figure out what we can learn from the whole episode.

First, let’s get clear on the facts. The exact trade that got JP Morgan in trouble was a complicated structure in the credit derivatives space. The trader bought credit protection, i.e. insurance, on sub-baskets of weaker credits and hedged the position by selling protection, i.e. selling insurance, on a basket of investment-grade credits.  Because the stronger credits were less volatile than the riskier ones, he needed to sell more face value of protection in order to be fully hedged.

According to Jamie Dimon, JP Morgan’s CEO, the trade did not go as planned. Instead, it was “flawed, complex, poorly reviewed, poorly executed, and poorly monitored.” and ended up costing at least $ 2 billion. Most of the people involved have lost their jobs. The consequences are very real for the bank and its employees.

As traders, here are some key lessons that we can draw from or reinforce from this episode. Let’s not let JP Morgan’s mistakes become ours. In no particular order, they are:

n  Hedging

Amongst some grizzled veterans, there is a famous saying—“The only true hedge is cash”. It’s a bit glib but contains a lot of wisdom. If you have a position that isn’t working, or you want to remove some risk, then the best answer is usually to close the position. If you’re sitting in cash with no position, then you simply don’t have the risk that stems from having any position on.

While hedging can possibly reduce the risk of a single position, it does not remove that risk. In the case of a hedge using the same underlying instrument, you are directly reducing your risk. One example would be being long a stock and hedging it by buying a put, as you are limiting your downside to the strike price of the put – minus the option premium. The clear link between the underlying and the hedge allows you to properly define your risk.

Problems emerge when the hedge is no longer in the same underlying instrument, as you now have to consider a host of new risks and relationships. These are called “dirty hedges” for a reason. Imagine hedging a long position in an individual stock with a put on a stock index, exposing you to several factors—the performance of the stock, the index’s performance, and the relationship of one versus the other. It’s quite conceivable that your stock drops, the index rallies and instead of saving P&L, you’ve lost money on both legs! At some point, as hedging strategies get more complicated, you are not reducing your risk on the original position—you are merely exchanging one set of risks for another. The hedge offers a false security, as you are not protecting the original position but rather expressing an entirely different view on a series of market relationships.

In the case of JP Morgan’s trades, the trade had numerous complicated risks factors that made it deficient as a genuine hedge. (You can read more about the structure here and also here). There was basis risk (the varying performance between the instrument they traded the underlying); volatility risk (as volatility in one instrument could have diverged from the other one); correlation risk (as the correlation between the subindices and higher-rated index could have diverged); and plain old credit risk, i.e. the risk of default by the components of either basket. The trade was more of a view on the relationships between all of those moving parts.

One thing’s for sure—it was not a proper hedge for JP Morgan’s existing portfolio. Because the position was not offsetting existing risks, it was not locking in any P&L for the bank, opening up a set of new risks and the potential for large losses.  To make matters worse, it exhibited negative convexity i.e. it increased in size as it went against them, something that shouldn’t happen if you’re trying to preserve P&L!

Bottom Line: Make sure you’re clear on what risks you want to hedge. After that, make sure you are genuinely hedged and not taking on a whole new position.

n  Do your homework.

On the conference call, Jamie Dimon said about the position that “It was a bad strategy”. In summary, it’s not clear if the team had done the right kind and amount of homework prior to putting on the trade. Prior to implementing a trade, it’s important to have a well thought-out rationale; to know what kind of risks you are running; and to make sure you understand how that position will work under a variety of scenarios. Similar to the hedging discussion above, you need to understand a thorough understanding of what view you are taking and what risks you are running. If you haven’t done the right kind of homework, then you are setting yourself up for losing money.

There is an old poker saying that “If you don’t know who the sucker at the table is, then it’s probably you”. In other words, if you haven’t figured out who the weakest competitor is and what your own edge is, then you are probably going to lose. This is important in all markets, and even more so in areas like credit derivatives where the instruments themselves are quite complicated. Just to show up in these markets, you need an in-and-out understanding of the product and all of its intricacies and risks. If you don’t, then you risk getting wrong basic stuff like hedging ratios and executing trades that were flawed from the very start.

n  Don’t become too big for the market

There is only one thing worse than having a trade that’s losing money—not being able to get out of it. Taking an excessively large loss will lead to account closure almost instantly. Apart from the aspects mentioned above, your position has to be liquid enough for you to get out—otherwise you are trapped and your potential downside is catastrophic.

In the case of JP Morgan’s trade, that seems to have compounded the damage. After the conceiving the trade, they put it on in massive size, in a way that appeared to distort the underlying market and invite traders to shoot against the bank. After rumors appeared in the press about the market activity and the trade started going against them, the situation worsened. The market, sensing that JP Morgan was one side of the trade, watched it struggle to get out of a position that was far too big for the market it was in. Ultimately, this compounded the losses and forced JP Morgan to recognize losses beyond the initial $2 billion estimate.  Ultimately,  when you are too big for the market and wrong, then you are going to have your head handed to you.

This matters not just in opaque markets like credit derivatives but also in markets that are supposedly trader-friendly. If you’re day trading equities, you can’t take positions that take more than one or two clicks to get out of. Even if you’re a long-term position holder, you still don’t want to buy 20% of the company where any attempt to get out of the stock will destroy it. Respect the market by trading smaller size and never, ever trying to push the market around.

Bottom Line: Always take positions that are right-sized for the market you’re trading in. Otherwise, you can’t control your losses.

Ultimately, this episode in the markets should provide a powerful reminder in why we study and repeat the basic principles of trading. A small team at JP Morgan ignored a few basic rules of trading and ultimately paid a very large price — despite working at one of the world’s most sophisticated banks, having a balance sheet of hundreds of billions of dollars and ample experience in the product area! If they can mess it up, then it should serve as a lesson to any trader, in any environment—master the basics and never, ever forget them.

Disclosure: No relevant positions

By Bruce Bower | E-mail: Bruce [at] howoftrading.com

Blog: www.howoftrading.com | Twitter: @HowOfTrading