In this series, we shall examine some famous trading losses. And note down what not to do in our own operations.
Background:
In 2005, Ina Drew appointed to manage “risks” using banks excess money (i.e. difference between deposits and loans). They were supposed to buy insurance. They decided to sell insurance and become a profit centre. They also removed stop loss of $20 million – apparently without informing Dimon.
By 2011, the profits swelled from this twisted operation. Now they have 4x the money up to 350 billion. In 2010, this unit accounted for 25% bank’s profit.
What was the trade?
1. Sell CDS on high grade US corporate debt. Essentially this is out-of-money PUT option writing, with expectation that US companies will not default. So, the bank can keep the premium.
2. Specifically the instrument itself was the ‘CDX North America Investment Grade Series 9 10-Year Index’. It is comprised of 125 equally weighted credit default swaps on investment grade entities distributed in six sub-indices – high volatility; consumer; energy; financial; industrial; and tech, media, and telecom.
What happened?
1. JPM positions were so big i.e., They sold a LOT of PUTs (presumably, in exchange for LOT of premia – but OTM Puts on a liquid market like this, would have been pennies on the dollar really). We don’t know what delta or what premium was collected.
2. If someone is selling a LOT of something what happens normally? The price drops, isn’t it?
3. That’s what happened here. The price of PUT options (CDS) started to fall. At one point, the prices had fallen by 21% to its fair value.
4. Hedge funds, led by Saba capital noticed. They start buying the PUTs (CDS’s) to wait for market to revert to mean. Comedy is that JPM’s another arm (unaware of that they are betting against own firm), also bought the PUTs.
Other challenges:
1. CDS is not a publicly quote market. Market is made by select big banks and giant counterparties. In other words, only smart money.
2. It is also illiquid – far more than public markets.
Tangling with smart money whilst taking giant bets in an illiquid market. Not a good idea. Even if you are mighty JP Morgan.
End game:
1. More the word got leaked, more & more hedge funds and other banks bought the CDS.
2. Pain at JPM became unbearable as they had to mark their losses daily. It reached $100 million / day.
3. Jamie Dimon & other adults ordered position to be unwound.
Loss: JPM booked some $6 Billion in losses.
What can we learn from this?
1. Pay attention to position size. If JPM can’t withstand oversized pain from oversized positions, nor can we.
In our stat arb model, no position is more than 2% of capital.
If our trades need large, concentrated positions, NEVER EVER take positions that can move the market. Trade highly liquid index funds, where your trades, no matter how large will not move the market.
2. If you are going to write PUT options, then
Trade only a size that your fund can take in if assigned.
Have sufficient liquidity to cover for sudden and violent increase in Implied volatility.
