Author Bio

There’s a massive amount of commentary in the news and among market participants about JP Morgan and the big loss it reported earlier this week. The politicians, and anyone else calling for stricter regulation of the banks, are having a grand old time with this development, suggesting that Dodd-Frank and the Volcker Rule were exactly intended to avoid this sort of thing happening. Actually, I’d argue that they are (or should be) designed to ensure the security of the financial system (FDIC insurance being there to protect depositors). To that end, here we are with no risk to the financial system from the JPM loss because the bank has a “fortress balance sheet”.

Isn’t that what every bit of discussion and legislation has been about the last few years? Shouldn’t we be looking at this case as being a perfect example of why all banks should have such strong balance sheets?

We cannot possibly expect banks to never have losses. In this case it was a bad trade/hedge decision and execution. In another case it could be a higher level strategic business decision (acquisition, entry into a new market, etc.). Just as we cannot prevent individuals seeing negative consequences from either rational or stupid activities, we cannot expect companies (banks, automakers, or otherwise) to have every decision produce a positive result. It’s a question of risk management and having the cushion to ensure the inevitable issues don’t get transmitted through the system.

That’s my political/social rant for now.

Getting into the trade
As for what JPM actually did to suffer the loss, it’s a pretty convoluted thing that most individuals won’t understand well and really don’t need to in any case. I won’t try to explain the details of it here because frankly I’m trying to work through what the Thomson Reuters reporters have pulled together thus far and we may never get the whole story regardless. What it seems to come down to is JPM having a short position in the credit default swap (CDS) market, which essentials is akin to going long a bunch of corporate bonds (taking credit risk). It’s hard to see this as any kind of hedge since JPM would have credit risk in its portfolio from the lending it does.

The hedge aspect seems to be from using different CDS instruments to go long later, but there was a maturity mismatch. It’s kind of like trying to hedge 10yr Notes with 2yr Notes in that it is different than a simple interest rate hedge because you have created a yield curve exposure (yield curve could flatten or steepen). JPM seems to have been caught out by events influencing the two maturities of CDS in different ways.

And of course all of this tends to get exacerbated by relatively illiquid market conditions and the fact that JPM essentially became the market at a certain point. This is part of what created the problems in 2007 and afterwards when the financial crisis began to unfold. There was suddenly no one to take the other side when institutions wanted to get out of their positions, and actually folks (read hedge funds) actively working against them.

Focus on the hedge structure
The hedge mismatch is something worth thinking about if you look to do hedging in your trading or investment activities (most individuals don’t, but some do). One thing I hear often among forex traders is their action (or intention) to use one currency pair to hedge a position in another.  For example, a trader might go long USD/CHF to hedge a long position in EUR/USD. The rationale here is that you remove the USD-related risk because you have a long USD position matched up with a short USD position.

Here’s the problem, though. While you do remove the USD risk, you have now added a short CHF exposure. You’re now long EUR/CHF. This is an entirely different trade than the one you started with.

Hedging should be about reducing or eliminating a certain risk, not about creating a new one. JPM seems to have made two mistakes. They introduced a “curve” risk by hedging with shorter-dated CDS, and they introduced a liquidity risk by being so big in a relatively illiquid market. Make sure you don’t create new risks with your own hedging.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Author Bio

I came across a poll being run by the folks at BabyPips today. The question is “Do you usually trade using hedging, i.e. making the opposite trade of the one that is currently open?” When I checked on the results this morning it showed that 29% of respondents responded that they do indeed use this sort of “hedging” (though I couldn’t see the actual vote count). This strikes me as a very high number, considering there is no economic benefit to this activity, and it can actually cost the trader money in the form of additional spread and carry costs. Maybe it’s a function of BabyPips being largely a newer trader oriented forum.

In retail forex, “hedging” has long been a hot-button subject. When the NFA ruled that US brokers could no longer use that type of accounting (“hedging” in this fashion is nothing more than a method of accounting), it created something of a firestorm among traders. My No More “Hedging” for Forex Traders post at the time remains by far the most commented one on my blog, with strong views expressed on both sides.

Needless to say, this sort of “hedging” will not be among the risk management subjects I will be discussing in Wednesday’s webinar. Instead, the focus will be on understanding volatility in the markets so one can be better prepared both for the risks implied and the opportunities it presents.

As a little bit of a taste, take a look at this chart.

What you see here is a comparison of daily volatility between the S&P 500 and the USD Index. The plots show the percent change for each market for each day, expressed as a positive figure (so a -1.5% would be plotted as +1.5%). As we can see, the stock market has moved around quite a bit more than the dollar has since the beginning of July, a time which encompasses things like the US debt ceiling debate and continued European sovereign credit issues. There may be a couple of sessions where the dollar was more volatile, but mostly the stock market moved markedly more than the currency index. That means on a strictly price volatility basis, the USD Index is quite a bit less risky than stocks. This is something investors looking for opportunities to diversify need to know.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Author Bio

One of the questions that came up during the “Perils of Autotrading” webinar I did a couple weeks ago was how long an investor should give a Trade Leader (or other auto trading trade provider) who isn’t seeing good results. This is a very good question. It relates as well to when one should pull money out of a mutual fund or other managed investment.

This is a tricky one. It’s something that all too often isn’t done very well. Investors have a habit of dumping a manager or fund at the wrong time following poor performance, generally after having put their money in at the wrong following really strong performance. To really get it right, one needs to think like a trader in terms of comparing the performance of a system or method to what should be happening.

Basically, what I’m talking about doing here is understanding how a manager operates. Looking at the Trade Leaders we can see they have a number of different styles and approaches to their trading. Part of an investor’s decision-making process when picking one or more should understand the basis of that trading. That doesn’t mean knowing the underlying system, because obviously there are things one will never see.

What it does mean, though, is having a good view of how that system performs. Is it very consistent in terms of daily/weekly/month trading? What sorts of gains and losses does it see on a trade-by-trade basis. How frequently does it trade? How does the system perform in trending and ranging markets? Some of this will be easy to see, while some will require a bit more work to figure out.

What we’re after here is a baseline from which comparisons can be made. That way, we can look at how a manager is performing and know whether it’s from some deviation from historical trading patterns or whether it’s a function of something external, like how the markets are performing. For example, a long-only stock mutual fund is going to struggle during a bear market, but that doesn’t mean the manager is doing badly.

One other consideration to keep in mind. Diversification is something that can be very important in creating a portfolio of Trade Leaders, etc. Naturally that means at times one or more managers is going to under-perform while others perhaps over-perform. We shouldn’t pull the plug on a manager just because their results don’t match the others because in the next market cycle it could just as easily be the other way around.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.