The Scorpion and the Frog

by Jay Pestrichelli on May 11th, 2012

Today’s news about the JP Morgan loss has been front and center. I won’t rehash the details about Bruno Iksil’s selling of credit default swaps going wrong, but what I will do is give it the Buy and Hedge spin.

Today I’ve had at least 3 conversations where someone told me facetiously that Mr. Iksil should have read our book. I chuckle a bit because he has…or at least he knows every piece of market theory that is in there.

He has probably implemented risk protection in more ways than we ever will. He has probably used hedging in more ways than we ever will. He has crunched the math on drawdown in more dollars than we ever will. So why did he take a $2 billion loss?

The answer is that it was inevitable. Or I should say, it was inevitable for anyone that tries to time the market with directional bets. We’ve said it time and time again that timing the market is difficult. Even for someone that deploys so much capital that they themselves can move markets to their benefit, as we saw in this case.

It would be irresponsible to make any assumptions about his holdings and to assume he wasn’t hedged. However, to take this kind of a loss, it most likely means that there was either a flaw in the risk calculations or the results that outlined the risks were ignored. Either way, a mistake was made when it came to risk.

Think of the fable about the scorpion and the frog. We all know the moral of the story is it’s inevitable that we will do what is in our nature regardless of the consequences. The same applies to trading and investing. It is inevitable that traders will get it wrong as it’s the nature of the game.

Always know the risks and be prepared to endure them because they will come, but you just don’t know when. This is where Rule #1 – Hedge Every Investment came from and this is why we do it. We protect ourselves against the very nature of the system we work in. It is inevitable at some point we will also be wrong about the markets, but that’s why we stay hedged.

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