There was another rogue trader in the news recently. This creates an opportunity to dissect the rogue trader’s mindset, and to extract a valuable lesson for investors.
A rogue trader is someone who makes a bad trade, covers it up with deception, and winds up costing their employer a huge amount of money when they get caught.
The typical rogue trader never closes the bad trade voluntarily. They just let it get bigger and bigger, hiding it from view the whole time, until they finally get found out.
Most rogue traders avoid taking vacations. This is because it requires an active effort to “cook the books” and keep the bad trade evidence hidden. If the rogue trader goes on vacation, that means somebody else has to take over their responsibilities for a few weeks, which in turn means a risk of being exposed.
Just a few weeks ago, a new rogue trader was caught in Singapore. He was foolish enough to go on vacation, leaving someone else to handle his duties. His disguised bad trades, which took place in the crude oil market, were immediately discovered and closed out.
The rogue trader, it turns out, had been covering his tracks for at least eight months. The trader had been bullish and wrong on crude oil, leading to a series of escalating losses. The bad trades cost his company, Petro-Diamond Singapore, and its much larger parent company, Mitsubishi, an estimated $320 million.
A $320 million loss may sound like a lot, but it’s really not that much in the annals of rogue trading. The biggest rogue traders have lost far more.
Nick Leeson, perhaps the most famous rogue trader of all time, lost an estimated $1.3 billion on Japanese stock index futures in 1995. But Leeson wasn’t famous for the amount of money he lost so much as the venerated stature of the employer he brought down.
Barings Bank was the oldest merchant bank in Britain, founded by Sir Francis Baring in 1762. Because of Nick Leeson’s loss, Barings Bank collapsed and ceased to exist, wiping out 232 years of business history. That probably takes the prize for ugly consequences. But in terms of trade size, Leeson’s $1.3 billion loss was still small.
In 1996, just a year after Nick Leeson brought down Barings, Yasuo Hamanaka was caught making rogue trades as the chief copper trader for Sumitomo Corporation. Hamanaka cost his employer an estimated $2.6 billion. Once caught and convicted, he spent seven years in prison.
Twelve years later, the loss numbers grew even bigger. Jerome Kerviel, a trader at the French investment bank Société Générale, had racked up an incredible $7.2 billion in rogue losses by 2008.
After Kerviel’s mind-blowing losses, the big investment banking houses all swore they would improve their risk management and compliance systems, in order to keep rogue traders from hiding losses or disguising their trades. It didn’t seem to help. A few years later, a rogue trader named Kweku Adoboli cost UBS, his Swiss bank employer, an estimated $2.3 billion.
Rogue trading is an oddly common phenomenon. When it comes to losses in the $50 million to $500 million range, there are too many examples to count.
Rogue traders also have a longstanding place in financial history. In the early 1930s, for example, a rogue trader at the London arm of Lazard, a famous investment bank, contributed to a global financial crisis.
This trader had lost $30 million on a bad currency bet in the 1920s, then covered up the loss for years. The trader had wiped out the bank’s capital, but thanks to accounting trickery nobody realized it. His deception was uncovered in 1931, when currency market stress brought the bank’s insolvency to light.
On being confronted with the evidence, the trader pulled out a gun and shot himself at his desk. The insolvency news, and the realization a famous bank had been secretly bust for years, touched off new waves of panic. The governor of the Bank of England had to arrange a multi-bank bailout, as waves of fear rolled from London to the capitals of Europe.
For all the variation throughout history, rogue traders tend to follow a similar pattern.
- They never intend to take a large loss.
- The loss is manageable at first.
- So they make another trade to “get back to even.”
- But the new trade puts them further in a hole.
- And then they just keep digging deeper.
The two signature moves of the rogue trader are first, deceiving their employer and coworkers, and second, denying reality until a manageable loss becomes a catastrophic loss.
Whether the loss tops $30 million, $300 million, or runs into the billions, the pattern is always recognizable. A bad trade or a poor investment decision is rationalized. There is a doubling or tripling down rather than acceptance of a loss. The pattern then repeats until a point of no return.
For investors, it is important to remember that nobody — unless they are crazy — throws away a fortune on purpose. The process of creating a huge loss often starts with a small loss and then compounds. The first mistake is typically a small step rather than a giant leap. A combination of ego, rationalization, and a refusal to accept reality then leads down a dark path.
To learn from the rogue trader phenomenon, a simple rule of thumb is: “Never let a planned loss become an unplanned loss.” In order to apply this rule, you have to know at least three things with every investment:
- How much you can afford to lose.
- How much you intend to lose (if things go wrong).
- The point at which you will close out or walk away.
If you never let a planned loss turn into an unplanned loss, then by definition you can never have a rogue trader experience. Your loss exposures will be planned, and none of them will be catastrophic.
Does this mean always having a stop loss or a “get out” point? Not necessarily. Some investors prefer not to use stop losses or risk points on their positions, and that is okay. There are many forms of risk management, some of which do not require stops.
If you put 3% of your capital into a risky investment, for example, and you know there is a possibility that the investment goes to zero, your risk is still limited. You cannot lose more than the capital you put in, which is 3%. The size of the position defines the risk.
Whatever the method that applies — be it a stop loss, a risk point, a defined position size, or something else — the key thing is having a contingency plan and sticking with it.
Maintaining an investment plan, and executing that plan consistently, is a much easier task with high quality investment tools. In fact, if the world’s rogue traders had been using great investment software — and understood the kind of behavior principles we focus on at TradeStops — they might never have become rogue traders in the first place.
Richard Smith, Ph.D.
CEO & Founder, TradeSmith