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It still isn't clear how JP Morgan (JPM) managed to lose $2B in a portfolio hedge trading an index of credit default swaps. It isn't clear whether the hedge was always just a hedge, or whether it morphed into an outright directional - that is, speculative - position at some point. Given the arcane nature of bank accounting, it isn't even clear whether JPM didn't make money, net of everything, due to something called a "debit valuation adjustment." One thing that is clear, however, is that there has never been a better time to be small and nimble. Instead of using derivatives to blow yourself up, use derivatives to lock in some gains while keeping upside exposure.
Banks, dealers, and market makers don't get to construct portfolios the way you and I do - they have to follow customer demand where it goes. And when you combine the need to hedge an exposed portfolio with the size and leverage of a JPM, there aren't always a lot of places to find the necessary liquidity. Lisa Pollack at the FT wonders whether the loss was actually the result of the bank unwinding what was a hedge into something more directional:
"[R]everse back to the summer of 2011, and put on a(n innocuous) trade like so: - Buy $12bn of 5-year protection on the index, maturing December 2012 (five years from when the index started to trade). - Sell $4bn of 10-year protection on the index, maturing December 2017 (ten years from index start). ... [T]he European Central Bank came riding to the rescue towards the end of 2011 with cheap three year loans for banks under its long-term refinancing operations (LTROs). It just won't do to have big hedges against systemic risk if the ECB is backstopping the system! We just won't be seen dead in this dress hedge it makes our butt carry look big! So let's 'manage' that off. And let's make money while we're at it."
The resulting activity starting in January of this year (cf. the bottom panels of fig. 1) is, on this theory, the result of JPM selling more 10Y swap protection - bringing in more premium - and not hedging it. Once the price of the index reversed course (top panel), the position started incurring some major losses.
Let's leave the detailed storytelling there. These are the lessons I think we can take, as individuals, from the tale:
1) Don't take on more exposure than you can hedge effectively in five minutes. It took a lot of time (months) for JPM to build up the exposure that it did. As an individual investor, you can choose to limit yourself to liquid assets and deep markets.
2) Don't confuse hedging and speculation. Let's say you're sitting on gains in some stocks that have performed well in the last 6 months. If you buy one at the money call option for every 100 shares of stock you sell, you're just converting shares to calls, which can be a very smart way to lock in gains while keeping some upside exposure in place. If you buy two at the money calls for every 100 shares of stock you sell, you're actually just adding speculative exposure, not hedging, and eventually you'll take the same kind of hit that JPM did.
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