$1 million in 60 seconds.
It was a shocking loss. And I had a front row seat for the entire show.
Not long after the Great Financial Crisis, I jumped into the world of trading, joining a proprietary trading firm.
My goal was to learn the art of trading currencies and futures. What I learned was more important: how not to trade.
One day, on my way out of the office, I stopped by one of the more senior trader’s desk.
He was a cowboy trader. He traded like he was riding a bucking bronco.
One day he would tame the beast. The next he would be thrown from his saddle, bruised and battered. But in most cases, he lived to fight again. Until that day…
That day, he kept piling in on a losing trade. He had a gut feeling that things would go his way…
And then the trading firm cut him off. His entire account was gone in 60 seconds.
It was painful to watch. But it was a lesson on risk management.
It’s a lesson I think back on often.
The Precursor
Financial firms implode. It happens during every market cycle.
Sometimes it’s legitimate. They made bad – but not illegal – decisions.
That was the case with Lehman Brothers in 2008. It was the case with many financial firms during the Great Depression. They played by the rules. They gambled with the firm’s money. And they lost.
But other times, firms don’t play within the rules. Like former financial broker-dealer MF Global.
MF Global acted as a custodian for its clients. It’s no different than brokerage firms like Fidelity or Charles Schwab. Except it catered to speculators of things like futures contracts and commodities.
Heading the firm was Jon Corzine, a former U.S. senator and governor of New Jersey.
Corzine was greedy. He wanted to make billions. So he bet big with the company’s money on things like the direction of the European bond market.
Things turned south.
Then came the margin calls… the bank demanding more money to cover the losses on Corzine’s trades. The problem was the company didn’t have the cash. It should have declared bankruptcy.
So Corzine did something unthinkable. He used client funds to meet those margin calls.
It was theft.
$1.6 billion of client money disappeared.
Brokerage firm Interactive Brokers discovered the fraud after a weekend of due diligence. MF Global collapsed into bankruptcy not long after.
Unfortunately, this wasn’t Corzine’s first foray into horrible business decisions.
Back in 1998, he was CEO of Goldman Sachs.
He told the firm to start trading like Long-Term Capital Management (LTCM).
If you’re not familiar with that story, LTCM basically made leveraged bets on the bond market. Its goal was to exploit large price gaps between two bonds. LTCM thought those gaps would narrow, netting the company a huge profit.
Corzine liked the idea. It was as close to a “get rich quick” scheme as you can get. And so he decided to do the same at Goldman.
Months later, LTCM blew up – and Goldman almost went with it. The Goldman board forced Corzine out. So he turned to politics.
Everyone got “Corzined.” In Goldman’s case, the firm almost went bust. In MF Global’s case, clients were left holding the bag.
And it’s something that happens during every market cycle.
MF Global Times Seven
The most recent high-profile fraud happened just two years ago. This time, it was carnage at crypto trading firm FTX Global.
Fortune magazine dubbed its founder, Sam Bankman-Fried (SBF), the next Warren Buffett.
Popular TV host Jim Cramer likened him to this century’s J.P. Morgan.
But it was all a façade.
SBF started in the crypto world with his hedge fund Alameda Research. He claimed to manage about $15 billion in assets as of June 30, 2022.
He started FTX after getting frustrated at the execution of his crypto trades.
FTX quickly grew to become the third-largest crypto exchange in the world. Customers parked nearly $16 billion in assets there.
SBF became the darling of the crypto world. People called him a genius. He used this status to his advantage.
He spent hundreds of millions of dollars on lobbying, sports sponsorships, celebrity endorsements, and political capital.
He was on top of the world… Until rival crypto founder, Changpeng Zhao (CZ) of Binance, helped bring it all down – similar to Interactive Brokers and MF Global.
CZ took to Twitter (now X) to criticize and question the relationship between FTX and Alameda. That panicked customers. It all collapsed within days.
FTX lost billions of its customers’ funds. It made Jon Corzine look like a cyclist riding among the cars on the Autobahn while SBF powered a Ferrari.
Ironically, it was Corzine’s earlier success at avoiding a perp walk that helped enable this behavior. But at least in this case, SBF faced justice. He’s serving a 25 year sentence in federal prison.
So what’s my point here?
Don’t Get Corzined
My point is: Be wary of fraud… be terrified of unmitigated risk!
People always ask me: What is the most important thing when investing or speculating? The answer is managing risk.
Risk can show up in many forms. There’s risk in the types of securities you pour money into… like stocks, bonds, options, or crypto.
And there’s risk in who you have your assets with. This is called counterparty risk. Your broker – like Schwab, E-Trade or Fidelity – is a source of this risk.
MF Global and FTX are also two examples of counterparty risk. Customers trusted them to hold their funds safe. Instead, they treated them like a slush fund.
So how do you mitigate counterparty risk? One way is to have accounts with several brokers. This is how I do it. In my case, one account is for some of my core assets. Another is for speculating.
It’s all about spreading around my risk in case one of those institutions fails.
And as far as mitigating risk within my investments, I break them down into two buckets.
Bucket one is for core assets. This is where your serious money belongs. These are assets that I plan on holding for years, if not decades. They’re typically your large-cap companies that consistently return capital to shareholders over time.
The second bucket is for speculating. This is the fun stuff that can turn dimes into dollars. And it can happen in a flash. Think weeks, days, or months. But this cash isn’t for the rent money. The investments are typically small and volatile. If you’re not careful, they could Corzine you.
But it goes beyond separating your core assets and speculations. It’s also about managing risk with proper position sizing and stop losses.
On core investments, I like to use trailing stop losses. Say I’m willing to take a 25% loss on a stock. After buying that stock, I watch the price. If it heads higher, I adjust the price I would sell it to reflect that move.
So if I buy a stock for $100 per share, I would sell it if it closes at $75 per share, assuming it only falls. But if it heads to $150 per share, I adjust my stop loss to $112.50 per share.
With speculative trades, I never invest more than I can afford to lose on any one position. If that trade goes to zero, it won’t really affect my overall portfolio. But if I get a 5x or 10x or more return, it makes a difference.
All of these things help take the emotion out of investing and speculating. That helps you make better decisions over the long run.
At the end of the day, simple risk management rules can help you preserve your assets. Or avoid disasters like MF Global and FTX.
After all, no one should ever feel the pain of getting Corzined.
Regards,
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John Pangere
Senior Analyst, Rogue Strategic Trader