Commodity Trading Mistakes and Catastrophic Blowups

Book: Commodities: Markets, Performance, and Strategies
Editors: H. Kent Baker, Greg Filbeck, Jeffrey H. Harris
Publisher: Oxford University Press, 2018
ISBN: 9780190656010

Three Mistakes That Kill Traders

The first half of Chapter 20 covered strategies that work. Now we get to the part that is honestly more useful: the mistakes that destroy traders and the blowups that result.

The chapter identifies three common mistakes in futures trading. They sound simple, but experienced traders fall for them over and over again.

Mistake 1: Demanding Returns Instead of Managing Risk

Here is a quote that sums it up perfectly. Gerald Loeb, the highly successful financier and founding partner of E.F. Hutton, once said: “Just when you think you found the key to the market, they change the locks.”

All trading strategies have life cycles. What worked last year might not work this year. Patel, Suri, and Weisman (2007) put numbers to this idea. They showed that the expected drawdown for a strategy is directly related to how consistently profitable it has been, if you keep demanding the same level of returns.

Markets have “periodic market efficiency.” Every strategy eventually stops working. When it does, the losses are proportional to the gains and inversely proportional to how often the strategy used to win.

The dangerous version of this mistake: a strategy starts losing money, so the trader doubles down to try to hit their return target. Natural gas bear calendar spreads were consistently profitable from spring 2004 to spring 2006. By early summer 2006, profitability had dropped by about half. If a trader had doubled their position size to maintain the same absolute return, they would have lost roughly twice their year-to-date profits in July and August 2006.

When a trader’s results differ dramatically from expectations, it can trigger a “critical liquidation cycle.” Client redemptions and margin calls force the trader to sell at bad prices, causing more losses, causing more redemptions, and so on until the fund is dead.

The solution? Do not target absolute returns. Target risk. As Eagleeye (2007) put it: “One can manage risk, but one can’t demand a threshold return from the market.”

Mistake 2: Getting the Sizing Wrong

Natural gas keeps showing up in trading disasters, and there is a reason for that. It offers a tempting combination of scalability and volatility, with pockets of predictability. But even experienced traders get the sizing wrong.

The commodity markets do not have natural two-sided flow like stocks or bonds. They have what the chapter calls “nodal liquidity.” Big trades happen when commercial participants need to hedge, not when a speculator wants to get in or out. Before taking a large position, you need a clear plan for how you will exit.

If no geopolitical, economic, or weather news exists about a market, and a spread relationship changes by many standard deviations from recent history, that is a clear signal that someone is liquidating in a distressed fashion.

The key risk-management lesson: keep your position size within a relatively small fraction of daily trading volume and open interest. This sounds obvious, but when prior success brings in a flood of new capital, the temptation to grow beyond what the market can handle is real.

Mistake 3: Ignoring the Psychology

This one hits different. Ralph Vince wrote that making money from market inefficiencies “requires discipline to tolerate and endure emotional pain to a level that 19 out of 20 people cannot bear.” He added: “Anyone who claims to be intrigued by the ‘intellectual challenge of the markets’ is not a trader. The markets are as intellectually challenging as a fistfight. Ultimately, trading is an exercise in self-mastery and endurance.”

Nassim Taleb illustrated this with an example. Take a strategy that earns 15 percent per year above Treasury bills with 10 percent volatility. Sounds great, right? But on any given day, there is only a 54 percent chance of making money. If you feel the pain of loss 2.5 times more than the joy of a gain, executing this strategy becomes exhausting and nearly impossible.

Psychological discipline is just as important as finding good trades and managing risk properly. Most people cannot handle it.

Amaranth: The $6.6 Billion Blowup

Amaranth Advisors LLC was a multi-strategy hedge fund founded in 2000 in Greenwich, Connecticut. The founder’s original expertise was in convertible bonds. The fund later expanded into merger arbitrage, long-short equity, leveraged loans, and energy trading.

By June 2006, energy trades accounted for about half of the fund’s capital and generated about 75 percent of its profits. The fund’s head energy trader was based in Calgary, and he held open positions sometimes worth tens of billions of dollars in commodities.

The strategy: bet on natural gas seasonal spreads. Go long winter contracts and short non-winter contracts. If a hurricane hit or winter was unusually cold, the winter contracts would spike and the fund would profit. The energy book was up roughly $2 billion by April 2006.

Then things went wrong. The fund lost nearly $1 billion in May 2006 when far-forward gas prices collapsed. They won it back over the summer. As of August 31, 2006, the fund had $9.2 billion in assets.

The scale of Amaranth’s positions was staggering:

• At times, Amaranth controlled 40 percent of all open interest on NYMEX for winter months
• Their January 2007 position equaled the entire amount of natural gas used that month by all U.S. residential consumers
• On one day, their trading represented almost 70 percent of total NYMEX volume in March and April 2007 contracts
• They held 81 percent of NYMEX futures open interest in the December 2007 contract

On Monday, September 18, 2006, the founder told investors the fund had lost 50 percent of its assets since August. The fund had lost $560 million on a single Thursday. By the time they transferred their remaining energy positions to Citadel Investment Group and J.P. Morgan Chase, they had to accept a $2.15 billion discount. Total losses: $6.6 billion.

The U.S. Senate investigated. Their report ran to 135 pages plus 345 pages of appendices. They examined several million individual trades.

The lesson: Amaranth’s strategy had a plausible economic rationale. But the sizing was catastrophic. They were so big that no financial counterparty could take the other side of their trades when things went wrong. Their natural counterparties were physical-market participants with storage facilities and pipeline companies who had no economic reason to unwind their hedges at Amaranth’s convenience.

As Robert Greer of PIMCO noted: “The market showed that someone can actually be so big that the market will punish them, rather than reward them for their size.”

MF Global: When Your Broker Steals Your Money

If Amaranth was about market risk, MF Global was about something worse: the violation of customer trust.

On October 31, 2011, the broker-dealer and futures commission merchant MF Global collapsed. About $1.6 billion of customer funds were not immediately available because the firm had apparently used segregated customer money to fund its own proprietary trades.

MF Global’s customers included small investors, farmers, ranchers, and grain elevator operators. These people thought their money was safe because regulations required it to be kept separate from the firm’s own accounts.

The proprietary strategy that brought MF Global down was a leveraged bet on European sovereign debt. They used repurchase-to-maturity (RTM) transactions to earn the yield on European bonds from countries like Italy and Ireland. The strategy was profitable as long as the bonds did not default and MF Global could fund its positions.

When credit agencies downgraded European debt and then downgraded MF Global itself, the firm faced margin calls from all directions. Banks pulled liquidity. Clearinghouses demanded more collateral. MF Global used customer funds to plug the gap.

The firm tried a fire sale of assets. Counterparties refused to trade with them because of settlement risk. The whole thing collapsed in a week.

By late 2015, customers were eventually made whole. But their assets were tied up in liquidation proceedings for about four years. Jon Corzine, the former CEO, settled with the CFTC in January 2017, paying $5 million out of his own pocket and accepting a lifetime ban on trading other people’s money in the futures industry.

The Lessons

The chapter wraps up with a sober observation: the daily mark-to-market process in futures markets is supposed to limit catastrophic losses. But in both cases, it failed.

With Amaranth, positions were so large that liquidating them was itself a catastrophe. With MF Global, the firm broke the law by using customer funds to prop up its own failing trades.

Gaining expertise in commodity markets usually happens through trial and error, and some of those errors are painful. The goal of this chapter is to help others avoid the same mistakes.

My Take

This chapter is required reading for anyone who trades commodities or invests in commodity funds. The Amaranth case is a textbook study in what happens when sizing goes wrong. The position was not just too big for the fund. It was too big for the market.

The MF Global case is scarier in a different way. It shows that even regulatory safeguards like fund segregation can fail if a firm’s management decides to break the rules. The lesson for investors: know what your broker is doing with your money. Look at the full scope of their business activities. Do not assume that regulations alone will protect you.

And the three common mistakes are timeless. Do not demand returns from the market. Do not size beyond what the market can absorb. And do not underestimate how hard it is to keep your composure when you are losing money every other day.

This concludes our two-part series on Chapter 20.

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