I recently finished reading the book Rogue Trader by Nick Leeson. Although I’ve seen the movie countless times in the last 6 years, I don’t know why I haven’t stumbled upon the book till now. Anyway, it was a great read and I highly recommend it. Not only because it’s well written, entertaining and has some funny moments, but also because it has two very important lessons for every trader. I’m talking here about risk management and discipline.
For those who haven’t heard of Nick Leeson, here’s a quick summary: he was employed by Barings Bank, the oldest investment bank in the UK as the general manager of trading operations on SIMEX, an exchange in Singapore. For over two years he made unauthorized trades, mostly long Nikkei futures and short JGBs (Japanese Government Bonds). As the losses on his positions kept growing, he continued to average down until he ran out of funds and the bank collapsed in February 1995 under the weight of more than £800 million in losses.
Nick Leeson’s risk management consisted of buying on the way down, in the hope that the market would come back and his positions would become profitable. At first this disastrous strategy worked. But then the market continued to go against his positions and not even a bank’s capital could turn around the tide.
We can learn from his story how important a proper risk management is: letting losses float, hoping the market will bail you out is a sure way to ruin. You might get away with it a few times, but in the end there’s no escape. Closely related to this is the discipline to respect your stop-loss and cut short every losing position no matter what.
It’s difficult, particularly in the beginning, to do this. There will be certain times when you’ll say to yourself something along these lines: ‘it can’t go any lower/higher, it’s extremely oversold/overbought, so I don’t want to close the short position at the top of the market or the long one at the bottom. Just this time I’ll remove the stop-loss and wait for the market to come back.’ Nick’s story is yet another example that it doesn’t work that way. You either have the discipline to cut your losses short every time or sooner or later you’ll end up blowing your account.