Saturday, January 05, 2008

Stop! Loss!

Perhaps nothing is more controversial, in the world of traders, than stop losses. The idea is that when you enter a trade you should have predetermined levels where you will take a profit or bail out. The idea is that you are most "rational" about the trade before it owns you. Every "how-to", tipsheet or other advice Guambat has ever read says you must have stop loss levels and stick to them.

And however easy it may be to state the theory, in practice, having a stop loss and exercising it is inordinately difficult. Setting the stop levels is really the difficult thing because Mr. Market has a devious appetite for ferreting them out, setting them off, devouring them, and going back to its usual business in such piggish manner that, had you ridden it out, often (how often is the key), the loss you incurred was only because you decided, blindly, to exit your trade at the arbitrary stop level.

Guambat reckons the art of setting stop loss levels and the psychology of exercising them is the toughest thing about trading. It makes "buy and hold" so much more new age hassle free. In the end, Guambat decided that "technical" levels just are not worth the effort, particularly since Mr. Market is particularly adept at spotting them. The only ones that worked for Guambat were those that put a limit on what Guambat was willing to loose in some nominal way: I will loose this much and no more. Even those, though, turn good (after the loss is taken in the stop) too often to make the exercise edifying.

Margin call levels can be very much like stop losses. You just never seem to know for sure if it was the right thing to do until after the fact, as Merrill Lynch discovered in its dealings with longtime client Bear Stearns, as Yalman Onaran explained in the Bloomberg piece, In Unforgiven Margin Call, Bear Funds Failed on Merrill CDOs (an awkward title, in Guambat's opinion).
Merrill Lynch, founded in 1914, sold hundreds of millions of dollars worth of collateralized debt obligations to hedge funds run by Bear Stearns, started in 1923.

Some 90 percent of the face value of the CDOs was loaned to Bear by Merrill, as is normal in such transactions. When the prices of the funds' CDO holdings started to fall in June, Merrill demanded that the firm increase collateral in what's known in the debt markets as a margin call.

Bear Stearns executives pleaded for time, arguing that the forced sale of their assets would push down all CDO prices. Merrill Lynch officials brushed off the entreaty....

The fire sale led to a further drop in CDO prices.

Among those that lost value: $23 billion of CDOs Merrill held on its own books.

On June 15, Merrill Lynch seized $850 million of the CDOs from Cioffi's funds -- as lenders are allowed to do when their margin calls aren't met -- and tried to sell them in the market. When the firm received bids of 20 cents on the dollar, it abandoned the effort. In July, Cioffi's funds declared bankruptcy, losing $1.6 billion of investors' money and triggering the repricing of CDOs around the world.

[And the rest, as they say, is history - or history in the making.]

Giving Bear Stearns a chance to shore up the hedge funds might have allowed time for Merrill Lynch to reduce its CDO portfolio or buy hedges against it....

The management of stop losses and margin calls is a "might" difficult, Guambat reckons.

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