A Cautionary Tale from An Incautious Hedge Fund

Today's New York Times has an interesting article about a hedge fund that's just posted massive ($3 billion) losses on a bad trade involving natural gas. Apparently Amaranth Capital had a position in natural gas futures that took a wrong turn when price spreads failed to increase as expected:

"Amaranth's biggest stake was a combination bet on the spread between natural gas futures prices for March 2007 and those for April 2007. Amaranth had often bet that the spread on that so-called shoulder month — when natural gas inventories stop being drawn down and begin to rise — would increase."

Unfortunately for Amaranth the spread didn't increase, it got smaller.

Without knowing all the details, there are still a number of questions this raises that are worth keeping in mind no matter how large or small your investment:

How much leverage (trading on borrowed funds) was Amaranth using? What percentage of their total capital was at risk in this trade? Did they take too large and too risky a position based on their available funds?

Was there any kind of stop-loss in place to bail out of this trade? If not, why not? It's possible the $3 billion loss was incurred when the position hit a stop-loss, which raises the additional question, was their stop-loss in the right place?

How much personal discretion was involved in placing this trade? Was there a strong emotional investment, aka wishful thinking, that made it more difficult to exit at an earlier point before losses mounted? What statistical & mechanical controls were in place when the trade was placed and when it was exited? Or was someone's gut instinct making the decisions - in which case, their gut and its instincts should be removed from future trading ASAP.

Natural gas is a highly volatile commodity (as well as a volatile gas, though that's not relevant here) - did the traders fully appreciate, and fully calculate, the potential downsides of such volatility?

Were the fund's managers overly attached to this particular commodity - perhaps addicted to its volatility - to the extent that they failed to diversify sufficiently into other markets? To put it another way, were too many of their eggs in one basket?

These are all questions worth asking in your own trading - and if you find the right answers, hopefully you won't be facing a loss of this scale someday!

Related link:
A Hedge Fund's Loss Rattles Nerves