What I learned the first time I lost a million dollars
Jeff Dorman, a columnist of CoinDesk, is the investment director at Arca, where he leads the investment committee and is responsible for portfolio size and risk management. He has over 17 years of experience in asset management and trading at companies including Merrill Lynch and Citadel Securities.
Do you see both ways?
Recently I took my 7-year-old son on a bike ride and he started crossing the street without looking. I grabbed his steering wheel and shouted, did you look both ways, and he answered, brother, I forgot. Fortunately, there was no traffic that day, and I was right beside him, but I explained to him that remembering both ways is not a luxury you can forget. But looking back, I realized that I didn't remind him of that before we started. Stupid, I only focused on the rewarding experience of riding a family bike in perfect weather, and for a moment lost the downside risks.
When managing external capital, downside risks must be put first. Even in a space like cryptocurrencies with the potential for asymmetric price increases, must investment thinking change from its high level? How low is it? Like my conversation with my son, managing risk is not something you can forget.
The first time I lost a million
I was a corporate bond trader at Merrill Lynch before the 2008 financial crisis. Time is good on pre-crisis Wall Street. There are some limits to the size of my trading book as long as I make money and nothing appears in my risk reports that will raise the red flag. The advantage is a big reward, while the downside is simply losing a job. Trading on Wall Street is like a call option - known weaknesses, unlimited.
I have worked hard to understand the financials of the companies I have traded and I have built a reputation in the corporate bond world as a smart credit trader. Throughout my trading career, I have made much better investments than bad ones. Unfortunately, since a 27-year-old works in a loosely managed system, I'm bad at risk management.
The first time I lost 1 million dollars actually happened in the same week that I made 1 million dollars for the first time. I have long been a bond of Trump Entertainment, a famous chain of casinos in Atlantic City owned by Donald Trump. Trump is seeking to sell one of the three casinos he owns and there are rumors that there is considerable interest. Selling this property will be a positive credit for bondholders, as the money generated from the sale will result in refinancing of the bond at a greater price than the bond being traded. However, sales are deteriorating rapidly in Atlantic City, especially at Trump facilities. CC CCC-rated bonds, live and any independent analysis of Trump credit, future revenue and cash flow will cause most people to shorten bonds, not own them (which is what many smart hedge funds did). This was the last investment directed to the Viking event with binary results.
I woke up one morning with a Wall Street Journal report that Trump Marina Hotel & Casino would be on sale, and there was a buyer willing to pay a price high enough to validate my long thesis. The bond I own increased 5 points that day to 104% of the par value. I had 32 million dollars in bonds and just made over 1.4 million dollars in interest. Remember when I said the only thing that drew attention to Merrill's desks was the red flag? Well, the Japanese green flags drew equally attention, and suddenly people were interested in what I was trading since I made a large profit on that day. However, what I remember most about that day, besides some celebrities, was a very smart, senior trader with over 20 years of experience leaning towards me and saying, The question is not is "are you right or not wrong, 'the question is' should you own a lot of bonds in the first place?'
I didn't think much about that statement at the time, because I had just made $ 1.4 million in my trading book, but I think about it every day since then. And while I sold some of the bonds I owned that day, I didn't sell enough. Definitely, later in the week, the news broke that the sale of Trump Casino's assets dropped and my bonds fell ~ 10 points. I lost nearly 2 million dollars that day.
In total, during the week, I only lost a margin in my trading book. But I raised a lot of green and red flags, ready to accept a ton of unnecessary fluctuations, and lost a lot of sleep for no reason.
Risk management in digital assets
When I first entered the digital asset industry in 2017, I met a lot of apparently smart people who bragged about their investments. It seems that many people in the blockchain have figured out how to buy and sell, but obviously many have found a way to manage risk. The general theme is big allocations for one or two digital assets, then sit back and watch them go up in a bull market. Many of them even launched money based on these virtual tracking records.
In March 2020, many young crypto investors learned difficult lessons on risk management, discovering that risk management is more than just protecting prices and managing outside capital. just make a profit. Risk management includes diligence in operations for the places you trade, discipline regarding who can trade and independent oversight through risk committees designed to challenge the rules. tissue position.
There are no winners when crypto funds are closed, but there are important strides. A strategy built around trading an asset (BTC), on an Exchange (Bitmex), with high leverage may not be the most appropriate way to bring investors into this type of asset. And those without formal training or experience might be better than learning from those who do it, because there's no shame in being an apprentice when it comes to managing others.
See also: Jeff Dorman - Never Mind Hodlers, Crypto needs more opportunity investors
Fortunately, I learned my lesson more difficult than a decade ago; A lesson that can help many people in today's crypto environment. I hear the advice of senior traders from 2008 in my head every day and apply it to every risk management decision I make. After 2008, I even built an exclusive risk management system, which was then used at the three hedge funds I work with and we still use it today in Arca. This tool is specially designed to ensure all positions are sized according to the appropriate quantitative and quantitative factors. The purpose of this tool is to make money, but instead, to avoid large and unnecessary losses.
The ability to stay disciplined with risk management has changed my career. I always knew that I had the tools I needed to become a successful investor and I always believed I could invest smartly, but it took years to realize that the difference between talent managers Good products and bad people do not just stop there and choose good investment.
Looking back, it's clear that there are lots of talented traders and investors, very smart, active, and that is also true in cryptocurrencies. But only aren that many talented risk managers. It can take only 20 days to learn how to trade and 20 months to learn to analyze investments, but it takes 20 years and counting to learn how to manage risk.
Cryptocurrencies love to disrupt games but you can only break the experience. There is no shortcut there.