Lessons from the Biggest Trading Losses in History

Trading failures result from several factors. These may include poor risk management or the lack of a clear trading vision or strategy. Failures may also result from impulsive or emotional decision-making, ignoring market trends, or even lacking market knowledge.

In this blog, we take a close look at some of the biggest trading losses in history. There are several lessons to be learnt from these events. These include creating a disciplined trading strategy, sticking to risk management plans, and having suitable entry and exit points in place. 

Case Studies of Major Trading Losses 

Here are a few case studies of the world’s biggest losses in trading: 

Nick Leeson & Barings Bank 

Nick Leeson is a former derivatives trader who earned notoriety for bankrupting the well-known Barings Bank (the oldest merchant bank in the UK) in 1995. Leeson first opened a futures and options (F&O) office in Singapore. However, he went rogue thereafter, leading to a massive loss of more than $1 billion in capital for Barings Bank. 

How it happened: 

Being the head of operations for the Singapore Exchange at the bank, he made several unauthorised trades, which led to massive losses. Being both the head of trading and settlement, Leeson bypassed internal controls, making trades without oversight. Yet, in a bid to recover these losses, he illegally continued trading with the bank’s capital. It led to eventual losses of about £827 million, after which the bank declared bankruptcy in 1995. 

How did he get away with it? 

Leeson concealed the losses from his bad trades in a secret account, while taking on bigger odds to recoup them. Losses in the secret account ultimately crossed £23 million in late 1993 and then £208 million by end-1994. He eventually placed a short straddle on the Tokyo and Singapore stock exchanges on 16th January, 1995, anticipating that it would remain stable overnight.

Yet, an earthquake struck Japan on 17th January, leading to a massive drop across Asian markets. Faced with even more losses, he made several risky trades based on the Nikkei’s rate of recovery. However, it did not lead to anything fruitful, and he finally fled Singapore on 23rd February, 1995. By this time, the losses accounted for twice the trading capital at Barings Bank. 

What happened to him? 

Leeson was arrested in Germany and charged with fraud. He spent over 6 years in prison, where he wrote the book Rogue Trader. 

Long-Term Capital Management 

Long-Term Capital Management, or LTCM, was a major hedge fund that was led by Nobel Prize-winning economists and Wall Street traders. However, it went bust in 1998, forcing the U.S. Federal Reserve to coordinate a private-sector bailout to avoid systemic collapse. Yet, at its peak in 1998, LTCM drew around $3.5 billion in investor capital, promising an arbitrage strategy that would yield lucrative returns. 

How did it function? 

The fund initially made convergence trades to profit from arbitrage opportunities between securities. However, they had to be incorrectly priced relative to each other at the time of the trade. LTCM also dealt in interest rate swaps, exchanging a series of future interest payments for another (based on a specified principal among counterparties). 

What went wrong? 

Overleveraged trading strategies were to blame, with losses increasing due to debt defaults by Russia. LTCM leveraged highly to make money, controlling about $5 billion in assets and leveraging their positions up to $125 billion. It held derivative positions worth more than $1 trillion at its peak. 

But then Russia defaulted, just when it was holding a major position in GKO or Russian Government bonds. The LTCM computer models recommended holding the position consistently, even as millions of dollars were wiped out in daily losses. 

Eventually, the Federal Reserve facilitated a $3.6 billion bailout by 14 major banks to avoid a global financial ripple effect.

The 2008 Financial Crisis and Trading Losses 

This crisis saw major trading losses owing to the housing market collapse and instability in the financial system worldwide. A subsequent global economic slump was seen, with a huge plunge in stock markets and failures of businesses. It all started with the housing bubble bursting, driven by high-risk loans to borrowers with poor credit histories in the market. 

How it spread: 

When borrowers defaulted, the value of products came down, leading to huge losses for investors and banks. It led to a global decline in stock markets, with the S&P 500 falling by 57% from its 2007 peak to the lowest point in 2009 in the US. 

Lehman Brothers and many other institutions declared bankruptcy as well. Lehman Brothers was the biggest bankruptcy filing in the US at the time. A global recession came about as well, leading to economic decline and job losses alike.

There were also widespread trading losses worldwide. In one such instance, Societe Generale lost €4.9 billion in January 2008 due to unauthorized trades by Jérôme Kerviel. This was not directly related to the subprime crisis but occurred earlier the same year.

Amaranth Advisors Loss 

Amaranth Advisors lost significantly in energy markets. The biggest loss occurred in 2006, when Amaranth Advisors lost a massive $6.6 billion. It was attributed to several bets made on natural gas futures, and they were impacted by rogue traders.

At its peak, the firm had more than $9.2 billion in assets under management (AUM), before collapsing with this huge loss. It is regarded as one of the largest hedge fund collapses in history till date. 

Key Takeaways from These Failures 

Some of the major takeaways from the world’s biggest trading losses include the following:

• It is important to maintain discipline and patience in trading. You should also avoid impulsive decision-making or falling prey to the fear of missing out or FOMO syndrome 
• A systematic trading approach is what matters. Stick to your strategy even during drawdowns or volatile periods
• It always works to take small breaks while dealing with major losses. Then get back to the drawing board and rework your position size and strategy. Remember to start small in terms of recouping your losses 
• Avoiding overleveraging is the biggest lesson here, especially from the Lehman Brothers case study. They were using huge borrowed money to finance assets, making them vulnerable to downturns 
• Regulatory compliance matters immensely. This is what helps combat market manipulation, fraudulent or rogue trading strategies, etc. Investing in too-good-to-be-true bundled products is also avoidable 
• Your trading plan should clearly define your goals, risk tolerance, and strategy. Also, have trading limits for each day or week
• There should be a proper risk management strategy with stop-loss orders and portfolio diversification. Also, make sure that you’re aware of the risks associated with using leverage.
  For instance, a synthetic long put is a strategy that replicates a long put option by combining a short stock position with a long at-the-money (ATM) call option. This structure is useful for hedging downside risk.  
• Staying informed, gathering data, and analysing market developments is essential too. Make sure you consistently adopt new trading techniques and strategies. 
• Overtrading and ignoring market volatility can be fatal. It is the same story if you’re only depending on software programs. Don’t be overconfident and ignore clear market indicators while trading.  

Conclusion: Learning from History 

The losses in trading hold valuable lessons for everyone. From the dangers of overleveraging to detecting fraudulent trades, there are several insights in them for everyone. It’s always important to learn and refine trading strategies. Keep track of market news and trends, and build a disciplined trading plan. There is no shortcut to success when it comes to trading. That is perhaps the biggest lesson of all!