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More thoughts on JP Morgan's dumb move (or how not to use options)

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May 14, 2012 – Comments (1)

As reported and as I blogged earlier, our friends at JP Morgan lost about $2 billion on a bet on high quality corporates. They effectively went long corporates through derivatives, by selling default swaps on a corporate index.

I am not a bond guy, and these were complex instruments. However, my intuition is that this was equivalent to selling puts on stock. Selling puts is a bullish position; you're betting that either the stock won't decline to the strike price, or that if it does, you'll be comfortable holding the stock.

Earlier, I said I thought that JPM must have sold a lot of swaps to wind up with a $2bn loss. When writing a put option, your notional exposure is equivalent to the strike price. Let's say you sell a 100-share lot of $20 puts on St Joe for $2.00 in premium each. You need to remember that your notional exposure is $1,800 (strike price minus premium, times 100).

It appears that the trader overlooked this. He let things get ahead of him, due to a blend of overconfidence plus a model that turned out to be faulty. And when he did, he wound up with a lot more exposure than he thought - Dave Sekera, writing for Morningstar, says that he is "amazed at the notional size of the risk position that J.P. Morgan must have undertaken to lose $2 billion."

Now, as I suspected, this isn't a large enough loss to dent JPM's capital position or its credit rating now. It really isn't a killed in the grand scheme of things. It's also not yet an indication of a culture of excessive, Bear Stearns- or Lehman-level risk taking.

But it does get mention as an example of how to use options properly - remember that it's easy to overleverage yourself, and plan accordingly. Don't do what this guy did.

I'd also argue that it's an argument for a stricter Volker rule. Remember, JPM isn't anywhere close to going into distress now, but that's not the issue. The issue is that overleveraging yourself on what is supposed to be a hedge can happen to anyone, as can letting underwriting standards slip, as can a lot of other things. Even if just one large bank goes under, we're not sure we can deal with the fallout as the bank damages its counterparties who can't get their money back. And again, if JPM did this, anyone can and most likely has already - so what happens if several large banks go into distress at the same time?

1 Comments – Post Your Own

#1) On May 14, 2012 at 4:02 PM, L0RDZ (90.27) wrote:

Reminds me of the phrase...   http://www.youtube.com/watch?v=DQQNwhJOiSc

there's  always free cheese in the mouse trap.

Interesting in  that   the  guy who did this  keeps his job,  why ??

because  he  made  a lot of money  for them on the other times.

So  where  were the  internal  controls ?

What were  the  bosses doing ? 

Coke in the bathroom ?

Personally  they  should switch to drinking pepsi...  LMAO...

 Where  were  the  regulators ??? 

I know  as a solution  lets just let some big shot retire with full benefits  ~  lets say some woman  who was in charge ??  ummm  yeah   maybe  fire  a couple of her lietenaunts under her ??? 

And just pass out a bunch of bonuses...

$$$$$$$$$$$$$$$$$$$$$$$$

Don't let the money fool you.

 

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