Amaranth Advisors: The 3 Investing Lessons Learned in a $4.5 Billion Trading Loss

by Guest Editorial

Amaranth Advisors: The 3 Investing Lessons Learned in a $4.5 Billion Trading Loss

by D.R. Barton, Jr., Advisory Panelist, Mt. Vernon Research

Wednesday, September 20, 2006: Issue # 583

Editor's Note: Connecticut-based Amaranth Advisors recently announced it suffered a multibillion-dollar loss on a quick swing in the natural gas futures market. How could this happen? And how can this devastating hit teach us a timely lesson in portfolio management? There's no one better to answer these questions than D.R. Barton, Jr., a trading specialist for Mt. Vernon Research and author of the best-selling Safe Strategies for Financial Freedom. Below, D.R. assesses the situation and offers three suggestions for safeguarding your principal and your profits...

What could you buy if you had an extra $4.5 billion?

I did a little research, and have a few suggestions:

  • You could buy a brand new Porsche Boxter for every man, woman and child in New York's capital city of Albany - and have $200,000,000 in change.
  • You could fund the total economies of Martinique, Somalia or Barbados (by matching their GDP) and let everyone take the year off.
  • You could buy the following companies for cash: Guess?, Inc., and Scotts Miracle Grow.

$4.5 billion is a lot of cash. Almost unfathomable.

But Amaranth Advisors recently lost that amount in just one week.

The trader that lost it was up $2 billion for the year, so I guess he got lost in all those zeroes. But he apparently absorbed the huge loss by ignoring the simple rules of proper risk management and position sizing.

Fortunately, you don't have to make the same mistake to learn about poor position sizing. Let's look at how the loss unfolded and, more importantly, how you can employ prudent risk control in your trading...

The Price of Placing Big Bets

Congressman Everett Dirksen is often credited with the phrase: "A billion here, a billion there, and pretty soon you're talking real money."

It sure seems like the trader at Amaranth prescribed to that theory.

He was known as a gunslinger, often taking huge positions, especially in futures contracts that had long-term delivery dates. Some also saw him as an innovator, adding liquidity to markets where none existed before.

But in this case, "innovation" was just a euphemism for poor position sizing.

According to The Wall Street Journal and other sources, Amaranth is not revealing the details of the series of trades that went badly awry. The best guess is that nobody wanted to take the contracts off of Amaranth's hands in such large volumes and so far out.

And when the trouble came calling, the firm suffered the double-whammy of poor position sizing and lack of liquidity at the same time.

Lessons Learned: Three Ways to Protect Your Portfolio

1. Know Your Risk: This might sound simple, but many people enter a trade without knowing the precise point where they'll get out if the trade moves against them. This is typically called a stop loss.

If your strategy doesn't include a protective stop loss, then drop everything right now and add this critical rule to your list.

2. Risk A Small Amount On Any One Position: As a guideline, you should risk a maximum of 1%-2% of your equity on any one position or idea. And there are several good reasons for risking this small amount on every trade or investment.

The first is that you can sustain many losses in a row without blowing out your trading account. The second is that if unexpected events occur that cause large fluctuations well beyond your intended exit point, you may lose two, three or four times your intended amount. But if that initial risk amount was only 1%, then it's not catastrophic.

Seasoned investors and traders may go as high as 2% risk, but only then for proven strategies. In the classic book Market Wizards, many legendary investors state that risking more than 2% on a trade is just gunslinging.

3. Understand The Risks In Your Positions: Not many of us will trade natural gas contracts far into the future like the Amaranth trader, but there are other instruments that suffer from similar "lack of liquidity" problems.

If you trade penny stocks or options that are out of the mainstream, make sure you adjust your position size to account for increased "slippage" (the difference between where you want to execute your trade and where it actually happens).

Don't wait for a costly lesson to come along and shock your system. Practice good position sizing techniques today for sustainable profits.

Great trading,

D. R.

Today's Investment U Crib Sheet

  • D.R.'s advice regularly appears in the Smart Options E-Report, the free, twice-weekly e-letter from the Mt. Vernon Research team. Sign up for these timely reports.
  • D.R. is also the editor of the ESP Profit System - an elite trading service that uses quantitative analysis to deliver accelerated returns. (Subscribers booked a six-day 108% gain yesterday.) To learn more about how his service works, contact VIP Services at 888.570.9830.

comments powered by Disqus