Feb 18, 2005

CAO's Lesson for Traders

Information about the CAO bankruptcy continues to unfold. The latest news is some good insight into how the world of trading works.

In an interview with China's state-owned Xinhua news agency, Chen Jiulin blamed the slow response from elusive senior officials at the Beijing-based China Aviation Oil Holding for the escalation of the scandal. Such finger-pointing is rare in China, especially given that the Xinhua agency is widely thought to be supportive of state-owned enterprises.

"When we realised on October 3 that we might incur serious losses, we had a loss of just $80m," Mr Chen was quoted by Xinhua as saying. "If we could get approval from the parent company to clear all positions on that day, the total loss would be less than $100m. But most senior executives [of CAOH] were then on holiday."

He said CAO on Oct 9 submitted to CAOH a formal request to liquidate its holdings, at which moment the actual loss was $180m. But the parent company didn't respond until a week later when it held the first meeting to discuss the crisis. (FT $$)

Volumes have been written about the need for trader's to manage their emotions but in the real world that is only half of the battle. All large trading operations utilize a chain of command usually with more experienced traders at the top with fewer positions of their own to manage. These senior traders act more to monitor the positions and state of mind of the people beneath them. This system should in effect backstop any trader's personal tendency to let losses run.

The fact that traders are not normally managing their own capital can also create risk management issues. In the above example it is not clear why a formal request was necessary to close the position but the existence of such a rule makes risk managment difficult because time is such a critical part of loss estimates. In such a situation it seems like a natural stop point has nothing to do with capital availability and needs to occur before the decision gets kicked up the chain of command.

At any rate at some point the loss grows big enough that it becomes more attractive to push it around than to stop the bleeding. That is what is being described above. Jiulin probably could have cut 1/3 or 1/2 of the postion while waiting to here from his bosses. It is the nature of a badly losing position to make its owner believe it will recover. In times like this the market is probably dislocated by the pressure of the position making the recovery all the more likely. Jiulin did not want to stop out at the top of a winning short. On vacation or not his bosses probably did not want to cover either. Now they try to pin the loss on each other. That is how it goes.

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