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Rogue Trader Psychology

  
  Education
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Jerome Kerviel. Rogue Trader. As this case unfolds, more and more information is being revealed. He was the quiet guy with a not-so-impressive education background. Many of his peers may have been picked from the prestigious Grandes Ecoles, the Harvards and M.I.T.’s of France, and wielded advanced degrees in math or engineering. Kerviel came to work with a business school background and started work in the bank in the back office. Can we learn a valuable lesson from this case? As personal “professional” traders (as opposed to institutional trading), are we guilty of being rogue traders every once in a while? No compliance department to answer to. No regulator breathing down your back.

Kerviel’s job was arbitrage: the art of exploiting tiny and momentary discrepancies in prices of very similar stockmarket instruments. To make money, the bank has to wager big volumes but the risk is usually small because each transaction is balanced with an equal and opposite one. The bank says he created fictitious accounts to make it look as though his bets that shares would rise had been covered. The bank was open to the risk prices would fall – they did. Kerviel was able to get away with it partly because SocGen’s risk systems do not check up on unregulated over-the-counter contracts straight away if no deposit is required, the bank said. Furthermore, the bank primarily looks at the net exposure to market prices rather than the total outstanding amount wagered. Bank risk experts say this approach is not peculiar to SocGen. To keep the checks at bay and continue trading, the dealer falsified documents and misappropriated passwords, SocGen said.

Rogue Trader Trading Psychology

Most would-be traders operating from home are either self-taught or taught from education package bought from a trading education company. We are very much like the rogue trader: we don’t have top class education, we have access to both the trading and the back office side of the business and we have the same psychological vulnerabilities. We are only human. It is easy to be seduced by money as much as Kerviel had been. It has been reported that he was attracted by the prospect of a 300,000 euro (US$503,778) performance bonus, but did not personally profit from any of the financial deals. He wanted that bonus. He may also wanted to keep up appearances with his peers.

Rogue trader psychology is one of delusion and illusions. The delusion of self in believing that taking on ridiculous levels of risk to “fix” a trade. Kerviel had taken a US$83 billion losing bet on European share prices. The illusions of a rogue trader include the belief that everything will go their way – the market will turn their way but when the time comes, the opportunity that they saw didn’t come into fruition – the mirage in the distance.

Back Office Rogue Trader

The problem was, rogue traders have access or knowledge about back office operations. It was the case with Nick Leeson in 1995 and also the case for Jerome Kerviel in 2008. Rogue trader’s can further their delusion by flexing the system to suit their reality. It was a total breakdown of the system.

Professional non-institutional traders don’t have the luxury of a compliance system. No compliance department to answer to. No regulator breathing down your back. No limits. They have 100% control over their own risk, their own compliance.

Lessons of Rogue Trader Psychology

Professional non-institutional traders aka traders operating from home; have to institute their own control systems. They must operate with their own trading rules taking into consideration what level of risks they are able to make. They must also consider how they will mitigate their own risks by creating a money and risk management system including stop losses and a buffer. Be wary when you do start flexing your own rules regarding risk. You may turn yourself into a rogue trader.

Why does it happen?

  
  Education
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There seems to be a consistent pattern when it comes to these trading teachers turned rogue traders. The story usually is that a trader struggled for years, then “made it”, and decided to teach others. Students etc began offering them money so they set themselves up as a money manager and then *bling* collapse in flames and do a runner.

One obvious theory is that their trading psychology had adapted to trading their own money at a certain equity level, and they might even have been very successful at that, thus making them confident and bold. But then all of a sudden they are thrust into new territory in terms of both a massive influx in equity and thus volume to have to trade, and the burden of being the crux for investors hope and fear all day.

Imagine it – you are happy trading 1 or 2 standard lots and you have a good rate of return on your own account, but now all of a sudden you are trading 100 lots per trade, and the phone is going every half an hour with someone yapping “So?! How’s it going? What level is my investment at now?! Has their been any losses??!!”

*Brring Brrring!!* – “Someone grab that god damn phone, I’m trying to focus here!”

You could almost feel how this would cause your heart to start pumping and you would break out into a sweat; your mind would go foggy – yet you are supposed to stay cool and trade. I personally sense that many of these guys just didn’t consider this at all. They thought they were ready; they weren’t.

Add to this possible new market issues that throw a spanner in the works, such as trying to get filled with bigger volume, slippage – your positions maybe starting to show up on the radar of other market players and drawing interest to yourself.

The trusty old scalping system seems to not work like it used to work. One bad day and you’ve drawn down 20% of the account and you can’t sleep at night. You can’t bring yourself to tell the investors right now until you try to reduce that loss, so you tell a bit of a white lie.

Down the rabbit hole you go. Soon everyone is calling you scum and saying the honourable thing to do is commit suicide and you are facing six years jail. The moral of the story – think twice before becoming a home-brew money manager.

5 Rogue Traders -They had Broke Banks

  
  Education
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So, who are the rogue traders that have experienced all of this? Here’s a small sample (the ones we know of!). They are not in chronological order but in order of how much money they actually lost their banks (from the lowest to the highest):

1. John Rusnak

Rogue Trader: John Rusnak

The guy that brought down the Allfirst Bank and incurred losses of $69.2 million.

He was sentenced to 7.5 years in prison on January 17th 2003 for hiding the losses that he incurred as a currency trader. He hid the losses for a year. He is now under confinement at his home (since January 2009, meaning that he served almost six years for his rogue trading).

He was ordered to pay back $1, 000 per month after his release from prison and despite the fact that he remains in debt to the full sum of $691.2 million he will probably never be able to pay it back. How did it all happen?

  • Allfirst Bank wished to make its forex operations go from just hedging to bringing in a yield of profits and thus increase the total profits of the bank.
  • John Rusnak was hired to do this.
  • Rusnak was bullish on the Yen. He believed that the Yen would not fall any more after the bursting of the Japanese bubble. He believed that the Yen would rise against the Dollar.
  • He neglected to hedge his forward contracts believing that the Yen could not fail to rise.
  • With the onset of the Asian crisis, the Yen fell.
  • He thus entered false options into the systems to make it seem as if the positions were hedged. He also asked for more money from high brokerage accounts in order to try to win back the money that he had already lost.
  • The management granted this to him and he invested even more money.
  • Rusnak made a personal gain of $550, 000 in bonuses plus his salary.
  • The losses only came to light when the bank asked for capital to be released and they realized that Rusnak had been working in the red all the time.
  • Rusnak was fired from his position and along with him he brought down 6 senior executives for failing to detect the scam.

One thing is for sure: Rusnak has kept his nose clean since getting out of prison and has managed to fall into relative anonymity. Nobody knows what he’s doing today for work. (more…)

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