The Day I Watched Several Traders Implode–A Bar-by-Bar Account (Part 1)

02/04/2008 12:00 am EST


Timothy Morge


Societe Generale, one of the largest French banks, recently announced they had recorded the largest trading loss by an individual trader, US$7.2 billion, by a stock index trader named Jerome Kerviel. This incident reminds me of the Sumitomo Corp. US$2.6 billion loss in 1996 by its chief copper trader, Yasuo Hamanaka, Nick Leeson's US$1.4 billion loss that brought down Barings Bank, Allied Irish Banks US$691 million loss in 2002 and similar incredible trading losses by Joseph Jett that brought down Kidder Peabody in 1994. These were once successful professional traders wrapped in safety nets by their institutions and yet they all lost incredible amounts of money. How does a trader get him or herself in such a position?

I have been a professional trader now for 35 years. I've probably made every mistake that can be made and broken most of the trading rules that can be broken—except one very important set of rules: :

  1. Always have stop loss orders in place when you open any position.
  2. Never lie to yourself or anyone else about your losses.
  3. When you find yourself out of step with the market, close all your positions immediately and walk away from that market. Then take a break from trading.

I was very fortunate when I first started learning how to trade because I was trading in my elder brother's trading account. He set an amount he would allow me to lose and if I lost that amount, he would end my access to his trading account. He made it very clear that if I could not control my losses and keep them below the level he set for me, he had no tolerance for me using his money and his account. Once I started trading, I couldn't imagine a fate worse than not being able to continue to trade, so the rule was easy for me to follow and was deeply ingrained in me early on in my trading development.

I have had the honor and pleasure of teaching hundreds of professional traders at the CBOT and CME over the past three years. I regularly mentor more than 350 of them and get to see their trades throughout the trading day, which means I see their successes and failures day in and day out. And at times, I see these professional traders make catastrophic errors in their trading judgment. One example sticks in my mind because the group of six traders involved had an office right down the hall from my proprietary trading room. Let me tell you about one trading meltdown situation I witnessed.

In my own trading and in my seminars and webcasts, I teach that the majority of trading profits come from the “middle” of the market. That doesn't mean traders can't make money picking tops and bottoms, but in my experience, traders that make a habit of fighting the market—by constantly picking tops and bottoms—tend to lose. The market is always right and we are just along for the ride. One of the most useful tools I have added to my tool kit is called “Separation,” and it refers to the distance between where price tested a line of support or resistance and where it closed. It can also refer to the distance price spiked past resistance and then closed back below the line of resistance—if price spikes above a line of resistance with good separation but then closes back below the line with good down separation, it is a sign of weakness. Similarly, if price spikes below a line of support with good down side separation but then closes back above the line with good up side separation, it is a sign of strength. Let me see if I can illustrate this important concept:

Separation is an important insight into the market because traders always have to decide what mode they think the market is in. For example, if price has been cascading lower and a small rally climbs above a prior swing high, is this current rally a counter trend rally—the trader should then be looking for an area to get short—or is this the start of a change in trend to the up side? Separation makes the market participants “play their cards” before you commit your capital to a position. If you don't see enough separation to clarify the situation for you, simply wait for another bar to form or pass on taking a trade altogether until price clearly shows you what mode the market is in.

But traders, even professional traders, are often an anxious group and like to anticipate movements. Sadly, when a trader successfully picks a top or bottom, it reinforces this dangerous behavior. At the exchanges, everyone has a story about a guy that picked the exact top in this index or that commodity but the story always ends the same: He “blew out” the next year and doesn't trade anymore.

More in Part 2 tomorrow Part 2 | Part 3 | Part 4 | Part 5

By Tim Morge

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