A rogue trader’s strategy

On the 26 of February 1995 Barings Bank was declared insolvent. It was single handedly because of the trading actions of one trader, Nick Leeson.

Nick Leeson became general manager in the Singapore trading office in 1992, making $10 million in his first year. This accounted for 10% of Baring’s annual profit that year.

However failed trades began adding up and, by hiding the losses in an account named 88888, he was able to persuade Barings in London to continue providing capital for his trades.

At the end of 1994 he had lost £204 million, unbeknown to the bank. The trade that finished him off was a short put, short call trade known as a short straddle. This is depicted in the diagram below.

ShortStraddleJPEG

The graph shows a payoff and profit diagram, with S(t) standing for the terminal share price and K for the strike price. Nick Leeson sold short a call (dashed line) and a put (dotted line) generating premiums of £c and £p respectively. His bet was a conservative one, that the stock market would remain within a certain range, that is where the bold black line remains above the x-axis. If the terminal share price remained at the strike price Nick Leeson would have profited £c+£p.

He placed this trade on the 16 January 1995. On the 17 January 1995 an earthquake hit Kobe, causing the stock market to go into free fall. The Nikkei fell from 19,241 to 17,785 in two days. In an attempt to shore up his position Nick placed large long calls on the market, hoping to influence other investors to trade the market upwards. The strategy failed and he lost the money on the short straddle and the long futures.

A payoff table is shown below:

shortstraddlepayofftableJPEG

In the words of Joe Granville, only losers hedge.

@ProdigyMarkets

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