Lessons Every Trader Needs to Learn From MF Global

Experience is always the best teacher, but it’s also the most expensive. There are a couple of very important trading lessons to learn from the collapse of MF Global that we can learn at the expense of others.

Futures broker MF Global held more than $7 billion in thousands of customer accounts. The firm was run by Jon Corzine, the former governor of New Jersey and also the former head of Goldman Sachs. Many believed he would move to a position in the government after the next election as part of the White House economics team. Instead, he led his firm into bankruptcy with about $41 billion in assets and $40 billion in debt. Despite the large asset base, MF Global did not have enough cash on hand to continue operating in the face of mounting losses from its $6 billion position of European sovereign debt.

As the company collapsed, there were a number of losers. Investors and account holders seemed to be surprised by the speed of the collapse. Account holders face unprecedented issues, but stock holders are facing a rather predictable outcome. The stock fell as hard and as quickly as the company’s financial position and although quoted at $1.20 in the days after the bankruptcy, the stock couldn’t be traded so the actual value fell significantly lower, to only $0.25, when trading was again permitted. Usually, there will be some investors willing to buy shares in a bankrupt company hoping that the eventual settlement will be more than the few cents a share they are willing to risk on their buy. That creates an active market for the stock and most traders should take advantage of that so they can claim a loss in the position on their taxes. Any eventual recovery after the bankruptcy proceeding will be minimal, well below the $8 a share price that the stock traded at early in the summer.

We have the usual lessons in the stock’s chart. Trading really does come down to buy low and sell high. Hope is not a successful investment strategy and traders can not make money by owning stocks that are in a downtrend. The lesson that needs to be relearned by traders seems to be, “don’t fight the trend.” The stock of MF Global had been a downtrend for several months and technically, there was no reason to own it below $6 where it closed below support. All momentum indicators were bearish in the months before the bankruptcy on daily and weekly charts. Relative strength, a valuable tool in the stock market, showed that MF Global was among the weakest stocks in the market. Moving averages were all on confirmed sell signals.

Selling stocks in a downtrend is the standard lesson that everyone takes away from these events. A more important lesson from MF Global is to have a backup in place for every trading capability. This was a big company, and that just means more traders are impacted by its bankruptcy. Big does not always mean safe in the investment world. Accounts around the world were frozen or restricted and traders were confronted with unexpected difficulties getting out of positions. An account at another broker would allow them to enter a closing trade and avoid a trading loss. Accounts at multiple brokerage firms is the most simple and effective backup plan a trader can use.

Backup accounts won’t be possible for the smallest traders, but should be implemented as soon as the account value makes it feasible.

While firm failures are a rare event, web site outages are a less rare event. Most online brokers will allow traders to place a telephone order as a backup, but that means you need to know what positions are open and markets need to be monitored from another data source besides the broker’s data feed.

This lesson about backups applies to every aspect of trading. All traders need a backup computer, a backup data source, and a backup trading location. Face the worst case in your mind and determine exactly what steps to take so you would be able to resume trading within an hour. For a part-time trader this may seem extreme, but every trader has money at risk and should not risk losses because of ‘technical difficulties beyond our control’ which is an age-old reason for down time in any system. Someone trained and authorized to enter trades as a backup is also a prudent risk management measure.

Account holder losses are insured against fraud by the Securities Investor Protection Corp. If MF Global did lose client’s funds because it failed to keep them segregated as required by law, investors will eventually recover their losses. But investors will not be compensated for any lost opportunities or the costs associated with spending time on claims paperwork. Unfortunately, this appears to be a risk that can be minimized but not eliminated. It is one of the few risks that must be accepted by traders.

No specific risk related to MF Global was readily identifiable to individual investors. It was one of the largest and most respected trading firms in the futures industry. Many other brokers, like E*Trade, had placed client money in the care of MF Global. That would only be done after compliance experts completed an extensive due diligence process. MF Global fooled big firms and small traders into believing it was following the rules. Another big commodities broker, Refco, entered bankruptcy a few years ago, and had also fooled a number of clients into believing their funds were safe. There are no guarantees in trading, and broker failures need to be considered as a rare, but very probable, event.

Finally, we can learn the lessons about leverage and unsound trades. MF Global seemed to collapse because of bets on European debt that went wrong. When Corzine joined MF Global, he seemed intent on remaking the firm into something as powerful and profitable as Goldman Sachs. He significantly expanded their proprietary trading, an area that delivers great profits to Goldman. This is always a highly leveraged endeavor at large firm, and Corzine seems to have followed the business model of Bear Stearns more closely than the Goldman strategy. Bear Stearns collapsed under the weight of leveraged trades in mortgage-backed securities while MF Global took excessively large position in European sovereign debt.

By all accounts, the positions in sovereign debt seem to have been bets, not trades. They were highly leveraged, contrary positions made solely to profit if the consensus opinion proved to be wrong. This is a black swan type of trade that offers a high return if it’s a winner, but more often turns into a loser. Without a sound basis for the trade, there was no rational expectation for a winning trade. In the end, this seems to have been the equivalent of placing a large bet on a single number at the roulette wheel. If the ball stops on your number, it’s a bet you’ll talk about the rest of your life but more often, as it did for MF Global, one of the other 37 number hits.

The lessons learned from MF Global need to be applied to all trading account, including stocks, futures, and forex:

– If a stock is going down, sell it or short it. The stock in a bankrupt company is worthless and it is always best to get out of a stock on rumors of a major problem. Occasionally the rumors will be wrong and the stock will shoot higher, but most of the time the rumors understate the problem.
– If a futures contract or foreign exchange currency pair is going down, it should also be sold or shorted. Long positions can not make money in a downtrend.
– Backups for every part of a trading system are a necessity.
– A plan on how to implement the backups is as vital as a trading plan for every trader.
– No firm can be trusted with 100 percent of your business. No matter how long they’ve been in business or how ell established they are, problems can and do occur.
– Don’t trade with too much leverage.
– Never trade on a hunch.

MF Global is the latest disaster stock of a major company that has fallen into bankruptcy. The company can trace its roots back to the 1790s. It had survived world wars and the Great Depression but couldn’t survive the latest European crisis. This proves once again that an overly leveraged position can be fatal to anyone, especially small traders.

By Michael J. Carr, CMT

Trading involves substantial risk of loss and is not suitable for all individuals. Past Performance is not indicative of future results.