There is big news in the world of hedge funds this morning, where Bill Ackman has, we are told, bailed out of his well-reported position in Valeant Pharmaceutical (VRX). For those who have managed to avoid the saga, Ackman’s fund, Pershing Square, invested in the firm a couple of years ago, when consolidation in the pharma industry was all the rage and buying existing brands in order to increase prices rather than doing much (very expensive) R&D of your own looked like a good business model.
Oh, and by the way, VRX was up above $250, a long way from the eleven dollars and change reportedly realized on the 27 million or so shares and options that Pershing Square bought.
The collapse came about as the result of a few things, a failed merger, some questions about accounting methods and, probably more importantly, a change of heart with regard to drug pricing and a political atmosphere that suggested that whoever won the election companies like Valeant would be squeezed.
Whatever the reasons, the collapse of VRX was spectacular.
Whenever I hear tales like this of massive trading losses - think Nick Leeson at Baring Bros, the London Whale at JP Morgan or any one of a host of less famous trading blow ups, I think back to the early advice I received as a trainee in the interbank forex market.
There were a few basic rules of survival that stood me in good stead for a couple of decades, which deal with the basic problems that traders can face. Those problems seem to always be at the root of these giant blow ups and, as the Ackman tale demonstrates, can happen to the best traders out there. It is, therefore, worth reiterating the advice.
I was told essentially the same thing in different ways by various different experienced traders. Hutch, the manager on the Cable (GBP/USD) desk where I started put it one way: ”Pride is a trader’s greatest enemy” he said.
Taxi, the Director on the same desk put it a different way, saying “What separates the survivors from the fired is not smarts or courage or any of the things that most people think trading is about, it is discipline.”
Essentially both of those guys were saying the same thing: having a plan and sticking to it is the key to success.
One of the biggest differences between “professional” desk and pit traders and most home-based traders is that those in the market focus on exits, whereas those who trade from outside tend to focus on entries. The difference comes largely from the different roles involved.
Retail traders have the luxury of simply picking something and then buying or selling it, whereas those on trading desks almost always have to provide liquidity (quote two way prices) in what they trade to their counterparts at other firms or the market in general. That means that many of the positions that desk traders have are not of their choosing, which in turn leads to the question “Where am I going to get out of this?” rather than “Where should I buy this?”
That focus on exit points rather than entry points leads to bracketing each trade, or at the very least finding a logical level for a stop loss. Of course, as every trader knows, setting stop loss levels and sticking to them can be two very different things, which is where Hutch and Taxi’s words come in.
In the case of VRX, it seems, Ackman fell afoul of Hutch’s warning. He has always had a very public style of investing, and making people aware of his positions and rationale for them has worked well in the past. However, the problem comes in situations like this. When everybody knows you have a huge losing position, pride can easily get in the way of cutting for a relatively manageable loss.
Of course, nobody reading this is likely to have a multibillion dollar, publicly declared position in anything, but the same rules and warnings apply, whether you are dealing millions of shares at a time for a living or having fun trading in a few hundred shares or a couple of futures contracts.
I have said it many times before in these pages, but I don’t apologize for saying it again: setting a stop loss level when you first enter a position before pesky emotions like pride get in the way, and then sticking to that stop, are the most important things a trader, big or small, can do.