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Yesterday's announcement by JPMorgan Chase & Co. (NYSE: JPM) that it lost $2 billion on a "hedge" position is not only surprising, it's frightening.
I'll try and make this short and easy to understand, but the truth is that it's complicated. If we have a decent idea about what happened (and I do), it's bad. And if it's a tip-of-the-iceberg thing (which I don't believe it is), it could be really, really bad.
Investors put on hedges all the time. In fact, in our investment services like the Capital Wave Forecast we put on essentially the same type of "economic" hedges that JPM CEO Jamie Dimon is saying blew up on them. The economic hedges we put on are essentially hedges against long positions we hold.
For example, if I see some potential danger ahead, then I recommend we buy some protection, like buying the VIX in anticipation of rising volatility, or buying puts on broad market indexes.
The broad protective measures we take are economic hedges because they are not specific hedges designed to hedge potential loss in any one position. For example, if we owned JPM stock and we wanted to hedge our position, we might buy puts on JPM, or sell calls, or employ another specific hedge against our long position.
Personally, one of my favorite hedging tactics regarding specific positions is to not hedge it at all, but to sell the position outright. Needless to say, there are times when taxes, dividend payouts, and other factors make specific hedging prudent.
Back to economic hedging...
JPMorgan had on an economic hedge against what they thought was going to be an adverse (to their net positions across the bank) movement. It wasn't a specific hedge.
The problem is that they blew the hedge, big time.
We'll find out more in the coming days about what really happened (maybe), but I know they had on a massive arbitrage, or spread-type, position in the credit derivatives markets.
What's important to know is, what were they really doing? Where they "hedging" or betting with house money? Okay, I'll answer that for you. They were betting.
It's impossible to put on an economic hedge that size and not have it be a directional or spread bet.
It was a bet that went bad.
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About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.
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