What risk management lessons can we learn from Melvin Capital 50% loss in Jan 2021?

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helpme_please

Melvin Capital was one of the top hedge funds since inception in 2014. They are one of the few hedge funds who handily beat benchmark stock market indices. I expect them to have top-notch risk management to produce this kind of performance. Yet, they lost >50% in a single month alone.

Can the risk management experts in this forum share their insights how could this happen to a top hedge fund? What mistakes did Melvin Capital make?

https://www.wsj.com/articles/melvin...y-hurt-by-gamestop-and-other-bets-11612103117

Melvin Capital Management, the hedge fund that has borne the brunt of losses from the soaring stock prices of heavily shorted stocks recently, lost 53% on its investments in January, according to people familiar with the firm.
 
Those Reddit users are probably newbie, amateur, rookie, greenhorn traders.
But bottom line is that they probably earned money (short-term wise).

How about those hedge fund managers?
Are they also the newbie, amateur, rookie, greenhorn hedge fund managers?
Why did they trade against the trend/flow/grain?
Are they trying to be like Nick Leeson?

When you entered such a counter trend trade (or any other types of trade), you must have in mind where is your hard stop.
Is it 5%? 10%? 100%? 1000?
 
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1. Aim for at least 1:2 risk/reward ratio.

2. Cut your losses early and let your profit run

3. Do not add to your losses i.e. when you are already making losses, do NOT add more capital.

Basic trading rules that we all have to abide to in order to survive against them. And perhaps we can add a new rule:

4. No matter how rich you are and/or how successful you think you are in trading, rules ALWAYS apply to you.
 
helpme_please said:
Melvin Capital was one of the top hedge funds since inception in 2014. They are one of the few hedge funds who handily beat benchmark stock market indices. I expect them to have top-notch risk management to produce this kind of performance. Yet, they lost >50% in a single month alone.

Can the risk management experts in this forum share their insights how could this happen to a top hedge fund? What mistakes did Melvin Capital make?

https://www.wsj.com/articles/melvin...y-hurt-by-gamestop-and-other-bets-11612103117

Melvin Capital Management, the hedge fund that has borne the brunt of losses from the soaring stock prices of heavily shorted stocks recently, lost 53% on its investments in January, according to people familiar with the firm.
More...

I doubt Melvin's position in GME was all that large in the first place. but in any convergence trade where your downside is unprotected (as in the case of any uncapped short), even a 5% position can blow you up. haven't checked the GME chart on this, but if the premarket gaps were significant, those positions never stood a chance.
 
re: op's question, aside from the obvious lessons in drawdown management, one good lesson is remembering that contagion is a bitch. avoid crowded trades to the best of your abilities (eg the GME short, but also the impending reversal), or a least have contingency plans, because when things unwind they get ugly, and fast.

imo it also reaffirms the sources of edge one should target as retail compared to the professional. while institutions generally have the upper hand in most respects (latency, economies of scale, t-costs, research platforms etc), they cant compete in low capacity strats and illiquid markets, which is where retail shines brightest. conversely, systematic alphas that are popular with institutions such as L/S and statarb, while generally consistent, are prone to contagion in high stress times. know your niche.

im also curious how this affects market microstructure going forward. markets have been exceptionally volatile since 2008 after retail volume dropped off a cliff. if this signals the widespread return of retail, volumes could pick up as volatility drops off, which would be a pretty big change in markets. I think other factors will bar such a return, but you never know
 
In my opinion, what the Risk management clowns at Melvin Capital didn't recognize (Or they recognized but overlooked & ignored) is that the fund was having too many correlated & concentrated trades on the short side. Most of the short trades were mainly in those retailers who were already struggling and they even struggled further because of the pandemic & the lockdowns.

Indeed you are in a crowded trade along with a lot of other (smart) hedge funds.

Risk Management lesson: don't concentrate your bets, even if you spread them around companies & sectors (Retail, Airlines, Leisure, etc...), they are still concentrated because they are all COVID driven and crowded.

Blackswans for you on the upside wipes you out also.
 
Normally the lesson is this: Diversify, diversify, diversify. Then you reduce your exposure to risk in a single firm. This is the main advantage that someone with a large portfolio has over the amateur with their stimmy check, reddit feed, and RH account.

But GME went from $20 to $350, a period in which Melvin have lost ~50% of their capital but not just on GME; let's call it 30%. So if they had a position on from 20 to 350 without doing anything about it that implies their starting position was about 2% which is hardly excessive. More likely they were covering on the way up so their starting position was a little larger, or they could have bought earlier in which case their start position would have been even smaller, but still it seems they weren't that concentrated.

(They had other positions on that turned out to be correlated, so the other lesson is: be careful what you mean by diversification)

So the lesson is that if you have short positions, diversify even more. Because the risk get's bigger when the price goes up and the downside is unlimited. With a long position the market exits it for you; if the price halves you will go from a position of 10% to one of 5% without doing any trading. With a short position you will go from 10% to 20% and you will need to close half your position immediately just to maintain the same risk, never mind cut.

However if Melvin had maintained their risk, or even better got out completely at $20 or $40 then we wouldn't be talking about them now. They couldn't because their position was too big.

So lesson three is: don't have large positions as a proportion of the free float. And this implies equally to long and short managers. Even if you diversify amongst 100 firms, if you are a $1 billion small cap manager and each of those firms has an average market cap of $100 million then you are 10% of their market cap which is way too much if you need to exit quickly.

Alternatively, consider taking a leaf out of the reddit/RH crowd's book and putting on a massively OTM long call hedge or just giving up: buy expensive puts instead of shorting outright, and taking your theta bleed like a man (because no woman would do such a stupid thing).

GAT
 
helpme_please said:
Melvin Capital was one of the top hedge funds since inception in 2014. They are one of the few hedge funds who handily beat benchmark stock market indices. I expect them to have top-notch risk management to produce this kind of performance. Yet, they lost >50% in a single month alone.

Can the risk management experts in this forum share their insights how could this happen to a top hedge fund? What mistakes did Melvin Capital make?

https://www.wsj.com/articles/melvin...y-hurt-by-gamestop-and-other-bets-11612103117

Melvin Capital Management, the hedge fund that has borne the brunt of losses from the soaring stock prices of heavily shorted stocks recently, lost 53% on its investments in January, according to people familiar with the firm.
More...

"top-notch risk management"? In an efficient market, there is supposed to be no riskless profit. In other words, every single $$ of profit that you make carries its own degree of risk. So following this line of thinking, if they were "handily" beating benchmark stock market indices and all profit carries risk, I would say they had very little or at least very questionable risk management.

They just had lots of money and I suspect inside look of retail traders' order books. One of their investors is Citadel which owns Citadel Securities which now we know is a liquidity provider that pays for order flows at RH. Before RH, how do we know it wasn't paying for order flows at other discount brokers? If they did, then they would've had close knowledge of where traders and especially retail traders' positions because it was the one who took the opposite side just like those MM brokers in retail forex. And how do we know Citadel Securities wasn't passing that information to Citadel who in turn wasn't passing to Melvin Capital? How do we know there were Chinese walls in place that ensured no sharing of information when all three companies are related?
 
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Fat, greedy, cocky, complacent, lost the hunger, lost the edge would be my guess.

But if you have money, most often you can still win it back by lobbying, coercing, bribery.
Illegal or out of reach for working class stiffs but standard fair for the suits.
 
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