What Is a Blow Up?
Blow up is a slang term used to describe the complete and abject failure of an individual, corporation, bank, development project, hedge fund, etc. The term is most often used when a hedge fund fails but is not exclusive to them.
- A blow up describes the complete and abject failure of an individual, company, or hedge fund.
- The high use of leverage by hedge funds can result in a blow up.
- Significant withdrawals from a hedge fund as a result of underperformance can lead to a blow up.
- Retail traders can avoid blow ups by using money management, setting favorable risk/reward ratios, and implementing trading rules.
Understanding a Blow Up
Hedge funds frequently engage in high-risk investment tactics and often invest in alternative assets to aggressively accumulate capital gains. Often a hedge fund is so highly leveraged that losses can be catastrophic, and since a hedge fund can have extremely large portfolios, even a small percentage loss can lead to huge cash losses. As funds fail to perform, investors may withdraw, forcing the fund to dissolve or blow up. Black swan events, such as the coronavirus epidemic that continues to severely cripple global economic activity in 2020, has the potential to cause corporate blow ups, particularly in the hospitality, tourism, and travel industries amid the closure of national borders, bars, clubs, and restaurants.
How Retail Traders Can Avoid Blow Ups
Money Management: Anything can happen in the financial markets. Therefore, it's important not to risk too much capital on any one trade—no matter how tempting an opportunity looks. Traders can implement this by never risking more than 2% on a single trade. For example, if a trader has a $25,000 account, they'd only ever risk a maximum of $500 per trade ($25,000 x 2 /100). To prevent a string of losses, traders could stop trading for the month if their capital falls by a certain percentage. For instance, a trader may decide to liquidate all positions and sit in cash if their account fell 10% from the previous month's closing balance.
Favorable Risk/Reward Ratios: For every dollar risked, aim to make a profit of at least double that amount, which provides a favorable 1:2 risk/reward ratio. For instance, if a trader decides to risk $100 per trade, they should set a profit target that returns $200. This allows traders to be right half the time and still make money. Although it's possible to make money scalping small intraday moves, setting larger risk/reward ratios make it easier to cover trading costs that can mount up and contribute to account blow ups.
Set Trading Rules: Consider establishing specific rules that must be met before entering a trade. For example, a trader could require a stock to be trading above the 200-day simple moving average (SMA) to ensure they trade in the direction of the longer-term trend. Setting trading rules helps avoid overconfidence and revenge trading—two common errors that can blow up a trading account.
Examples of a Blow Up
Perhaps, Long-Term Capital Management was the most famous blow up in modern financial market history. Founded by former bond trading heavyweights from Salomon Brothers and anchored by two Nobel Prize-winning economists, Long-Term Capital Management was a veritable Dream Team of finance and investments. In 1998, in response to a Russian debt crisis, they blew up their hedge fund anyway. The saga was chronicled by Roger Lowenstein in his book, When Genius Failed: The Rise and Fall of Long-Term Capital Management.
Other popular bets that resulted in a blow up:
- Bear Stearns: $1.6 billion collapse of highly leveraged hedge funds in mid-2007—one of the first distress signs in the credit markets.
- Societe Generale: SocGen's Jerome Kerviel blew up 4.9 billion euros with another rogue trader scandal.
- Amaranth Advisors: The Greenwich, Conn., fund amassed a $6 billion loss on disastrous gas bets, which precipitated its collapse in 2006.
- Barings: Singapore-based derivatives trader Nick Leeson in 1995 fled from authorities after sinking Britain's oldest merchant bank, Barings. While at Barings, Mr. Leeson made and tried to hide a series of derivatives trades on the Japanese stock market that led to a $1.3 billion trading loss. Leeson's story is the stuff of lore: sparking the nickname, Rogue Trader.
- Platinum Partners: The fund, which generated annual returns of about 17% between 2003 and 2016, was shut down after its co-founder Mark Nordlicht was arrested for perpetrating a $1 billion ponzi-like fraud. However, a federal judge later acquitted Nordlict of all charges related to defrauding hedge fund investors.