Never Trade an Error

A long time ago, I was the floor manager for the Chicago Board of Trade operation of a firm called Timber Hill. I had a junior trader working for me along with three clerks. Our job was to quote the MMI Futures market and execute futures trades to hedge the stock index option arbitrage that was the firm's specialty. The MMI futures were a Dow Jones look-alike index with the ticker symbol MX and were usually referred to as "missile futures" (Reagan was still president). For a futures contract, the action was very fast. The clerks rotated around their three roles: working the desk for data input, quoting from the pit, and chasing tickets and paperwork. I traded off with Kenny, my junior trader, executing the trades in the pit and overseeing the market quotes. Kenny had served in the Marines during Vietnam, and his demeanor typically oscillated rapidly between hyper-vigilant and fearfully paranoid. He had grown up in Chicago and seemed to know everybody on the Board.

At that time, the MX contract traded twenty to thirty thousand contracts per day. Our floor operation would execute seven to eight hundred contracts, sometimes up to two thousand, but always in small batches. Our job was not to speculate in the contract; instead, we executed as precisely as possible and provided market insight for the option traders. Typically we "faded" the market. Buying as the market fell and selling as the market rallied.

Late one afternoon, probably in the summer of '87, we missed the input of a trade I had executed. Kenny was the first to become aware of it - we had bought 10 futures contracts about twenty minutes earlier and at much higher levels. Those 10 contracts had yet to be reported on our trading system. If we had entered the trade into the system at that point, we would have had to explain to the head of the firm in New York how our carelessness cost the firm six or seven thousand dollars. We could also sell the contracts back into the market and establish the loss.

Each of us went through our logs to try to figure out how we had messed up and to be sure that we actually had messed up. By the time we were sure, we were ten thousand dollars in the hole and losing fast. It was near closing, and the market continued to sell off. Kenny floated the idea that we just lose the ticket and come back in the morning. We would treat it like an "out trade." An "out trade" is a trading error found in the overnight clearing process and reconciled prior to opening the next day. There were almost always "out trades," and we could probably bury the mistake with the typical noise of the clearing process. Hey, maybe overnight, the market would rally.

And then I very clearly saw the problem. An honest mistake was quickly becoming a conspiracy to commit fraud. I entered the trade into the system, booked the trade to our position, and called the New York office. It cost us about seventeen thousand dollars.

Never trade an error. Close the trade, establish the cost, and get back to your business. If you profit from it, you'll be tempted to do it again. Most likely, you'll make a series of increasingly bad decisions, ultimately resulting in an enormous cost or even ending your career.

I'll bet that's what happened to Nick_Leeson.