When Hedging Goes Awry – High & Low Finance – NYTimes.com
http://www.nytimes.com/2012/05/18/business/what-jpmorgan-didnt-learn-high-low-finance.html
Nice simple ex. of the anatomy of a bad trade
QT:”
It helps to understand what was in many ways the simplest — and seemingly among the surest — trades that got Long Term Capital into trouble. It was a bet that yields on the newly issued 30-year Treasury bond would converge with those of the 30-year bond issued three months earlier. When the bonds’ interest rates diverged, for what were surely temporary market reasons, the obvious trade was to buy the
higher-yielding Treasury and short the lower-yielding one. When they came together, that strategy would produce a certain — but small — profit.
But the profit would be large if the fund borrowed a lot of money to take a large position.
What happened then was that so many people put on the trade that even the large and liquid market in Treasury securities was strained. The divergence grew larger. If you could be sure the yields would eventually converge, the obvious course was to increase your bet, which is what Long Term did.
In the long run, that trade would have worked. But the margin calls mounted and it ran out of capital.
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