French Trader Paid Price for Leverage, Hubris

Although the investigation is far from over, it would appear that Kerviel blew up for the same reasons that brought down Brian Hunter, Nick Leeson and so many others: huge positions, zero discipline and an overriding need to be right.

How big was Kerviel betting? Anyone who thinks that the free market can be muscled or manipulated, should consider the fact that Kerviel's trades were valued north of $83 billion dollars, bigger than the bank at which he worked, bigger than the gross domestic product of Slovakia, Qatar or Libya, and the equivalent of about half of France's gold and currency reserves. Sacre Bleu!

The fact that he was able to deploy such immense firepower in his trades — $44 billion into the Eurostoxx index and $26 billion into the German DAX, for example — and still have it move sharply against him shows that nobody is bigger than the market. You can bet an entire multinational bank that XYZ is going to rise... and it can just as easily fall. Whether you are a rogue trader betting billions or Joe Sixpack wielding an E*Trade (ETFC) account, it is impossible to reliably muscle the market into going your way — no matter how much you buy.

When looking at the list of the largest publicized trading losses, it's worth noting that the majority of them were facilitated by trading in futures, options or other derivatives, all highly leveraged contracts that permit big bets with little money down. Whether it's an Internet stock or residential mortgage, oversized positions can be fatal. When the market moves against you — and it always does, eventually — rogue traders and regular folks alike find that leverage can quickly torpedo a portfolio whose risk far exceeds the capital standing behind it.

A big part of controlling risk is having the humility to reduce it. Difficult as it was to unwind Kerviel's massive losses in the midst of last week's full-scale meltdown in the equities, bank management did the right thing in immediately exiting the trades. The best way to stop a loss is to take it.

Still, it does seem as if the market's cruel sense of humor brings the most destructive price action at exactly the wrong time. Case in point, at least in the United States, was Sept. 11, 2001, which as you might recall, occurred only after the Dow had already dropped from roughly 11,500 in the spring to under 10,000 by early fall. Stock investors were already hurting before the attacks caused another massive plunge.

Most interesting was the fact that, unlike other rogue traders, it doesn't appear Kerviel was personally profiting from his massive, unauthorized bets. Given his reported computer skills, he could have probably simply transferred the bank's cash to an account of his had money been his goal. So why'd he do what he did instead? Like many investors with an unhealthy obsession with the financial markets, it would seem that Kerviel wasn't interested in getting rich, but in being right. Such vanity will sink any trader.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC.