Lessons to Learn from JPM's Trade
The contract is typically five years until expiration, although other maturities trade in much smaller volume. Every six months a new IG index is created with some of the names changing to reflect the current market. Right now we are CDX IG 18, the 18th.
The old indices continue to exist, but, not surprisingly, volume is heavily concentrated in the current index. The CDX IG 18 trades many billions of dollars every day. The 17 still has reasonable volume, but after that, trading is sporadic at best.
JPMorgan trader Achilles Macris saw something he thought was tradable in the CDX IG 9 index, which would have been the current index about four years ago. What exactly he was trying to do isn't clear right now, but my understanding is that he was using options on a shorter-dated version of the index and trading that against a longer-dated version.
Media reports suggest his exposure was something like $100 billion, which I'd guess (without his involvement) would have constituted around a year's worth of volume on an old index like this.
I don't know what he thought was so sexy about the IG 9 index, but for our discussion here, it really doesn't matter. He made two obvious mistakes, and ones that you could be making yourself.
First, always remember that liquidity is part of any trade. Now, maybe you aren't swinging around $100 billion in credit derivative exposure. But that doesn't mean you might not have a trade go badly because liquidity turns against you. Have you ever bought an option contract that was way out of the money or very long dated or on an off-the-beaten-path stock? Essentially that is what London Whale, as he was known, did. He thought he saw something worth trading in a very low liquidity instrument. But because he dominated the instrument he started influencing the pricing.