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Metallgesellschaft

Do you think a systematic trading approach could have brought one of Germany’s largest company to its knees? Unfortunately for Metallgesellschaft (MG), a German metals and oils conglomerate, it happened. MG was long crude oil futures on New York Mercantile Exchange (NYMEX) most of 1993. They lost, depending on the estimate or source, $1.3 to $2.1 billion dollars. Those traders in short crude oil futures made the money MG lost. It’s a zero-sum game. If you trade like the mindless majority, you lose. MG traded like the majority.

Chart A

During the course of 1993 crude oil futures had a steady slow decline from May through December (see chart A). A move such as the crude decline is not necessarily unusual, but this time was different. Why? There is always someone on either side of a futures trade. The difficulty lies in determining who is on the opposite side of a trade if one side is known. We know MG lost as crude prices dropped, but who won the other side of the trade and how? More important, can the individual investor or trader benefit from an understanding of who won and how? In the aftermath of MG losses a variety of explanations developed. People were treated to academic mumbo jumbo from MBA programs as to why MG lost money and numerous articles condemning futures and their speculative nature. The actual explanation is simply that MG were not good traders. However, this case is a primer not because MG lost but because someone else won.

Trend following played the hand in MG’s defeat. Trend followers left a performance trail of their activities over the course of 1993. The job of explaining this is made easy by the near 100% correlated performances (see chart B).

Chart B
6-93
7-93
8-93
9-93
10-93
11-93
12-93
Abraham
-1.2
6.6
-5.3
1.2
-6.6
3.5
12.5
Chesapeake
1.0
9.5
5.8
-2.7
-0.1
1.1
5.8
EMC
-1.5
22.0
9.3
-2.9
-2.0
-2.4
8.2
JPD
-6.9
10.2
-2.1
-4.1
-2.0
2.7
8.6
Rabar Market
-1.3
14.8
-3.9
-4.1
-6.0
5.6
10.1
Saxon
-2.7
20.5
-14.3
-2.1
-1.1
6.6
17.1
Sjo
8.0
4.3
12.6
-11.4
-1.3
-0.9
6.0

There is slight variation in performance data due to differing levels of leverage employed by trend followers, but the key to the explanation lies in the months of July 93, December 93 and January 94. Those months don’t require much more than a glance at the correlation to confirm the similarity in the strategies employed. They all made money in July and December, and all lost in January. How did trend followers position themselves to benefit from a completely unforeseen event (MG’s bad trading plan)? Here are some insights as to why:

- Trend followers don’t predict market movement, they react to it. May and June showed downward crude pressure and trend followers followed the trend. They have limits on market sectors and risk limits on the total portfolio as well. Position sizes are based on the amount of money under management.

- Every day trend followers know how many contracts must be on based on total capital. The key to their strategy is to place good profits at risk to participate fully in a trend. For example, after trend followers initiated positions and were rewarded with strong profits in July, they were willing to risk those profits again, which is what they did with their crude oil positions.

- Trend followers will risk 100% of the profit in a trade. For example, in August with nice profits in hand, they would have been willing to risk all of their profits and still lose a fixed % based on the original stop.

- Trend followers are willing to let profits on the table turn into losses. Trend followers let the market tell them when the trend is over (i.e. Jan-94).

- Trend followers don’t favor liquidation. They want to capture 60-70% of a trend, not just 15%. Big money is made in the big moves. For example, trend followers want to hold silver as it moves from $6 to $30, not just hold it from $6 to $9.

The July Entry

Examine the crude oil chart and the performance chart. Trend followers all entered in the May and June 93 period and then, in July, the market nose dived. Trend followers were now in for the long haul with a fantastic and very profitable short position firmly established. What’s the lesson? If trend followers had not been profitable, but had lost their maximum percent allowable instead, they would have taken their losses and exited.

After July: The Waiting Game

In August trend followers are firmly established short in crude oil futures. Obviously, MG is long at this point. MG is desperately trying to hang in there (hoping for crude to stop falling) while trend followers wait patiently (and aggressively short). Trend followers are no doubt opportunistic predators. Their waiting game continues through the summer with no real movement up or down (see chart A). MG has met margin calls and stayed in the game in hopes of an upward crude push. They do not anticipate or understand the discipline of their opponent on the opposite side of their long trades. Trend followers are not exiting anytime soon since the trend is down. An exit would violate their most fundamental rule: Follow the trend.

Trend followers were not just short, they were aggressively short with profits reinvested back into additional short crude oil positions. On the other hand, MG has no apparent strategy. They refuse to take a loss early on. The whole MG debacle would have been a footnote in trading history if they had simply exited after the July losses.

The Late November and December Route

Moving through October and November, the situation culminates in MG’s near corporate destruction. Crude oil begins its final descent in late November and into December. At this time MG management closes out of all of their trades that fueled the November and December crash. Trend followers are still short from the May, June and July period and raking in profits at the expense of one ill-fated firm.

Ultimately all good trend following must come to an end. Trend followers would eventually need to begin their crude oil futures exit. The exit came sooner than later as January 1994 proved to be the month of trend followers’ liquidation. Look at the performance of January 94. All trend followers lost for the month as they extricated themselves from their history making winning crude oil trades of 1993.

Performance Chart Returns % 1993
Abraham Trading (Turtle 2nd gen) 33.6
Chesapeake Capital 61.8
EMC 64.2
JPD 23.3
Rabar Market Research 49.7
Saxon 52.6
Sjo 8.9

Conclusions

Trend followers reacted to crude oil movements with a steady plan of systematic trading. They played short to MG’s long.

The MG example, with trend followers winning, is not 20/20 hindsight. Trend followers make money in the same months in the same stocks, commodities and currencies by employing consistently their trend following systems. Scandals and rogue traders in the trading game come and go, but trend following continues to produce great profits by taking advantage of other traders’ poor strategies.

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