Lessons about Leverage

What the May 6th 2010 Flash Crash Taught Me About Leverage, Liquidations, and Living to Trade Another Day

Yesterday was the wildest liquidation I ever saw in crypto.

What was particularly disturbing was not the volatility per se (we’ve all seen worse), but the sheer speed, systemic chaos, and the acute dispersion of outcomes that skewed towards total wealth destruction for professional retail crypto traders that tend to traffic in non-BTC assets and non-spot instruments.

As the numbness crept in- that strange, weightless, levitating feeling, I was immediately pulled back to the last time my stomach clenched this hard: May 6, 2010, when I was a junior sell-side derivatives trader watching $1 trillion evaporate in thirty min during the infamous flash crash.

That day taught me a few lessons I’ll never forget, especially when it comes to leverage. These lessons are timeless, and I am going to share them here with the hope that I can help improve even a little better someone else’s risk management capabilities.

1. Always lock in duration. There are many temptations that exist where financial services offer “open terms,” “perpetual instruments,” “break-able swaps,” or “knock out options” etc. These are dangerous implementation techniques because ultimately you cannot control your own destiny. If your financing cost is floating, or your conditional payoff is cancelled despite its terminal certainty, it doesn’t matter how skilled you are; you are at the whims of Mr. Market, your counterparty, and luck.

2. Stay away from manufactured liquidity. There are certain investments that demand an illiquidity premium: venture capital, insurance, litigation financing are good examples. However, there are other sinister things that masquerade as being illiquid, not because it needs to be, but because of incentive misalignment between buyer and seller. Private credit is a great example. Just because there is no “mark-to-market” does not mean that it is “safe”- it just means there is no price discovery until the moment you most need it which is simultaneously when you should not want it.

3. Do not short volatility. This doesn’t strictly mean don’t short vega/gamma. It also means don’t trade things that have asymmetric loss potentials relative to capital inlay. It also means don’t trade OTC with a counterparty who might not pay you (there’s a reason banks are barred from selling CDS contracts on their own names). Most importantly, it also means don’t sell something where the payoff can be manipulated by an exogenous actor; for example, being long First Brands loans when billions of dollars “vanished” after years of normalcy. The exogenous actor can also be something like a bad “oracle.”

Perps fail at all three tests. They are the worst “open-term” in nature because the liquidation mechanics deprive you of the opportunity to be in control especially when liquidity in altcoins can often be completely manufactured. While perps appear to be “long volatility” and are marketed as such due to the embedded leverage, these are actually short volatility instruments: a high volatility event without directional trend will create certain loss. The key for professional retail is to create unbreakable 10x bets with capped downside. You cannot build a portfolio of perps and expect to win, especially when downside correlation is almost always 1.

With that, I’ll end with what my senior trader told my 21-year old self: there are only two rules in trading. Rule #1 is “don’t fuck up.” Rule #2 is “There is no Rule #2. Only Rule #1.”

Because in markets, as in life, longevity is the edge, I’ll add a Rule #3: “Keep showing up. Survive, learn, and that’s how you win in the end.”