The Improbable Seems to be Quite Probable

What do Melvin Capital and Long-Term Capital Management both have in common? They both took highly leveraged positions on the statistically improbable being improbable.

Yet, Melvin Capital lost 53% in January 2021 and LTCM had to be bailed out. In a case study of the LTCM blow up, they mark the key takeaways as the following:

Market values matter for leveraged portfolios;
Liquidity itself is a risk factor;
Models must be stress-tested and combined with judgement; and
Financial institutions should aggregate exposures to common risk factors.

LTCM had put two global financial crisis concurrently in the bucket of events that are statistically impossible to occur, yet, through 1997-1998 that is exactly what happened.

In 2020, we had another set of statistically impossible sequences from market panic selling to the pulling of liquidity.

All of this should be painting a pretty clear picture. Funds go bust when they don't consider the impossible possible. Leverage is a fickle little little guy and it can be catastrophic or glorious. However, funds must take more responsibility for the capital they manage. For Melvin Capital to allow their traders to short over 100% of the float on $GME then not bail at the first sign of failure, gross negligence from the risk desk.

The lesson here is simple. No matter how improbable something seems, have fixed safeguards in place, know your REAL risk. Know what the real hit you will take if the liquidity from the market is pulled and you have to exit with massive slippage, bake it into the risk profile.

The statistically impossible is quite probable.