Amaranth, 2006

At a glance

What happened

Amaranth's energy book, run by a single trader, built huge positions in natural gas calendar spreads: long winter delivery months against short spring months, betting the gap would widen. By 2006 the fund held a large share of the open interest in the contracts it traded. In September the spreads collapsed, the fund lost about $6.6bn, then the largest hedge fund loss on record, and what remained of the book was transferred to JPMorgan and Citadel at a steep discount.

Why it went wrong

A spread has two offsetting legs, so exchanges margin it lightly, which is what let the fund carry such a large position. But the problem was its size relative to the market, not relative to capital. With so much of the open interest, there was nobody to sell to except at prices that moved the market against it. Moving positions to the then lightly regulated ICE platform avoided the position accountability levels that applied on NYMEX, a gap later closed by legislation.

What it teaches

A position that looks hedged is not necessarily small: low margin buys a much larger notional, and the loss when the legs stop moving together scales with it. Liquidity has to be measured against the depth of the market, not the size of the fund. A mark is only a price if someone would trade the whole position there.

Key terms

Calendar spread

Long one delivery month and short another in the same commodity, trading the gap rather than the level.

Open interest

The total number of contracts outstanding, and so the measure a position’s size should be read against.

Spread margin

The reduced margin charged on offsetting legs, on the assumption that they move together.

Widow-maker

The March–April natural gas spread, across the end of the withdrawal season, and its reputation for violence.

Position limits

Caps on how much of a contract one participant may hold, applied on a regulated exchange.

Liquidation discount

The gap between a portfolio’s marked value and what a buyer will pay to take it on whole.

Where it sits in the course

Case studies like this one are used throughout risk management teaching, including FRM® preparation, as worked examples of market liquidity and concentration risk. In OTC Learn the lesson runs in five steps: what happened, the position, why it broke, what it cost and what it teaches, followed by a worked example with the numbers. See the lesson outline.

The instruments behind it

OTC Learn lessons on the products this case turns on:

• Commodity SwapFixed price for floating market price
• Crack Spread SwapHedge the margin between crude and its products
• Swing OptionThe right to choose how much you take