When you are investing, one of the things you need to be concerned with the reversability of a trade. I.e., can you get out of the trade if the investment goes your way, or if it goes against you. This reversing a trade is often called unwinding a trade (especially if it's going against you).

One of the things that's striking is that big swinging traders who explode (like Amaranth) seem to not have this automatically encoded in their initial positions. So, I wonder why hedge funds risk management teams don't require an unwinding plan for any trade.

From an analytical perspective, a planned trade consists of an algorithm to get into a position, and an algorithm to get out of the position. Failure to specify the exit algorithm and when the exit should occur will cause traders to explode if they hope against hope and hold losing positions too long.

Given this, rational investors will require their investment managers to plan all trades and require the planned trades to clear an expected loss hurdle. Of course, the system can be gamed, as the investment manager can fudge some of the parameters to the trade, but that would require a credulous risk manager who audited the trade.

But here we run into a problem. Audit teams suck because anyone smart enough to critique trades well has a huge financial incentive to be a trader and not an auditor.

So, why don't traders audit other traders' trades? Probably because of the time commitment. So, given a choice between work at fund where you have to spend time checking other people's trades and a firm where you don't, can the careful firm pay you enough over the other?

I don't think it can, probably either because at that level of income, no one wants to do "drudge work", or that the long-term benefits of safe trading minus the multi-year corporate costs do not outweigh the short-term benefits. Which is why we will still see hedge funds explode.

Interestingly Jim Cramer who I gather was reasonably successful at managing his hedge fund married a trader who at times helped audit his decisions. In his "Real Money" book he talks about one point in particular where she came out of retirement for a while to help him get his hedge fund back on track after some risky moves didn't pay off. From the sound of it her primary role was to help objectively analyse his positions (ie take faith and hope out of the picture). Since they were married I would guess the financial incentive for her to trade was somewhat lessened because his financial gains would result in gains for her as well. - David Whittington
True, the only other "Extreme Trading" example I know of is Buffett and Munger. The peer review ideas of extreme programming do not seem to have made it into the world of finance, but I could be wrong as I haven't worked in a major finance shop. -- Patrick.