Since FX prices are shaped by customer flows, in order to fully understand what makes the market lick we need to understand the players involved and their moti¬vations. Although over half of all FX turnover is handled by the interbank market (essentially banks trading with each other) this percentage has been rapidly shrink¬ing (it accounted for two-thirds of all trading 10 years ago) due to the increased participation of sophisticated and varied investors. Where FX was once solely the domain of global banks, nowadays a growing number of speculators such as hedge funds and eTAs actively jostle for space alongside the more traditional players.
In a way, it seems only filling that the largest market in the world should also have the most varied group of panicipants, and everybody from the hedge fund crowd to the frequent flier crowd now has an interest in foreign exchange rates. In order to simplify things, we can divide the FX market into the four major types of panicipams: marker makers, corporate accoums, speculawrs, and central banks.
MARKET MAKERS (Dealers)
In contrast to the other FX participants, market makers are lhe only nOllcustomers in the market and are there instead to provide a service to paying clients. Banks are the only ones with deep-enough pockets to handle the biggest of FX transactions. from billion dollar M&A flows to structured products for corporate clients, but since not everyone can trade directly with a bank specialist brokerage houses have long existed to handle the "leftovers". Unlike bank dealers, whose primary purpose is to m.ake markets for their corporate cl ient base, a dealer for an FX brokerage should playa blind third-party role by simply matching up the orders of their wide customer base and collecting a spread for their trouble (much like a specialist on the NYSE). Speculators can use them to gain anonymity while trading, prop desks may lise them for arbitrage, and individuals may use them because of their smaller size.
Although a dealer's role in the market shou ld theoretically be limited to providing liquidity for their clients, in reality much more is expected of i.I good dealer. and an FX desk is expected 10 generate substantial "off-the-books" prallts for the company by actively trading against their client basco
CORPORATES
Multinationals are the bread-and-butter of the FX world and arc, by and large, seen as the most logical participants in the foreign exchange market. Along with insur¬ance and pension funds. they are known as "real money" accounts as opposed to the leveraged crowd, which borrows substantial amoullls (0 trade. The Coca-Colas and GEs of the world receive and make payments all over the world. which neces¬sitates their involvement in the foreign exchange market. These corporate nows need to be carefully predicted and hedged in advance so that accurate budgets and projections may be created. Since corporate clients are not a particularly SpeCll¬lative bunch, they arc primarily interested in hedging flows through the forward market. For them. the less volatility, the better.
A well-run and pro-active treasury can have a tremendous impact on a company's bottom line, as in the case of BMW, which successrully avoided being hurt by a 13 % rise in the value of the euro against the dollar in 2003 -unlike rival Volkswagen, which had to take a €400 million hit because of bad hedging decisions.
SPECULATORS (Hedge Funds, CTAs, Prop Desks, COMs)
Speculative traders come in all shapes and sizes and tend to be the most interesting bunch in the FX world. Their primary aim is to generate prolits through their views on the markel, as opposed to simply collecting transaction fees (brokers) or using FX as a means to an end (corporates). The big players in this group include prop desks (banks trading their own proprietary accounts), hedge funds. commodity trading advisors (eTAs), and currency overlay managers (COMs). These traders have an appetite for risk and a put-your-money-where-your-mouth-is mentality. but their use of leverage also means that they are more prone to "blowing-up" than other participants. Along with dealers. they are responsible for the majority of intra-day moves.
CENTRAL BANKS
The central banks of the world act as the administrators of the FX market. Each national bank is responsible for their currency. and it is nO secret that they often play active roles "nudging" the market in their preferred direction. Central banks are loathe to see their currency being used for speculation. and although their primary aim in the FX world is to reduce harmful volatility, if fundamental imbalances exist they will sooner or later be refieclCd in the exchange rate. Since CBs love to sec speculators get hurt. interventions in the market are made at strategic moments to catch the market off-guard, and smaller countries may choose to close the doors to speculators altogether by limiting capital flows.
THE FOOD CHAIN
FX participants are arranged in a certain pecking order that ensures that the lOp rung always feeds on the bottom dwellers. In this world, the bottom rung of the food pyramid is occupied by the "public", usually customers whose field of expertise lies olltside trading currencies (corporates) or unsophisticated market participants (retail). Since everybody feeds off the public (especially banks and brokers) this is not where you want to be, and if you are a retail trader paying a 5 pip spread for a 20 pip trade then you immediately fall into this category.
Hedge funds and other sophisticated speculators, on the other hand, are at the top of this food chain, Due LO their speed and market insights, these advanced players are able to prey on banks and brokers that are more concerned with collecting spreads than identifying arbitrage opportunities, It's a speculator's duty to take some of the bank's risk-free profits and pocket them for themselves.
Because a player's positioning on the food chain is dictated by their level of infor¬mation and speed, retail investors unfortunately often have a hard time overcoming the disadvantages that keep them at the level of the "public",
THE ROLE OF THE SMALL SPECULATOR
Small speculators occupy a very peculiar position in the FX world, and often find themselves at the boltom of the food pyramid being preyed upon by more experienced players. Although the odds are stacked against them, some retail traders do, however, manage to overcome the odds with a mix of confidence and sk ill that any bank trader would envy. Such is the story of Yukiko Ikebe, a 59-year-old housewife in Tokyo who was recently indicted for evading income taxes from her roughly 400 million yen trading profits, a story that inspired the head of foreign exchange at Soci~le Generale in Tokyo to proclaim: "She must have made more than us! Find her and hire her!" These outstanding individuals have learned not to " fight" the market. because the market is certainly not fighting them. so they instead focus their altention on taking whatever the market is willing 10 give them, and going by Mrs Ikebe's example it is apparently quite a JOl!
Unfortunately these bright Slars seem to be few and far between, since the vast majority of retail spot FX traders are just not very good in the long run. After all, if market makers profit by trading against their client basco then their client base must be wrong most of the time for them to make money. Retail traders in any market make great contrarian indicators. and their positioning is in fact a valued commodity that is actively traded upon by many funds and money managers. Although you may think their chances of success are 50150, somehow amateur traders have the innate ability to pick tops and bottoms and consistently get chewed up by the market because of their misguided trading decisions and lax money management rules. On the back of the great news, Creative's stock gapped higher the next day and traded as high as 7.60, having closed around 6.00 the previous day. The volume traded was almost len times the daily average, indicating large retail participation. Dealers were well aware of the news, but maybe surprisingly they begin to sell soon after the opening bell (they were selling while the masses were buying). Why did Lhey choose La go against the lide? If you look at the bigger picture you soon realize that although $100 million may be a nice chunk of change, it will in no way alter the prevailing trend -i.e. the iPod will continue to dominate the market. If the lawsuil had changed the fundamentals of the industry (forcing Apple to stop producing their product, for example) then their reaction would probably have been different, but in this scenario they were happy to sell all day long to the unsuspecting buyers and finish the day with a healthy profit when the buying subsides and the price returns to its pre-news level.
Friday, August 28, 2009
Today's FX Market
The enormolls technological advances thal we have seen over the last 20 years have had a profound impact on how the FX market operates. Everything from backortice systems to trading has been affected by the changes, generally making things faster, more accurate, and more reliable. Bank dealers are now less likely to find "surprises" ilt the end of the day. having second-by-second access to their exposure. Technology has also enabled a new breed of competition to arise for the old-school voice brokers, namely electronic platforms like Reuters, FXAII, EBS, Currenex, etc.
Whereas before a trader was forced to make the rounds in an effort to find a price. he can now instantly see the best tradable bid/ask with a single key stroke. With all of the liquidity providers now imputing their best price into a common platform, it should in theory be a much better way of going about things, and for the Illost part it is. However, don't feel lOO sorry for the dealer, for there will always be a place for his trade. Although electronic platforms are great for "vani lla" transactions, if you are a fu nd trying to push through a large Mexican peso trade in early Sydney time. your only hope for success is contacting a good dealer that can make it happen. No e-platform wi ll ever make a market out of thin air.
A QUESTION OF NUMBERS
Technological advances have helped drive the growth in FX turnover, and although much is said of the tremendous volumes traded on a daily basis, the oft-quoted statistics should be taken with a grain of salt. The FX market is by far the largest and most liquid market in the world, with daily FX turnover estimated al around $2 trilliol1. If this seems like a lot to you, it is because it is. Compare FX volumes to the tiny $50 billion traded at the NYSE or the $800 billion traded in government debt and you gel an idea of the size of the market. yet the first thing to take into consideration when hearing that "FX turnover has increased 50 % over the last 3 years" is that turnover is measured in US dollars. A depreciating dollar will directly translate into ballooning turnover volume. l However, even if the figures are sOl11cwhal skewed, the fact remains that billions and billions arc being traded every day. So the question becomes. "Who is trading all of these thousands of billions of dollars?"
The truth is that nobody really knows, but it may be the case that turnover numbers are greatly exaggerated due to the multiplying effect of FX transactions and the use of notional funds. For example, when multinational X approaches their bank to trade 100 million euros for dollars, a two-way transaction lakes place, so the 100 million goes on both of their books. The bank then quickly contacts one of their counterparties to offset their exposure, which may in turn offset their exposure through the derivatives market. A single transaction can therefore set in motion a whole set of subsequent transactions totaling well over the original € 100 million in cash.
Although it is hard to tell exactly where these flows are coming from, what is undeniably true is that FX volumes have been steadily increasing. Volumes are in fact rising at such a tremendous pace that only a fundamental shift in people's perception of FX can explain the current situation.
THE NEW ASSET CLASS
As little as ten years ago. most asset managers regarded FX as an annoying side transaction that simply had to be done, and most did not panicularly care for it. If a large international mutual fund wanted 10 buy European stocks. they would simply approach lheir custodian bank and tell them to take care of it. This was a case of Ihe simpler the better, since in their minds their core competencies lay in picking stocks, Ilot the direction of the dollar. This may seem like a reasonable, approach when things are going well, but III times of uncertainlY and low yields,
every penny begins to matter.
After the bursting of the stock market bubble and 11 September, times got tougher for asset managers and lhey soon began to look at FX with kinder eyes. They realized lhal their FX holdings could actually be regarded as a separate asset class, which had to be "optimized" in their constant search for alpha (excess return).
This change in perception proved to be a radical shift for the investment com mu¬nity, and continues to be a major driving force in the FX markets today. More and more funds are now actively managing their FX exposure, either in-house or by employing a currency overlay manager (COM). This renewed the foclls on FX and the search for yield has in turn led to the resurgence of the carry trade,3 which in turn often leaves strong trends in its wake. In an age of low yields and increasingly competitive (efficient) markets, this new brand of FX participant is here 10 stay.
Black Wednesday, 1992
Perhaps the most infamous FX trade was George Soros & Co's short sterling bet that managed to ~break the Bank of England." By September of 1992. Soros and other speculators had begun to take increasingly large short sterling positions on the groundS that the UK economy was suffering from high inflation and a slumping housing market. At the lime, the UK had entered the ERM (forerunner to the Euro) at 2.95 Deutsche Mar1<.s to the pound, and the GBP/DM pair was allowed to trade a narrow range, with 2.n8 set as the bottom. If the rate fell below that level, the Bank of England would have to intervene in order to prop up their currency. On Sep.13th, now known as "Black Wednesday" several big players including Soros and Goldman Sachs realized thaI the BoE would nol be able to support the pound Indefinitely, so they decided to stage a massive speculative attack on the currency. The UK Chancellor tried to stir up some demand for the pound by raising rates not once, but twice in the same day, yet by evening it became obvious that they could not continue to prop up "Her Majesty" so they decided to throw in the towel and unceremoniously withdrew from the ERM. The pound was then free to trade outside of the fixed range and eventually fell to as low as 2.20 OM. The UK govemment is said to have lost around 3 billion pounds in their effort to prop up their currency, while Soros is said to have personally taken home around $1 billion in the process ...... not winning him many friends in the UK!
Moral of the story: When everything is in your favor, go for the home-run trade
Whereas before a trader was forced to make the rounds in an effort to find a price. he can now instantly see the best tradable bid/ask with a single key stroke. With all of the liquidity providers now imputing their best price into a common platform, it should in theory be a much better way of going about things, and for the Illost part it is. However, don't feel lOO sorry for the dealer, for there will always be a place for his trade. Although electronic platforms are great for "vani lla" transactions, if you are a fu nd trying to push through a large Mexican peso trade in early Sydney time. your only hope for success is contacting a good dealer that can make it happen. No e-platform wi ll ever make a market out of thin air.
A QUESTION OF NUMBERS
Technological advances have helped drive the growth in FX turnover, and although much is said of the tremendous volumes traded on a daily basis, the oft-quoted statistics should be taken with a grain of salt. The FX market is by far the largest and most liquid market in the world, with daily FX turnover estimated al around $2 trilliol1. If this seems like a lot to you, it is because it is. Compare FX volumes to the tiny $50 billion traded at the NYSE or the $800 billion traded in government debt and you gel an idea of the size of the market. yet the first thing to take into consideration when hearing that "FX turnover has increased 50 % over the last 3 years" is that turnover is measured in US dollars. A depreciating dollar will directly translate into ballooning turnover volume. l However, even if the figures are sOl11cwhal skewed, the fact remains that billions and billions arc being traded every day. So the question becomes. "Who is trading all of these thousands of billions of dollars?"
The truth is that nobody really knows, but it may be the case that turnover numbers are greatly exaggerated due to the multiplying effect of FX transactions and the use of notional funds. For example, when multinational X approaches their bank to trade 100 million euros for dollars, a two-way transaction lakes place, so the 100 million goes on both of their books. The bank then quickly contacts one of their counterparties to offset their exposure, which may in turn offset their exposure through the derivatives market. A single transaction can therefore set in motion a whole set of subsequent transactions totaling well over the original € 100 million in cash.
Although it is hard to tell exactly where these flows are coming from, what is undeniably true is that FX volumes have been steadily increasing. Volumes are in fact rising at such a tremendous pace that only a fundamental shift in people's perception of FX can explain the current situation.
THE NEW ASSET CLASS
As little as ten years ago. most asset managers regarded FX as an annoying side transaction that simply had to be done, and most did not panicularly care for it. If a large international mutual fund wanted 10 buy European stocks. they would simply approach lheir custodian bank and tell them to take care of it. This was a case of Ihe simpler the better, since in their minds their core competencies lay in picking stocks, Ilot the direction of the dollar. This may seem like a reasonable, approach when things are going well, but III times of uncertainlY and low yields,
every penny begins to matter.
After the bursting of the stock market bubble and 11 September, times got tougher for asset managers and lhey soon began to look at FX with kinder eyes. They realized lhal their FX holdings could actually be regarded as a separate asset class, which had to be "optimized" in their constant search for alpha (excess return).
This change in perception proved to be a radical shift for the investment com mu¬nity, and continues to be a major driving force in the FX markets today. More and more funds are now actively managing their FX exposure, either in-house or by employing a currency overlay manager (COM). This renewed the foclls on FX and the search for yield has in turn led to the resurgence of the carry trade,3 which in turn often leaves strong trends in its wake. In an age of low yields and increasingly competitive (efficient) markets, this new brand of FX participant is here 10 stay.
Black Wednesday, 1992
Perhaps the most infamous FX trade was George Soros & Co's short sterling bet that managed to ~break the Bank of England." By September of 1992. Soros and other speculators had begun to take increasingly large short sterling positions on the groundS that the UK economy was suffering from high inflation and a slumping housing market. At the lime, the UK had entered the ERM (forerunner to the Euro) at 2.95 Deutsche Mar1<.s to the pound, and the GBP/DM pair was allowed to trade a narrow range, with 2.n8 set as the bottom. If the rate fell below that level, the Bank of England would have to intervene in order to prop up their currency. On Sep.13th, now known as "Black Wednesday" several big players including Soros and Goldman Sachs realized thaI the BoE would nol be able to support the pound Indefinitely, so they decided to stage a massive speculative attack on the currency. The UK Chancellor tried to stir up some demand for the pound by raising rates not once, but twice in the same day, yet by evening it became obvious that they could not continue to prop up "Her Majesty" so they decided to throw in the towel and unceremoniously withdrew from the ERM. The pound was then free to trade outside of the fixed range and eventually fell to as low as 2.20 OM. The UK govemment is said to have lost around 3 billion pounds in their effort to prop up their currency, while Soros is said to have personally taken home around $1 billion in the process ...... not winning him many friends in the UK!
Moral of the story: When everything is in your favor, go for the home-run trade
FX Dealers
To understand how dealers trade, you simply have to understand how dealers think
(i.e. make money). If the big banks arc the FX wholesalers, then dealers are the
salesmen trusted to push their inventory. Like the used cur salesman who wants
to clear his lot, FX dealers are looking to move as much in ventory as possible
("chopping wood" in dealer speak) and regularly adjust their profit margins here and there in order to accomplish this. It may be worth accommodaling a transaction for a customer at a slightly lower commission (or loss) if it means locking up business from that client in the future.
Because of the wheeling-and-dealing style of their work, dealers have historically been more associated with the streets of Brooklyn than any Ivy League school, and they are renowned for being quick on their feet and excelling at order-flow trading; they are the definition of the intra-day trader.
ALWAYS BE FADING
A dealer's motto. Market moves are rarely one-way and dealers understand that the majority of the time intra-day markets are range-bound (around 80 %), so any sharp move (gap) is likely to be faded by dealers who have the deep pockets and knowledge that the price will eventually come back to them ... at least most of the
time!
Another favorite trading rule of the spot dealer is 10 never trusl the first price. After a news release, dealers know that the first price print is the knee-jerk reaction of the market and most often wrong, so dealers routinely use news events to Rush out any weak positions by moving the market against them. This is commonly known as the "head fake," whereby the price moves sharply in one direction before reversing course, catching many traders off-guard in the process. Yes. A dealer's biggest nightmare is a runaway market. where they are forced
to either stop quoting prices (and risk losing customers) or continue taking the
other side of the trade and risk being stuck with a losing position. Prices can al times run away from a dealer so quickly that they are unable to offset their exposure, and leaves the stressed-out dealer with positions deep underwater. Many risk-hungry dealers that continued to quote prices during the USDJPY crash of 1998, for example, were wiped oul. In general, any one-way market is bad for dealers, since prices do not retrace and they are forced to eventually unload their positions at a loss. However, from a dealer's perspective, this is simply seen as the "cost of doing business." through their quotes and fills. and dealers complaining about traders "picking them off' in arbitrage opportunities. Both have valid points in this love-hate relationship (actually mostly hate). but in the end one cannot do without the other. As in any business, good market contacts and relationships are fundamental to success in the market, and a trader may put up with a dealer's shoddy quotes if he knows he can count on him to take a large CADJPY order on a Friday afternoon. for example. You can have the best ideas in the world. but if you cannot find a counterparty (Q take your trade then you are going to be stuck with just that: an idea.
Of course, having a good relationship does not mean you are not willing to take the mher party's money. Every time a trader picks up the phone to deal, he knows that the person on the other end of the line is going to try to rip him off, but smart traders also routinely play tricks on their brokers. A favorite FX trick was to leave small stops with dealers all over the city and wait for them to take the bait before entering the market with your real move in the form of massive orders that would catch dealers wrong-fooled and looking sill y. Similarly, dealers often know the position of their client directly (through the margin deposit) or indirectly (through industry contacts) and actively push the market against them. The street is littered with stories of one party pulling the wool over the eyes of the other in what seems like an endless game of cat and mouse,
Forward/Swap Dealers: The most cerebral of the bunch. More concerned with time than price, these guys have to constantly keep track of value dates and expirations. Calculations can turn complicated in a hurry when clients approach them with obscure set•ups for which they must either quote a price or risk losing a client. Spot Dealers: Fly-by-the-seat-of-your-pants crowd. Rely more on their gut than their head. Can instantly calculate averages and are above all concerned with their net exposure at any given time. Generally more street-smart than book-smart. they are very attuned to human behavior and trade according to flows. If they smell blood they pounce. Retail Spot Dealers: Usually ex-bank dealers that were MretiredMor decided to move on to a cushier gig . They occupy an awkward place between the interbank and the retail market, with most transactions being generally straight-forward. Cushy job that entails little more than tracking customer flows and offsetting risk with their market makers. Now and then they organize ambushes on their clients, something they revel in. To put it in perspective, the head dealer at one of the major retail FCMs used to show up to work wearing a cap that read -FUCK YOU."
Pretty much sums it up doesn't it? But thats the FX Market Trading Ambiance
(i.e. make money). If the big banks arc the FX wholesalers, then dealers are the
salesmen trusted to push their inventory. Like the used cur salesman who wants
to clear his lot, FX dealers are looking to move as much in ventory as possible
("chopping wood" in dealer speak) and regularly adjust their profit margins here and there in order to accomplish this. It may be worth accommodaling a transaction for a customer at a slightly lower commission (or loss) if it means locking up business from that client in the future.
Because of the wheeling-and-dealing style of their work, dealers have historically been more associated with the streets of Brooklyn than any Ivy League school, and they are renowned for being quick on their feet and excelling at order-flow trading; they are the definition of the intra-day trader.
ALWAYS BE FADING
A dealer's motto. Market moves are rarely one-way and dealers understand that the majority of the time intra-day markets are range-bound (around 80 %), so any sharp move (gap) is likely to be faded by dealers who have the deep pockets and knowledge that the price will eventually come back to them ... at least most of the
time!
Another favorite trading rule of the spot dealer is 10 never trusl the first price. After a news release, dealers know that the first price print is the knee-jerk reaction of the market and most often wrong, so dealers routinely use news events to Rush out any weak positions by moving the market against them. This is commonly known as the "head fake," whereby the price moves sharply in one direction before reversing course, catching many traders off-guard in the process. Yes. A dealer's biggest nightmare is a runaway market. where they are forced
to either stop quoting prices (and risk losing customers) or continue taking the
other side of the trade and risk being stuck with a losing position. Prices can al times run away from a dealer so quickly that they are unable to offset their exposure, and leaves the stressed-out dealer with positions deep underwater. Many risk-hungry dealers that continued to quote prices during the USDJPY crash of 1998, for example, were wiped oul. In general, any one-way market is bad for dealers, since prices do not retrace and they are forced to eventually unload their positions at a loss. However, from a dealer's perspective, this is simply seen as the "cost of doing business." through their quotes and fills. and dealers complaining about traders "picking them off' in arbitrage opportunities. Both have valid points in this love-hate relationship (actually mostly hate). but in the end one cannot do without the other. As in any business, good market contacts and relationships are fundamental to success in the market, and a trader may put up with a dealer's shoddy quotes if he knows he can count on him to take a large CADJPY order on a Friday afternoon. for example. You can have the best ideas in the world. but if you cannot find a counterparty (Q take your trade then you are going to be stuck with just that: an idea.
Of course, having a good relationship does not mean you are not willing to take the mher party's money. Every time a trader picks up the phone to deal, he knows that the person on the other end of the line is going to try to rip him off, but smart traders also routinely play tricks on their brokers. A favorite FX trick was to leave small stops with dealers all over the city and wait for them to take the bait before entering the market with your real move in the form of massive orders that would catch dealers wrong-fooled and looking sill y. Similarly, dealers often know the position of their client directly (through the margin deposit) or indirectly (through industry contacts) and actively push the market against them. The street is littered with stories of one party pulling the wool over the eyes of the other in what seems like an endless game of cat and mouse,
Forward/Swap Dealers: The most cerebral of the bunch. More concerned with time than price, these guys have to constantly keep track of value dates and expirations. Calculations can turn complicated in a hurry when clients approach them with obscure set•ups for which they must either quote a price or risk losing a client. Spot Dealers: Fly-by-the-seat-of-your-pants crowd. Rely more on their gut than their head. Can instantly calculate averages and are above all concerned with their net exposure at any given time. Generally more street-smart than book-smart. they are very attuned to human behavior and trade according to flows. If they smell blood they pounce. Retail Spot Dealers: Usually ex-bank dealers that were MretiredMor decided to move on to a cushier gig . They occupy an awkward place between the interbank and the retail market, with most transactions being generally straight-forward. Cushy job that entails little more than tracking customer flows and offsetting risk with their market makers. Now and then they organize ambushes on their clients, something they revel in. To put it in perspective, the head dealer at one of the major retail FCMs used to show up to work wearing a cap that read -FUCK YOU."
Pretty much sums it up doesn't it? But thats the FX Market Trading Ambiance
A Rare Breed
PUlling aside all arguments about erficient markets, traders are around for one thing and one thing only: to make money from their views on the market. Although theory states that investors should not be capable of beating the market in the long run, people like Paul Tudor Jones l are happy to go against conventional wisdom by consistently beating the market year aner year. Either their success is merely the resuh of a statistical fluke or great traders are simply a breed apart.
The mark of a great trader is their ability to walk the walk and talk the talk. While most people actutilly find thal all paper they make great trading decisions, when real money becomes involved they soon lose the upper hand. That is because as soon YOLI enter the market, you become emotionally artached to your position and the switch from paper profils to real dollars and cents clouds your Lhinking by inserting doubt into your reasoning. Think about the past investment decisions you regret the most. They usually involve sou nd investments that you pulled the plug on too SOOI1 (I knew I should have held on to that property in Florida!) or never entered into (I knew I should have bought the Google IPO!). Either way, the error in judgment is frequently caused by the emotional rush brought on when switching from percentages to greenbacks. This mental toughness is the reason great traders are often referred to as having ice-water running through their veins or having private parts made out of steel.
Trading is one of the few professions lhal enable you to quantify exactly how good you are. since all it takes is a quick glance at your PIL. How does a consul¬tanl/engineer/manager know they are good at what they do? Usually it is through a combination of peer respect. promotions, and recognition that they use for mea¬surement. And how do they know if Ihey had a good or bad day? Traffic? Problems with suppliers? Now imagine being able 10 look at your screen at (he end of your shift and let it tell you how your day was. For traders, the measuring stick is simple: money. The lllorC you make, the better you are at your job. If you made morc than the guy to your right that must mean that you are better at your job than he is, and if you lost money today thal means you had a bad day at work. This turns trading floors into pure meritocracies, and those that make money have the power. while those that don 't are soon out the door.
Unlike investing, where the focus is on creating wealth (e.g. dividends), traders make money by catching short-term moves for quick gains. Trading, like poker, can be described as a zero-sum game. If you are winning then someone else must be losing. This battlefield aspect to the markets is something that the novice trader disregards at his/her own peril, since humans sit behind those trading screens and you can bet that they will do everything in their power to take your money, even if that means bending the rules in their favor.
The fact that 1110S( traders are also avid gamblers should come as no surprise, and thus you may find at anyone time that bets on sporting events or the eating capacity of the latest intern overshadow
Deal ing with ullcenainty can also mean being pro-active ;:lnd forcing your oppo¬nent's hand. When asked about his playing. Ed Lasker. one of the greatest chess players of all time. noted that in order to succeed he would ask himself, "What is my opponent's present state of mind. and how can I worry him the most?" Simi¬larly, the very best traders have the innate ability 10 look at the market objectively while at the same time perceiving it from the eyes of their opponents. What move do they fear the most? What will they do if prices go down? Lasker explained that he "sometimes achieved victory by boring my opponents to death, or by luring them into allacks when allacks weren't III their nature". Successful lraders apply these same concepts on a day-to-day basis. and use this edge to actively shape their future by playing to their opponent's weaknesses.
Market panicipants (and pawn shops) know that it is much easier to rip-off someone in trouble than to make money through your own trading skills, so over the years they have evolved into efficient killing machines that would make Darwin proud. If the market catches a wisp of a hedge fund III trouble. you can be sure that the sharks will move in and actively push the market against them until they are dead in the water. This active "hunting" role is something that most model developers do not take into account, and to a large degree it can be said that their "sigma-nine,2 events are often self-perpetuated. If Amaranth had not gone balls-ollt long on natural gas, for example. the market would probably not have dropped like it did.
Foreign exchange speculators are often regarded by developing nations as "eco¬nomic war criminals" who prey on (he weak and defenseless, yel ask FX traders and they will tell you that they are simply the instruments of global macroeco¬nomjc forces. As George Soros famously proclaimed, "As a market participant, I don'l need to be concerned with the consequences of my IflnancialJ actions:' In other words, he did not create the imbalance, so why should he be blamed when he corrects it?
Forex traders are a unique brand of speculator with an almost monastic devotion to their profession, working obscene hours and concerning themselves with global macro events. What effect will the Tokyo eanhquake have on the Swiss franc? How will the US dollar react to inflationary signs coming oul of Germany? Try explaining how you make a living to a stranger (or your spouse) and they will look at you as if you are crazy. The ability to select. process. and take advantage of seemingly unrelated and unending data points in the blink of an eye is what sets currency traders apan. Through the eyes of a forex trader every asset trade is essentially a bet on exchange rates. and those that learn 10 connect the dots faster than anyone else end up on top.
The world's economies are now one giant interconnected machine, and the grease that keeps the gears running smoothly is foreign exchange. Legendary FX traders have made their careers by figuring out. before anyone else. what repercussions event X will have on country Y's currency. This clairvoyance often instills a level of self-confidence that would humble professional athletes. and when combined with the tremendous amounts of leverage available 10 traders it often leads to some truly mind-boggling bets.
In 1988. for example, when Bankers Trust hotshot Andrew Krieger was asked about his short Kiwi position he famously replied, "How large is the monetary supply of New Zealand?" Believe it or not. through the use of derivatives Krieger managed at one point to actually short more than New Zealand's entire monetary supply! Although this gutsy bel ended up netting him a cool $300 million. when self-confidence turns into arrogance the effects can be devastating.
Yasul Hamanaka. The Sumitomo Corp. traders positions were so huge. that he eamed the nickname "Mr. 5%~ for allegedly controlling five percent of the world's copper market. Unfortunately for Sumitomo, his 10 year career was mostly filled with bogus contracts and fictitious entries meant to hide his mounting losses. By the lime he was discovered, he had racked up $2.6 billion in losses which he paid for by doing eight years in jail.
Nick Leeson. Star trader for Barings Bank. his derivative losses hidden in his secret 88888 account ended up costing the "Queen's Bank~ $1.2 billion and managed to bring down one of the world's most venerable banking institutions overnight.
John Rusnak. Allied Irish Bank's chief rogue trader. His out-of-control fx trades ended up costing the bank a cool $691 million.
Peter Young. Morgan Grenfell's star trader is not best remembered for his unauthorized trades (a mere $350m). but the fact that he showed up to court wearing women's clothes in an attempt to plead insanity. Seems like Young got the last laugh since the court declared him unfit.
The mark of a great trader is their ability to walk the walk and talk the talk. While most people actutilly find thal all paper they make great trading decisions, when real money becomes involved they soon lose the upper hand. That is because as soon YOLI enter the market, you become emotionally artached to your position and the switch from paper profils to real dollars and cents clouds your Lhinking by inserting doubt into your reasoning. Think about the past investment decisions you regret the most. They usually involve sou nd investments that you pulled the plug on too SOOI1 (I knew I should have held on to that property in Florida!) or never entered into (I knew I should have bought the Google IPO!). Either way, the error in judgment is frequently caused by the emotional rush brought on when switching from percentages to greenbacks. This mental toughness is the reason great traders are often referred to as having ice-water running through their veins or having private parts made out of steel.
Trading is one of the few professions lhal enable you to quantify exactly how good you are. since all it takes is a quick glance at your PIL. How does a consul¬tanl/engineer/manager know they are good at what they do? Usually it is through a combination of peer respect. promotions, and recognition that they use for mea¬surement. And how do they know if Ihey had a good or bad day? Traffic? Problems with suppliers? Now imagine being able 10 look at your screen at (he end of your shift and let it tell you how your day was. For traders, the measuring stick is simple: money. The lllorC you make, the better you are at your job. If you made morc than the guy to your right that must mean that you are better at your job than he is, and if you lost money today thal means you had a bad day at work. This turns trading floors into pure meritocracies, and those that make money have the power. while those that don 't are soon out the door.
Unlike investing, where the focus is on creating wealth (e.g. dividends), traders make money by catching short-term moves for quick gains. Trading, like poker, can be described as a zero-sum game. If you are winning then someone else must be losing. This battlefield aspect to the markets is something that the novice trader disregards at his/her own peril, since humans sit behind those trading screens and you can bet that they will do everything in their power to take your money, even if that means bending the rules in their favor.
The fact that 1110S( traders are also avid gamblers should come as no surprise, and thus you may find at anyone time that bets on sporting events or the eating capacity of the latest intern overshadow
Deal ing with ullcenainty can also mean being pro-active ;:lnd forcing your oppo¬nent's hand. When asked about his playing. Ed Lasker. one of the greatest chess players of all time. noted that in order to succeed he would ask himself, "What is my opponent's present state of mind. and how can I worry him the most?" Simi¬larly, the very best traders have the innate ability 10 look at the market objectively while at the same time perceiving it from the eyes of their opponents. What move do they fear the most? What will they do if prices go down? Lasker explained that he "sometimes achieved victory by boring my opponents to death, or by luring them into allacks when allacks weren't III their nature". Successful lraders apply these same concepts on a day-to-day basis. and use this edge to actively shape their future by playing to their opponent's weaknesses.
Market panicipants (and pawn shops) know that it is much easier to rip-off someone in trouble than to make money through your own trading skills, so over the years they have evolved into efficient killing machines that would make Darwin proud. If the market catches a wisp of a hedge fund III trouble. you can be sure that the sharks will move in and actively push the market against them until they are dead in the water. This active "hunting" role is something that most model developers do not take into account, and to a large degree it can be said that their "sigma-nine,2 events are often self-perpetuated. If Amaranth had not gone balls-ollt long on natural gas, for example. the market would probably not have dropped like it did.
Foreign exchange speculators are often regarded by developing nations as "eco¬nomic war criminals" who prey on (he weak and defenseless, yel ask FX traders and they will tell you that they are simply the instruments of global macroeco¬nomjc forces. As George Soros famously proclaimed, "As a market participant, I don'l need to be concerned with the consequences of my IflnancialJ actions:' In other words, he did not create the imbalance, so why should he be blamed when he corrects it?
Forex traders are a unique brand of speculator with an almost monastic devotion to their profession, working obscene hours and concerning themselves with global macro events. What effect will the Tokyo eanhquake have on the Swiss franc? How will the US dollar react to inflationary signs coming oul of Germany? Try explaining how you make a living to a stranger (or your spouse) and they will look at you as if you are crazy. The ability to select. process. and take advantage of seemingly unrelated and unending data points in the blink of an eye is what sets currency traders apan. Through the eyes of a forex trader every asset trade is essentially a bet on exchange rates. and those that learn 10 connect the dots faster than anyone else end up on top.
The world's economies are now one giant interconnected machine, and the grease that keeps the gears running smoothly is foreign exchange. Legendary FX traders have made their careers by figuring out. before anyone else. what repercussions event X will have on country Y's currency. This clairvoyance often instills a level of self-confidence that would humble professional athletes. and when combined with the tremendous amounts of leverage available 10 traders it often leads to some truly mind-boggling bets.
In 1988. for example, when Bankers Trust hotshot Andrew Krieger was asked about his short Kiwi position he famously replied, "How large is the monetary supply of New Zealand?" Believe it or not. through the use of derivatives Krieger managed at one point to actually short more than New Zealand's entire monetary supply! Although this gutsy bel ended up netting him a cool $300 million. when self-confidence turns into arrogance the effects can be devastating.
Yasul Hamanaka. The Sumitomo Corp. traders positions were so huge. that he eamed the nickname "Mr. 5%~ for allegedly controlling five percent of the world's copper market. Unfortunately for Sumitomo, his 10 year career was mostly filled with bogus contracts and fictitious entries meant to hide his mounting losses. By the lime he was discovered, he had racked up $2.6 billion in losses which he paid for by doing eight years in jail.
Nick Leeson. Star trader for Barings Bank. his derivative losses hidden in his secret 88888 account ended up costing the "Queen's Bank~ $1.2 billion and managed to bring down one of the world's most venerable banking institutions overnight.
John Rusnak. Allied Irish Bank's chief rogue trader. His out-of-control fx trades ended up costing the bank a cool $691 million.
Peter Young. Morgan Grenfell's star trader is not best remembered for his unauthorized trades (a mere $350m). but the fact that he showed up to court wearing women's clothes in an attempt to plead insanity. Seems like Young got the last laugh since the court declared him unfit.
The Currency Market
Foreign exchange trading has essentially been around since lile advent of money, and although the mechanics have advanced somewhat since the time of the money-changers in the temple. it still boi ls down to the exchange of one currency for another.
Of all financial markets. the FX market can probably be considered to be among the most ';purc" in the sense that supply and demand (in the free-Hoating currencies) is strictly what determines prices, For the most pan, the market is unregulated and free of distorting red lape. and the sheer size of the trading volume means that government intervention has little long-term effect on prices. After all, in a market that trades over $2 trillion a day government intervention can only go so far, and at the end of the day it is the two hundred thousand traders around the world that act as Adam Sm ith's invisible hand in guiding prices.
Since a market this free and liquid is typically hard LO out-guess. you would be right to think: "is it even worth trading such an efficient market?" The good news for traders is that the FX market is not as efficient as it may first appear, and the root of this inefficiency can be {raced back to the panicipam's motivation. The FX market has never been a value creator. but rather a vehicle for other transactions. A US portfolio manager buying Japanese stocks or an Italian company acquiring raw materials from Brazil both inadvertently become FX participants. yet the currency part of their transactions are not usually motivated by profit. The portfolio manager simply needs the yen to buy the stocks and the company needs dollars to buy the coffee.
This type of behavior breeds inefficiencies eagerly exploited by more active market panicipants, and fonunately for FX traders small arbitrage oppOI1unities still abound. Although the market may be very efficient at giving you a price, whether that price is an accurate reflection of the currency's true "value" is another story altogether, which is why good analysis and trading techniques do payoff in the long run.
Research and analysis in FX proves valuable because the currency market is different than Wall Street. The interbank market is by no means a perfect market since information is not freely available, market access is restricted, manipulation takes place. governments intervene. and a large number of participants routinely buy and sell irrespective of profit, which all comes together to turn conventional trading wisdom (such as "let your winners fUll. cut losers short") on its head in this mostly range-bound market. The FX market is different than other markets. and if you can find a way to recognize, predict, and exploit these imperfections. then there is a great deal of money lO be made. Profitable trading strategies do exist and can be found. Off-balance sheet earnings are the declared aim of most banks, and spot dealing in FX, which presents high loss potential (as far as price is concerned) but practically no credit risk, falls directly into this category. To understand a bank's motivation for getting involved in this market, all you have to know is that by combining a large FX dealing desk with a decent prop trading group, pretty soon you will be talking about billions in profits. These types of numbers have long made FX the playground of only the biggest and baddesl global banks, and because at its core the FX market continues to be a credit market. their dom inance is unlikely to be challenged any lime soon.
Unlike other markets, an FX transaction is not the exchange of cash for another asset (stocks or oil, for example), but rather the exchange of cash today in return for the acceptance of cash at n later date. The interbank market operates on this somewhat unusual principle. where one party depends on the OIher to meet their obligation without extending credit to each other. As you may wel l imagine. when dealing in this way it is crucial to know that your counterparty is of the highest credit standing, lest you be len holding the bag on one side of the transaction. For this reason, big banks prefer to deal with big banks, and smaller fish are essentially shut out of the FX pond. As a result. a small group of commercial and central banks (you can call it a cartel if you wish) has always handled the majority of FX turnover with each other, and for each other.
Technology has managed to open up this tight-knit group somewhat. although not to the extent that you may think. Most banks now either operate their own electronic dealing platforms or provide liquidity to a matching system/prime bro¬kerage platform. Products from EBS, Currellex, FXAIl, elC., enable banks to reach a larger client base whi le still maintaining full control over their risk, yet in the end, who do you think owns 1110st of these platforms anyway? The reality is that the same small group of banks still controls the FX market.
From the very beginning. the FX market was designed to ensure that market "insid¬ers" had a considerable edge over market "outsiders", Because of the tight-knit nature of the market and its lack of regulation, the FX market is a fundamentally unfair market for the nonprofessional to operate in. For example, in some emerging countries a Citibank or UBS may be the only game in town, so anyone wanting to trade that currency is forced to "pay up" to play in their turf. A player's positioning on the FX food chain depends on his/her access to information and speed, and with no central clearing exchange, it can be difficult for nonprofessionals to gain access to this information and come up with an accurate view of the market. More often than not this leaves those with limited access to information at the mercy of their bank dealer.
This is where the FX world differs from traditional financial markets, and things deemed illegal in most other markets are simply regarded as "part of the game" in FX. Insider trading. front running, price shading. etc .. are all regularly seen in FX trading, and have absolutely no legal repercllssions,
No governmem oversight and no central deal book to compare trades means that banks are pretty much free to do whatever they want to their unsuspecting customers. Unlike exchange-traded markets (NYSE) where a market maker has a responsibility to quote the Same price to two different parties, an FX dealer may quote his clients whatever price he wishes. Spreads mysteriously widen and shrink, and the "who's who" factor dominates. Good customers receive decent prices (a salesman will sha Ul to the dealer "good price, mate!"), but for irregular or com¬plicated clients it becomes practically impossible to receive fair market prices. God forbid that the dealer "read" you correctly and guessed your intentions. An FX trader who did not want to get ripped off before had to place 5 to 10.
calls to different banks and take their average as the "fair" market price. These inefficiencies, of course, all play into the hands (and pockets) of the brokers.
Dealers are free to behave in this way because they are very often the only game in lown, and they know that there is not much customers can do about il. In the same way that you and I knowingly get ripped off by the exchange booth guys at the airport, traders know they arc gcning short-changed but often have line. If Goldman is the only one willing to take your trade at that moment, you can either take it or leave, it is as simple as that.
Of all financial markets. the FX market can probably be considered to be among the most ';purc" in the sense that supply and demand (in the free-Hoating currencies) is strictly what determines prices, For the most pan, the market is unregulated and free of distorting red lape. and the sheer size of the trading volume means that government intervention has little long-term effect on prices. After all, in a market that trades over $2 trillion a day government intervention can only go so far, and at the end of the day it is the two hundred thousand traders around the world that act as Adam Sm ith's invisible hand in guiding prices.
Since a market this free and liquid is typically hard LO out-guess. you would be right to think: "is it even worth trading such an efficient market?" The good news for traders is that the FX market is not as efficient as it may first appear, and the root of this inefficiency can be {raced back to the panicipam's motivation. The FX market has never been a value creator. but rather a vehicle for other transactions. A US portfolio manager buying Japanese stocks or an Italian company acquiring raw materials from Brazil both inadvertently become FX participants. yet the currency part of their transactions are not usually motivated by profit. The portfolio manager simply needs the yen to buy the stocks and the company needs dollars to buy the coffee.
This type of behavior breeds inefficiencies eagerly exploited by more active market panicipants, and fonunately for FX traders small arbitrage oppOI1unities still abound. Although the market may be very efficient at giving you a price, whether that price is an accurate reflection of the currency's true "value" is another story altogether, which is why good analysis and trading techniques do payoff in the long run.
Research and analysis in FX proves valuable because the currency market is different than Wall Street. The interbank market is by no means a perfect market since information is not freely available, market access is restricted, manipulation takes place. governments intervene. and a large number of participants routinely buy and sell irrespective of profit, which all comes together to turn conventional trading wisdom (such as "let your winners fUll. cut losers short") on its head in this mostly range-bound market. The FX market is different than other markets. and if you can find a way to recognize, predict, and exploit these imperfections. then there is a great deal of money lO be made. Profitable trading strategies do exist and can be found. Off-balance sheet earnings are the declared aim of most banks, and spot dealing in FX, which presents high loss potential (as far as price is concerned) but practically no credit risk, falls directly into this category. To understand a bank's motivation for getting involved in this market, all you have to know is that by combining a large FX dealing desk with a decent prop trading group, pretty soon you will be talking about billions in profits. These types of numbers have long made FX the playground of only the biggest and baddesl global banks, and because at its core the FX market continues to be a credit market. their dom inance is unlikely to be challenged any lime soon.
Unlike other markets, an FX transaction is not the exchange of cash for another asset (stocks or oil, for example), but rather the exchange of cash today in return for the acceptance of cash at n later date. The interbank market operates on this somewhat unusual principle. where one party depends on the OIher to meet their obligation without extending credit to each other. As you may wel l imagine. when dealing in this way it is crucial to know that your counterparty is of the highest credit standing, lest you be len holding the bag on one side of the transaction. For this reason, big banks prefer to deal with big banks, and smaller fish are essentially shut out of the FX pond. As a result. a small group of commercial and central banks (you can call it a cartel if you wish) has always handled the majority of FX turnover with each other, and for each other.
Technology has managed to open up this tight-knit group somewhat. although not to the extent that you may think. Most banks now either operate their own electronic dealing platforms or provide liquidity to a matching system/prime bro¬kerage platform. Products from EBS, Currellex, FXAIl, elC., enable banks to reach a larger client base whi le still maintaining full control over their risk, yet in the end, who do you think owns 1110st of these platforms anyway? The reality is that the same small group of banks still controls the FX market.
From the very beginning. the FX market was designed to ensure that market "insid¬ers" had a considerable edge over market "outsiders", Because of the tight-knit nature of the market and its lack of regulation, the FX market is a fundamentally unfair market for the nonprofessional to operate in. For example, in some emerging countries a Citibank or UBS may be the only game in town, so anyone wanting to trade that currency is forced to "pay up" to play in their turf. A player's positioning on the FX food chain depends on his/her access to information and speed, and with no central clearing exchange, it can be difficult for nonprofessionals to gain access to this information and come up with an accurate view of the market. More often than not this leaves those with limited access to information at the mercy of their bank dealer.
This is where the FX world differs from traditional financial markets, and things deemed illegal in most other markets are simply regarded as "part of the game" in FX. Insider trading. front running, price shading. etc .. are all regularly seen in FX trading, and have absolutely no legal repercllssions,
No governmem oversight and no central deal book to compare trades means that banks are pretty much free to do whatever they want to their unsuspecting customers. Unlike exchange-traded markets (NYSE) where a market maker has a responsibility to quote the Same price to two different parties, an FX dealer may quote his clients whatever price he wishes. Spreads mysteriously widen and shrink, and the "who's who" factor dominates. Good customers receive decent prices (a salesman will sha Ul to the dealer "good price, mate!"), but for irregular or com¬plicated clients it becomes practically impossible to receive fair market prices. God forbid that the dealer "read" you correctly and guessed your intentions. An FX trader who did not want to get ripped off before had to place 5 to 10.
calls to different banks and take their average as the "fair" market price. These inefficiencies, of course, all play into the hands (and pockets) of the brokers.
Dealers are free to behave in this way because they are very often the only game in lown, and they know that there is not much customers can do about il. In the same way that you and I knowingly get ripped off by the exchange booth guys at the airport, traders know they arc gcning short-changed but often have line. If Goldman is the only one willing to take your trade at that moment, you can either take it or leave, it is as simple as that.
Tuesday, August 25, 2009
On Markets
If one believes in a random universe, a strong case can be made for the facl that any sort of technical analysis and trading taclics arc in fact quite useless. Under this scenario. random and unpredictable price movements makes research. analysis, and market timing an exercise in futility. and relegates any kind of strategy (other than
buy-and-hold) to a game of chance, 110t skill. As Burton Malkiel famously noted, "A blindfolded monkey throwing darts at the financial pages of a newspaper can select a portfolio that will do just as well as one carefully selected by the experts". This market view is supported by the fact that the vast majority of mutual funds fail to beat the broader market year after year. and history shows us that the len best-performing funds in anyone year will drop to the bolt om of the pack in the following two to four years, meaning that a manager's outperformance is largely the product of luck, like a gambier's short-term winning streak. Simply put. there is no way to consistently beat the market.
Needless to say, this view of things does not sit well with Wall Street, which preaches that research. analysis. and relying 011 expertise are the keys to investing (and their business model !). Assuming that we can draw a similar parallel to other markets, then why bother trading? Why spend so much time researching (he market and analyzing prices when we could just as simply close our eyes and buy or sell ?
Thankfully for traders, although the random walk theory paints a strong case against IllUlual funds. it is not el1lirely bullet-proof. Investors consistently fall prey to fear, envy, overconfidence, faddism, and Olher recognizably human imperfections that make markets not only inefficient but predictably inefficient. In the short run, recognizable patterns are indeed visible in the stock market. Bubbles are created, and then burst. If the DOW goes up one week, it is more likely to go up the next week. In the long run all of these moves smooth themselves out, but in the short run, predicting and trading these constant adjustments can actually make ror quite a profitable proposition. Through research and analysis we can visually identify these inefficiencies and market anomalies in charts, and then trade their Stock market bubbles lend to be of similar length. duratiun. and size. The chart pauems are similar since the impetus behind them I!) the !'>lllllC (low borrowing COM!), greed. and overconfidence). 'This time it's different ... :'
expected outcomes. The point in trading is therefore not to forecast the future events themselves. but rather to predict and profit from their !;onsequences instead.
The day the financial community realized exactly how imperfect a science it praclices was 19 OClober 1987, On this "Black Monday" US sLOck markels man¬aged to drop an incredible 22.6 % for no apparent reason. which proved especially shocking to the brilliant mathematical minds that had spent their academic careers solving most of the puzzles surrounding proper pricing and valuation. By the late 1980s it seemed that markets had finally been "figured out" and trading was no longer the realm of risk-hungry cowboys as technology quickly came to replace the gut in pricing (and trading) decisions. Yet in light of all this, the world's biggest and most sophisticated market still managed to shed nearly one-quarter of its value in olle day and on no news, putting into question even the most basic financial assumptions. By noon of that day, IBM 's stock stopped trading in the face of only sell orders; literally no one wanted to buy. If a stock is only worth as much as someone is willing to pay for it, did this mean that IBM 's stock was, at least for the time being. worthless? What exactly was going on? How could we call the market rational and efficient. let alone figured out?
The fact that this evelll now seems as distant as the stock marker crash of 1929 is evidence of just how much we have moved forward. yet many of the underlying reasons behind the crash are still around today and the trading lessons behind thcse underline the major differences from what we may call the "academic" view of markets and the trader's view.
A LITTLE MARKET THEORY
As we know, professors love formulae, and perfect formulae make for perfect markets. The problem with this kind of oversimplified interpretation of the market is that it tends 10 marginalize an individual's contribution. while traders realize that sometimes individual actions are actually the driving force behind markets. Why did people sell on Black Monday? h was because everyone else was selling; it is as simple as that.
The problem for the academic world is that whi le real risks (interest rates. stock prices, ctc.) arc easy enough to understand, perceived risks are much harder to quantify and are therefore generally ignored. After all, how on earth can we measure Joe Investor's sensitivity to risk when on the one hand he spends days researching and analyzing which car to buy and on the other hand he buys Pets.com stock on a friend's tip?
Over the years traders have learned to get a grasp on this tricky subject, and some interesting things about the perception of risk have emerged. We know that risk tolerance decreases once the market is fully invested, which is why asset bubbles build up slowly and dellatc violently. We also know that our brain is hard-wired to shy away from pain and regret, thus making us sell our winning stocks while holding on to losers hoping that they will turn around. How many dead internet stocks do you still have in your portfolio?
What we now know is that markets are efficient, but they are not perfectly efficient. The point where buyers and sellers meet does not always reflect "equi¬librium", and the sheer number of arbitrage-hungry hedge funds out there can be taken as an indication of the market's imperfection. Since prices are man-made creations thaI reflect our biases as much as they do economic reality, markets may stay in a slale of disequilibrium for a long time when the very reason for buying (prices going up) in turn leads other people to buy.
Those used to doing the day-to-day dirty work in the markets, the traders, deal¬ers, and "locals" in the pit, have all come 10 realize thaI at least in the short run, markets are orten manipulated and highly ilTalional. Psychology mailers. fear mat¬ters, Momentum often trumps economic facl, and we can be fairly certain that a$ long as there is human involvement in the financial markets they will continue
to exhibit the same erratic behavior patterns as human beings. Logic often takes
a back seat to greed and fear since at the end of the day it is the trader/money manager that has his job and bonus to look after. •'A perfect market thinks only of the future, nol the past." The market may not have a memory_ bUl traders certainly do. The eerie similarity between the crash of 1929 and 1987 can probably be attributed to traders in 1987 using the past as a wny of predicting the future. unwittingly creating a self-fulfilling prophecy with their actions. (Source: Lope Markets)
Traders that overlook these behavioral aspects end up in trouble when confronted with tumultuous and emotional markets. even if for a brief period of time: hence there is the famous saying. "The market can stay irrational longer than you can Slay solvent". This saying is more true that you can imagine, and the Wall Street graveyard is littered with traders that made money trading rational markets 99 % of the time, yet got wiped out by that irrational I %.
Legendary hedgc fund manager Julian Robertson found out just how dangerous it can be to fade I irrational markets when he rationally shorted thc tech bubble of the 19905 and turned his stellar $22 billion dollar fund into a mere $6 billion basically overnight. His farewell letter to investors pretty much says it all:
The key to Tiger's success over the years has becn a steady commitment to buying the best stocks and shorting the worst. In a rational environment, this stratcgy functions well. But in an irrational market, where earnings and price considerations take a back seat to mouse clicks and momentum, such logic, as we have learned, does not count for much. From a trader's perspective. this means that the market is always right. If irra¬tional investors make a bundle on the way up, while rational investors lose their shirts shorting the move, then who is rational and who is not? Markets are not rational or irrational. they just are, and the only view that traders will ever hold sacred is their need for volatility, because it holds the key to their profits. As long as people are buying and selling, short-term speculators are indifferent as (Q the rationale behind the moves because they know there is money to be made on both sides of any trade. All that traders care about is maximizing their profits by posi¬tioning themselves in advance of the next move, while academics oflen miss the forest for the trees by being so far removed from the trading floors of the world.
buy-and-hold) to a game of chance, 110t skill. As Burton Malkiel famously noted, "A blindfolded monkey throwing darts at the financial pages of a newspaper can select a portfolio that will do just as well as one carefully selected by the experts". This market view is supported by the fact that the vast majority of mutual funds fail to beat the broader market year after year. and history shows us that the len best-performing funds in anyone year will drop to the bolt om of the pack in the following two to four years, meaning that a manager's outperformance is largely the product of luck, like a gambier's short-term winning streak. Simply put. there is no way to consistently beat the market.
Needless to say, this view of things does not sit well with Wall Street, which preaches that research. analysis. and relying 011 expertise are the keys to investing (and their business model !). Assuming that we can draw a similar parallel to other markets, then why bother trading? Why spend so much time researching (he market and analyzing prices when we could just as simply close our eyes and buy or sell ?
Thankfully for traders, although the random walk theory paints a strong case against IllUlual funds. it is not el1lirely bullet-proof. Investors consistently fall prey to fear, envy, overconfidence, faddism, and Olher recognizably human imperfections that make markets not only inefficient but predictably inefficient. In the short run, recognizable patterns are indeed visible in the stock market. Bubbles are created, and then burst. If the DOW goes up one week, it is more likely to go up the next week. In the long run all of these moves smooth themselves out, but in the short run, predicting and trading these constant adjustments can actually make ror quite a profitable proposition. Through research and analysis we can visually identify these inefficiencies and market anomalies in charts, and then trade their Stock market bubbles lend to be of similar length. duratiun. and size. The chart pauems are similar since the impetus behind them I!) the !'>lllllC (low borrowing COM!), greed. and overconfidence). 'This time it's different ... :'
expected outcomes. The point in trading is therefore not to forecast the future events themselves. but rather to predict and profit from their !;onsequences instead.
The day the financial community realized exactly how imperfect a science it praclices was 19 OClober 1987, On this "Black Monday" US sLOck markels man¬aged to drop an incredible 22.6 % for no apparent reason. which proved especially shocking to the brilliant mathematical minds that had spent their academic careers solving most of the puzzles surrounding proper pricing and valuation. By the late 1980s it seemed that markets had finally been "figured out" and trading was no longer the realm of risk-hungry cowboys as technology quickly came to replace the gut in pricing (and trading) decisions. Yet in light of all this, the world's biggest and most sophisticated market still managed to shed nearly one-quarter of its value in olle day and on no news, putting into question even the most basic financial assumptions. By noon of that day, IBM 's stock stopped trading in the face of only sell orders; literally no one wanted to buy. If a stock is only worth as much as someone is willing to pay for it, did this mean that IBM 's stock was, at least for the time being. worthless? What exactly was going on? How could we call the market rational and efficient. let alone figured out?
The fact that this evelll now seems as distant as the stock marker crash of 1929 is evidence of just how much we have moved forward. yet many of the underlying reasons behind the crash are still around today and the trading lessons behind thcse underline the major differences from what we may call the "academic" view of markets and the trader's view.
A LITTLE MARKET THEORY
As we know, professors love formulae, and perfect formulae make for perfect markets. The problem with this kind of oversimplified interpretation of the market is that it tends 10 marginalize an individual's contribution. while traders realize that sometimes individual actions are actually the driving force behind markets. Why did people sell on Black Monday? h was because everyone else was selling; it is as simple as that.
The problem for the academic world is that whi le real risks (interest rates. stock prices, ctc.) arc easy enough to understand, perceived risks are much harder to quantify and are therefore generally ignored. After all, how on earth can we measure Joe Investor's sensitivity to risk when on the one hand he spends days researching and analyzing which car to buy and on the other hand he buys Pets.com stock on a friend's tip?
Over the years traders have learned to get a grasp on this tricky subject, and some interesting things about the perception of risk have emerged. We know that risk tolerance decreases once the market is fully invested, which is why asset bubbles build up slowly and dellatc violently. We also know that our brain is hard-wired to shy away from pain and regret, thus making us sell our winning stocks while holding on to losers hoping that they will turn around. How many dead internet stocks do you still have in your portfolio?
What we now know is that markets are efficient, but they are not perfectly efficient. The point where buyers and sellers meet does not always reflect "equi¬librium", and the sheer number of arbitrage-hungry hedge funds out there can be taken as an indication of the market's imperfection. Since prices are man-made creations thaI reflect our biases as much as they do economic reality, markets may stay in a slale of disequilibrium for a long time when the very reason for buying (prices going up) in turn leads other people to buy.
Those used to doing the day-to-day dirty work in the markets, the traders, deal¬ers, and "locals" in the pit, have all come 10 realize thaI at least in the short run, markets are orten manipulated and highly ilTalional. Psychology mailers. fear mat¬ters, Momentum often trumps economic facl, and we can be fairly certain that a$ long as there is human involvement in the financial markets they will continue
to exhibit the same erratic behavior patterns as human beings. Logic often takes
a back seat to greed and fear since at the end of the day it is the trader/money manager that has his job and bonus to look after. •'A perfect market thinks only of the future, nol the past." The market may not have a memory_ bUl traders certainly do. The eerie similarity between the crash of 1929 and 1987 can probably be attributed to traders in 1987 using the past as a wny of predicting the future. unwittingly creating a self-fulfilling prophecy with their actions. (Source: Lope Markets)
Traders that overlook these behavioral aspects end up in trouble when confronted with tumultuous and emotional markets. even if for a brief period of time: hence there is the famous saying. "The market can stay irrational longer than you can Slay solvent". This saying is more true that you can imagine, and the Wall Street graveyard is littered with traders that made money trading rational markets 99 % of the time, yet got wiped out by that irrational I %.
Legendary hedgc fund manager Julian Robertson found out just how dangerous it can be to fade I irrational markets when he rationally shorted thc tech bubble of the 19905 and turned his stellar $22 billion dollar fund into a mere $6 billion basically overnight. His farewell letter to investors pretty much says it all:
The key to Tiger's success over the years has becn a steady commitment to buying the best stocks and shorting the worst. In a rational environment, this stratcgy functions well. But in an irrational market, where earnings and price considerations take a back seat to mouse clicks and momentum, such logic, as we have learned, does not count for much. From a trader's perspective. this means that the market is always right. If irra¬tional investors make a bundle on the way up, while rational investors lose their shirts shorting the move, then who is rational and who is not? Markets are not rational or irrational. they just are, and the only view that traders will ever hold sacred is their need for volatility, because it holds the key to their profits. As long as people are buying and selling, short-term speculators are indifferent as (Q the rationale behind the moves because they know there is money to be made on both sides of any trade. All that traders care about is maximizing their profits by posi¬tioning themselves in advance of the next move, while academics oflen miss the forest for the trees by being so far removed from the trading floors of the world.
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