Ben and his posse.
Monthly Archives: January 2008
Economist Willem Buiter has a dream about the wording of the Fed statement:
Oops! We goofed last week. Clearly, being alone in the office on an official holiday is not conducive to producing the right mind set for rational decision making. Also, that man Noyer at the Banque de France failed to inform us on Monday that SocSec was unloading the massive long equity position built up by that other perfidious Frenchman, Kerviel.
We now have had time to sleep on it. It is obvious that we overreacted. The economy is slowing down but not collapsing. The 75 basis points cut does more damage through the up-side risk to inflation it creates than it does good by reducing the risk of a prolonged, deep recession. “Risk management” therefore requires that we minimize the risk of getting stuck with persistently higher underlying inflation. Consequently we have decided to raise the target for the Federal Funds rate by 50 basis points with immediate effect. We have also decided to raise the primary discount rate by 100 basis points, to restore the normal 100 basis points penalty associated with discount window borrowing, although we will apply a wider definition of eligible collateral.
We all make mistakes. Better to recognise them and correct them immediately, than to sit tight and hope a low-probability scenario with low inflationary pressure and a collapsing real economy materialises that will appear to justify ex-post a decision that clearly made no sense ex-ante.
During future official holidays, the Fed will be closed, except for security personnel and guard dogs.
Because we are shaped by our environment, it is important to remember that the longer we spend in the company of the market, so our perception of the market (eg: as an ecosystem, a battlefield, an unequal competition between players, a fight, etc) becomes important in defining us around the edges.
Sarah Miller: You know you never told us your name.
John Rambo: John.
Sarah Miller: Lived here a long time?
John Rambo: Long Time.
He who would fight monsters must take care not to become one. – Nieztsche
Wyatt Earp: …I’m going to Tombstone.
Crawley Dake: Ah, I see. To strike it rich. Well, all right, that’s fine. Tell you one thing, though… I never saw a rich man who didn’t wind up with a guilty conscience.
Wyatt Earp: Already got a guilty conscience. Might as well have the money, too.
Doc Holliday: What do you want Wyatt?
Wyatt Earp: Just to live a normal life.
Doc Holliday: There is no normal life, Wyatt, there’s just life, ya live it.
Wyatt Earp: I don’t know how.
Doc Holliday: Sure ya do, say goodbye to me, go grab that spirited actress and make her your own. Take that spirit from her and don’t look back. Live every second, live right on through to the end. Live Wyatt, live for me. Wyatt, if you were ever my friend… if ya ever had even the slightest of feelin’ for me, leave now, leave now… please.
Wyatt Earp: What makes a man like Ringo, Doc? What makes him do the things he does?
Doc Holliday: A man like Ringo has got a great big hole, right in the middle of him. He can never kill enough, or steal enough, or inflict enough pain to ever fill it.
Wyatt Earp: What does he want?
Doc Holliday: Revenge.
Wyatt Earp: For what?
Doc Holliday: Bein’ born.
Wyatt Earp: You gonna do somethin’? Or are you just gonna stand there and bleed?
I wonder how Jerome Kerviel was feeling when he was checking his positions. Can’t have been good.
When he hear the term ‘survival of the fittest’ bandied about, people are usually referring to contests of absolute strength and think of the Darwinian struggle for life. Trading is often thought of in a similar light.
It’s interesting to note that while Darwin came up the idea of natural selection, the term ‘survival of the fittest’ was coined by economist philosopher Herbert Spencer. What is more, both Darwin and Spencer were not referring to competitions of brute strength, but of best fit. That is, the survivors were those who best fit in to the environment around them. Brute strength is an aspect of this, but it is only half the story. Adaptation to the environment is also required.
Chance and randomness plays a big role in natural selection, as it does with trading success, but we can be sure that regardless of how strong we are with respect to risk management, discipline etc, if we don’t have an edge then we will likely die out. Likewise, an edge and no strength could prove equally fatal. Because the environment of the active investor is dynamic and forever changing, it may be useful to think of the circles below as constantly moving around about other, only rarely intersecting.
Financial markets are forward looking, giving guidance on the future state of the economy. However, if the Fed lowers interest rates purely because the markets are tanking, we are left to wonder whether the Fed is targeting the true economic problem or whether they are just recalibrating the economic barometer (equity market), and what purpose this will serve. There are endless issues of real effects, feedback loops, confidence etc that make the situation far more complex than this, but I do wonder about the extent to which recent Fed action is a simple deceptive signal, blurring the underlying equity market signal.
It brings to mind another thought about dieting and deception:
It is widely accepted that a slim, toned body is attractive to the opposite sex because it signals that individual are living a healthy lifestyle. The problem is that there is a kind of deception at work. Many people lose weight by not exercising but simply by eating less, and sometimes what little they are eating is not healthy. However, these people still manage to achieve their goal of generating the same signal as people who eat healthy food, exercise etc. They are not necessarily living a healthy lifestyle but have instead focussed on the end goal, the change in body shape.
The trader behind ‘High Probability Trading‘ loses $31 thousand (around 80% of equity) over the long weekend. Warning: this video contains pretty much nothing but the f-word:
In his blog entry, the High Probability Trader says:
Good Bye………I hope you all have a nice life. I need to be to work in 2 hours, and I can’t manage this position, I have to sell out. About 40k in 2 days,,,,,,,,,,,,gone. Speechless. One bad trade, is all it takes. 2 and a half years of trading thrown down the drain on 1 trade. Who would’ve thought the Futures would tank as much as -500pts on YM with the US markets closed. I didn’t, and I never really wanted to be in this position, but I couldn’t accept the small loss.
And so it is that the High Probability Trader (HPT) gets wiped out by a low probability event.
I can relate to HPT on several levels:
- Before I started this blog, I had been trading full-time for over a year and was experiencing a peak-to-trough drawdown in the region of 85%. While I had a strong edge over this period, I simply pressed to hard and too often as a variety of psychological problems took hold.
- See how HPT shouts at the market to keep going against him? I also experienced similar feelings of self-loathing and have willed self-harm after taking positions (the market obliged). When all hope is lost we can turn on ourselves. (Remember ‘Billy’ in the film Predator? Midway in the film Billy says ‘we are all going to die’, and toward the end he stops running from the Predator and sacrifices himself on the bridge.)
- In the first few months of the recovery process, there was a very strong chance of getting completely wiped out. I also took outsized risks but I was lucky. Now, If I get hit by a tsunami that blows a hole in my equity, I feel I am psychologically ready to deal with it.
What can we learn from HPT’s experience?
The longer we stay in the trading game, the greater are the chances that we will get hit by unexpected, low probability events. Looking at the history books provides some guidance on what to expect, but history provides only the finest slither of the infinite possibilities that could have occurred. So it is that traders must tread extremely carefully, always balancing the upside with downside, appreciating that extreme, unexpected events will probably net out over the long term. Its all about navigating through these squalls and staying alive to trade another day. These days, I am more comfortable with my relationship to trading uncertainty. My risk per trade is still too high by most standards but it is much lower than it used to be. I don’t hold FX positions overnight and based on current risk taking, a 200pip gap in an exchange rate shouldn’t cost me more than 25% of my equity.
It can serve us well to imagine that the horsemen of the trading apocalypse are just behind us.
(Hat tip to Trader Eyal for pointing out this story)
Stock markets around the world are tumbling (at one point today, the FTSE was down 5.71%, the biggest one-day fall in six years) , reminding us that asset prices tend to fall faster than they rise. The reasons for this crisis seem clear: inflation has picked up, economic growth is easing, the fiscal stimulus package announced by Bush appears insufficient, and significant interest rate cuts from the Fed are already priced in. There is very little further wiggle room for policy makers. Against this toxic, stagflationary backdrop, it’s understandable why investors are nervous.
However, we also know that economies and markets tend to self-correct over time – as prices change and agents respond – with new, unpredictable events and themes taking hold as the years go by. My problem is that markets do not seem to be very forward looking when it comes to pricing in the unknowable. They can be forgiven because not only does uncertainty multiply exponentially the further forward we move in time, but we are also faced with the fundamental question of how to price something that is unknown and so can’t be measured!
Nevertheless, I feel that markets are underpricing the risk that something will occur which will provide some degree of offset to the current gloomy outlook. I don’t know what it is, but that doesn’t concern me one bit. All I know is that a lot of downside seems to be in the price. Equity prices may well fall in coming weeks. However, because the market can’t see a way out of the current mess I believe it may be a good time to start loading up on equities for the long-term. Broadly speaking, good times are followed by bad and bad by good, but the market tends to rise over the long term.