Wishing everyone a happy 2007
My favourite regular contributors to Daily Speculations include Jim Sogi and, of course, Victor Niederhoffer. In response to a piece by Sogi titled ‘1001 Ways to Lose Money’ (Dec 28), Victor Niederhoffer made a few comments that got me thinking:
On market design
“Never be overconfident. You can sink in a moment on a boat, and lose everything with one bad trade in the market. Try not to be overly pessimistic either though, as the market is very resilient, and the infrastructure is designed so that the system can continue and capital can be raised and entrepreneurs will reap returns for their creativity.”
I believe it pays to appreciate the purpose of marketplaces and the differences between them. The central and original function of the equity market, for example, is to act as a meeting place for capital providers and entrepreneurs seeking to finance their ideas. Despite the pervasive bearishness in the media, this vital role helps to explain the upward drift we observe in the market. If capital providers failed to achieve reasonable returns over the long-term, the system would likely starve itself of capital as investors directed funds to more profitable activities. The positive drift tells us that all is well, and that we should not be overly pessimistic.
The foreign exchange market however, is a very different beast. There is less transparency (eg: no central clearing of currency prices or information on volumes), and the fx market does not appear to serve as noble a purpose as the equity market in financing creativity and driving economic growth. Exchange rates are vital to international trade and are important to a fully functioning free-market economy, but it seems many countries are content to live without freely floating rates. Also, despite all the talk of foreign exchange as an asset class, I still do not really perceive any real assets as being traded – in my view fx rates are simply the relative prices between two countries (with a carry component). Indeed, whereas the equity market can reward all ‘long’ investors over time (it is not a zero-sum game), in the currency market a trader cannot be long one currency without being short another. So, even before frictional transactional costs, currency trading is a zero-sum game. The point of this ramble is that if we look at the foreign exchange market place, the structure and purpose of the market is such that, on average, participants should expect to lose more often than equity investors who tend to trade from the long side. The very nature and structure of the currency market helps to explain the general absence of drift, and warns us of undue optimism.
On grinding and the ‘stress frontier’
” … remember that the only one that can really grind is the house.”
No doubt some traders employing grinding approaches will make a living , but the tendency surely has to be for the majority of short-term trader’s to get ground down to dust as transactional costs eat away at their equity. In the equity market, investors generally pay a spread, a brokerage charge and sometimes a tax. In the spot forex world, the trader is faced with a spread that is extremely low as percentage of the exposure, but this charge is present and it has to be acknowledged. If a trader is to be profitable, their edge has to to beat both the randomness of the market and the charge. In currency trading, macro traders would appear to have a clear advantage because if they are looking for moves of several hundred pips on trade, a spread of 1-3 pips (major currency pairs) usually brings the transactional costs to a fraction of a percent. In contrast, when a short-term trader is looking for a swing of 20-40 pips, the spread can often exceed 10%, making life exceedingly difficult. But still we keep trying.
I find a parallel with nature: in ecological systems, species often operate on what I call a ‘stress frontier’, where population sizes grow to a point at which predators, natural habits, prey etc become significant pressing factors. Most species seem to operate on this ‘stress frontier’, struggling but managing to find food and defend against enemies. Quite often, this ensures a certain dynamic stability in the wider system. When it comes to trading, as transactional costs have fallen in nominal terms over the past decade, my impression is that more traders have been attracted to the system and that traders have tended to focus on ever shorter time horizons (I am one of them); reading blogs of others currency and equity traders, transactional costs still seem to average between 1-5% for many trades. Perhaps it is in our nature to make life a little difficult for ourselves. This could be tested by looking at the historical percentages of profitable traders to losers, which I estimate would be largely unchanged over the years despite the significant reduction in trading costs.
‘Guts’ll get you so far, then they’ll get you killed’ – Jeff Daniels in Speed.
‘One of the things we’d always like to remind ourselves before we went in to any job was ‘expect the unexpected’. Always sounds like good advice , except of course, if you are expecting the unexpected, well then, it isn’t really unexpected anymore, is it, and that leaves you vulnerable to the truly unexpected, because you’re not expecting it.’ – Bruce Willis during the rolling end credits of Bandits
Over here in the UK, the Queen delivers a message to the the nation every Christmas. The opening line of her speech this year really hit home:
“I have lived long enough to know that things never remain quite the same for very long.”
I returned 4.3% last week, bringing my end of month balance to £9600. I score myself 7.5 out of 10 for following the road map, but the reality is that the going is getting tougher. In this light, the decision to cut back on the aggressiveness of my trades appears to have been a prudent one.
When I started writing this blog, my aim was to get back to break-even by April 2007, but I realise this is increasingly unlikely with my current strategy, and I can ill afford to start experimenting with new approaches. I find myself on an unexpected path as I planned to either achieve break-even or to die (financially) trying. Instead, I have landed somewhere in between. My edge has fizzled out, at least for now, and I have a little capital which I am trying hard to preserve. What these weeks of profitability have brought me is precious time to find new ways of earning some coin should my edge fail to return. Based on past expenditures I estimate I have enough funds to last anywhere between 3 to 6 months before I am forced in to a corner of desperation.
The trading journey continues, but the frequency of my trades is being significantly reduced as I am narrowing my focus on the more potentially profitable trades. Because weekly results will be less meaningful in this context, from here on I will be reporting my trading results on a monthly basis. At least this effective ending of a chapter of my trading life neatly coincides with the end of the calendar year.
My weekly results to date:
Over at Daily Speculations, Victor Niederhoffer re-emphasises a central tenet of his investment philosophy that is well worth bearing in mind, particularly for investors in the equity markets:
“One must repeat that the unconditional drift of the market is 10% a year. Whenever you are short, you have a drift going against you. When you wish to go short, chances are that the drift of the market will be above 10% a year. That’s because you and others think there’s a bear market retrospectively, and require a higher rate of return to be invested. In addition there are frictional costs to being short. Put them all together, and I’ve never seen a short seller who’s made money, nor has the Palindrome (Soros) . It does give psychic value however in that it lets you vent your hatred of the system and yourself. It also gives stature because you are always on the negative which seems so much more poignant than the positive.”
Following up on this, trading doctor Janice Dorn provides an interesting insight:
“Part of the profundity of Chair’s remark is that the bears make poignant arguments which are almost tailor-made to touch something very deep inside of those who are always watching and waiting for some disaster or catastrophe. The bearish arguments tend to be more scholarly, detailed, laced with Latin words and appeal to the limbic core of the brain (which holds memories of fear and terror and sees them even in their absence), as well as the higher neocortical areas which are, in some way, hard-wired to process, consolidate and retain bad news more firmly and longer lasting than good news. Bad news is stored as pain and that pain can be evoked in almost any situation. Good news tends to be more fleeting and there is more difficulty reaching into the brain stores to retrieve the memories of euphoria. Perhaps the neurochemistry of euphoria (be it dopamine, serotonin, norepi, or any of the thousands of neurochemicals) is configured in a way as to be more transient, spontaneous and non-entrained. Depression, disaster, danger lurking around every corner is much more “reachable” in terms of our psyche. Once again, this is likely a function of the way that the cortical neuro-pathways are laid down and communicate electrochemically with each other in the vast cortical landscape.
In any case, the rah-rah cheerleaders are often seen as buffoons, whereas the permabears are the scholars and masters of Latin.”
I believe drift becomes a more important feature the longer the holding period of the investment, but the general ideas above are relevant to all traders, even for fx traders despite the absence of a long-term drift in most currency pairs. The material certainly provides food for thought. From personal experience, for example, I would say there certainly seems to be a lack of symmetry in human psychology when one contemplates bullishness and bearishness. I find that bad news is so much easier to sell, and not just for journalists, bloggers etc, but even in terms of the conversations we are having with ourselves as investors.
The latest edition of Bloomberg’s Markets magazine has an interesting feature on the Clarium macro fund, run by Peter Thiel. Here are some interesting quotes from the piece:
– One morning in 1998, at Hobee’s coffee shop, near Stanford University, a young money manager named Peter Thiel decided to gamble on an Internet startup. Thiel ended up investing $240,000 in the company, which eventually became PayPal Inc., the giant of online payments. Thiel ran Pay-Pal, took it public and, in 2002, sold it to EBay Inc. for $1.5 billion. Thiel, then 34, walked off with $60 million.
– Clarium turned heads by posting a 65.6 percent return that year. “Investors often called to ask whether he was lucky or good,” says Steven Drobny, a partner at Manhatten Beach, California–based Drobny Global Advisors, which advises global macro funds on world markets. “Whenever you have someone who puts up sensational returns out of the gate, people wonder if he’s rolling the dice or if there is real thought behind it.”
I find the topic of how randomness and chances permeates our lives fascinating. In many cases, we believe we are in control of our situation or environment when we are not. In trading, for example, it is impossible to know for certain what portion of trader’s fortune can be attributed to sheer luck and how much is due to the skill of the individual, regardless of whether there is ‘real thought’ behind the investment decision process. Indeed, while successful traders often share common traits, perhaps these are more of a pre-requisite requirement to stand any chance at success; i.e, a trader’s emotional and intellectual intelligence may take them into a certain threshold or category, reducing the probability of being wiped out due to naive errors, but perhaps the odds of success still remain close to random. What am I doing, talking like a proponent of the efficient market hypothesis? No, I must stop with this heresy (at least for now).
– Clarium has taken some hits along the way. Three times, Thiel has lost as much as 11 percent in a month. “Thiel can be a scary guy if he’s the only one in your portfolio,”
says David Philipp, a Clarium investor and managing partner at San Francisco–based Gyre Capital Management LLC.“He’s not afraid to put his money where his convictions
are, and he’s not the guy who’s happy with 5 percent returns and 3 percent volatility.”
While arbitrage type strategies can often produce abnormal returns with low risk, the majority of funds have to accept risk as part and parcel of trading life. Losses and drawdowns are part of the game. Traders just have to make sure you are generating sufficient returns for each unit of risk. A monthly drawdown of 11 per cent is nevertheless uncomfortable, but investors can always diversify their risk by including these high risk investments as part of a wider portfolio.
– Thiel’s alter ego at Clarium is a physicist named Kevin Harrington, who used to do mathematical research for the U.S. Department of Defense. The two sometimes talk strategy for five hours at a stretch. “Peter is my foil, and I’m his foil,” Harrington, 37, says.
Even if the final investment decision is made by a single individual, finding someone to bounce ideas against can be invaluable. They can play a role in interrogating a trader’s views for robustness, and help with the hatching of new ideas. For such a partnership to be productive however, the individual must have complimentary characteristics to the decision maker and this can be rare.