Trader’s Narrative

With the exception of bankers and their lobbyists, the financial crisis has also been hard on everyone. No single group feels more besieged from the outside and beset by fretful soul-searching from within than economists. They are scrambling about to come up with not only explanations of what happened but also to build better models that will predict and therefore, prevent, future crisis.

There is an overflowing bookshelf by now composed of books trying to explain to a shell shocked public what just happened. A great one that I reviewed a few months ago, and highly recommend, is Bailout Nation by Ritholtz. Another that I’m reading now and will review shortly is The Cost of Capitalism by Barbera.

An interesting idea getting traction now is from Geanakoplos, a partner at Ellington Capital Management and a professor at Yale. While the interest rate or liquidity cycle is well known to everyone, Geanakoplos posits that the leverage cycle is even more important. He explains:

… when banks set margins very low, lending more against a given amount of collateral, they have a powerful effect on a specific group of investors. These are buyers, whether hedge funds or aspiring homeowners, who for various reasons place a higher value on a given type of collateral. He called them “natural buyers.”

Using large amounts of borrowed money, or leverage, these buyers push up prices to extreme levels. Because those prices are far above what would make sense for investors using less borrowed money, they violate the idea of efficient markets. But if a jolt of bad news makes lenders uncertain about the immediate future, they raise margins, forcing the leveraged optimists to sell. That triggers a downward spiral as falling prices and rising margins reinforce one another. Banks can stifle the economy as they become wary of lending under any circumstances.

Source: Wall Street Journal

While this is persuasive, it isn’t all that new or innovative. During the first bubble of the millennium, many called for the Fed to increase margin requirements on trading accounts to curb rampant speculation in technology shares. Being against intervention, Greenspan muttered something about free markets and offshore asset flows and didn’t do his job. We’ll never know if the first bubble and subsequent crisis would have been averted had the Fed removed the punchbowl before everyone got tipsy.

Right now, the leverage cycle is fighting against the interest rate cycle. The Fed has instituted a new carry trade which has decimated the US dollar and awakened the great gold bull. As the two giant cycles battle it out, the economy and the stock market hang in the balance.

Curtis Faith’s new book: Inside the Mind of the Turtles is primarily about risk and how traders should approach it. But it is also about Faith’s life, his background, successes, failures, and the many lessons learned as a trader and an entrepreneur.

The book starts with a gut wrenching decision that he had to make when a friend was thrown overboard from their sailboat. In a split second, the situation required him to analyze the risks of each option and to make the right choice between going back to try to help his friend in extreme weather or going for shore to get help.

Risk, according to Faith involves three elements: uncertainty, consequences and exposure. Without all three, you really don’t have ‘risk’. After defining it, he dedicates a chapter each to the seven proper approaches to managing and profiting from risk:

• Overcome Fear
• Remain Flexible
• Take Reasoned Risk
• Prepare to be Wrong
• Actively Seek Reality
• Respond Quickly to Change
• Focus on Decisions, not Outcomes

Most of those are self-explanatory so I’ll limit myself to detailing just the ones that aren’t. By “Actively Seek Reality” Faith is referring to having the most accurate perception of reality in order to be able to take advantage of opportunities. There is a difference between reality and our perceptions of it. So it is a constant struggle to not only untangle any misperceptions that we have, but also to be cognizant of how others are approaching the same set of variables and how the interplay of those two things presents opportunity or danger. Faith uses a business management analogy to expound this concept but I wish he had used an example from trading.

And by “Focus on Decisions, not Outcomes”, Faith means that traders are better served by paying more attention to the process of a trade rather than whether it was profitable or not. We all know that being right and making money are two separate things. So it is possible to make a poor decision, and make money. It is extremely important to be aware of this because if it becomes a pattern, it can be devastating.

There is a lot more of Faith in this book (than his first). He mentions the origins of his own interest in computer programming, his first ‘big break’ with Rotchie Barker (his trader mentor), why he dropped out of college, and what he did after he left trading behind. The book is peppered with personal anecdotes that either directly related to trading or are used as analogies to demonstrate a principle. In the last section of the book, Faith outlines his more general ideas, getting into philosophical on education, political views on government, society, management practices within corporations, etc.

You will be disappointed if you were expecting more of Way of the Turtle. But if you’re interested in a book that explores the psychological aspects behind the decision making process of trading, then you’ll enjoy Faith’s second book.

If you haven’t already, click to read my review of Faith’s first book, Way of the Turtle. That book is about the story of how Faith joined the small club of ‘turtles’ and how they made their millions.

Since I got my hands on my copy of Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy, I’ve been devouring it almost non-stop.

Written by Barry Ritholtz, Director of Equity Research at Fusion IQ, and blogger at The Big Picture, it promised to be a definitive guide to the financial mess - and it didn’t disappoint.

In his inimitable colloquial tone Ritholtz sets out to meticulously explain how the stage was set for the historic unraveling of the global economy in 2008. Although we will no doubt have a plethora of similar books, Ritholtz’s book, for its detailed historical approach and its comprehensiveness will probably end up being the encyclopaedia that future historians and traders come back to.

Filled with charts, diagrams, cartoons and highlighted sections, Bailout Nation grabs hold of your attention and never lets you come up for air until the very end. I found very few errors or bumps along the way. Some sections were a bit repetitive. For example, referring to the case of LTCM, he says:

The collapse of that hedge fund in 1998 and its subsequent Fed-orchestrated rescue plan provided one of the greatest — and most terrible — examples of moral hazard ever known.

Then a few paragraphs later:

Contrary to what Greenspan claimed, the Federal Reserve’s involvement did not create “slight” moral hazard. Rather, the 1998 Fed-orchestrated rescue was moral hazard writ humongous.

Yes, we get it Barry! But because the book is so well written and researched, I’m nitpicking here really.

I truly appreciate that Ritholtz comes across as politically agnostic. He excoriates both the Democrats and the Republicans for reckless policies and decisions that have no logic but foster a culture of entitlement, reduce or entirely eliminate regulation and get private enterprises addicted to public funds.

Most Americans are labouring under the patriotic delusion that they live in a free market society. But for all their pro-capitalistic bravado, America’s history is replete with corporate welfare. Both Democratic and Republican governments have lavished public funds on businesses that would have gone extinct in a real free market. To start at the beginning, Ritholtz highlights the precedent setting bailout of Lockheed Martin in 1971. This was the first time the US government had acted to help out a single corporation. He then proceeds to describe the other bailouts, which by now had become the norm.

Ritholtz spies a 10 step pattern of bailouts:

1. Risk Event
2. Pre-awareness
3. First Reactions
4. Bigger Reactions
5. “Interested Party” Agitation
6. Official Concern
7. Broader Worry, Deepening Panic
8. Major Intervention/Bailout
9. Rationalization & Apologies
10. Expected Results and Unintended Consequences

It isn’t too hard to spot us at stage 9 - with Greenspan’s sheepish “flaw” apology and Geithner’s haphazard attempts to sell everyone on his ill thought out PPIP proposal.

When it comes to casting blame, Ritholtz doesn’t pull any punches. As you can imagine, with a foreword written by Bill Fleckenstein (author of Greenspan’s Bubbles), Ritholtz doesn’t shy away from criticizing the Maestro. In fact, he puts him front and center, as the primary enabler of this convoluted tragedy. But he also defends what he considers to be “misplaced fault” such as naked shorting, mortgage interest deduction, etc. I don’t totally agree with him on naked short selling. The deregulation that he cites elsewhere was also why naked shorting was allowed to take place - at times on a massive scale, with devastating consequences.

Ritholtz also cites a very clever reason for why Wall St. got greedy in the first place and went into overdrive, taking on fatal amounts of risk. I won’t ruin the aha! moment for you but it is signature Ritholtz to be able to pull together very disparate variables and see a pattern emerge.

I’m often asked by friends and family members to explain why Wall Street just imploded. Bailout Nation is an accessible and fun to read book that explains every question they have - and a few they never even thought of asking.

Congratulations to Norman, the winner of my latest trading book giveaway!

Thank you to all who entered. I wish I could give each of you a prize as well. Since I can’t do that, with the permission of the publisher, I’m going to do an extra bonus draw for a second winner as well.

That way, two of my readers can enjoy Hedge Fund Trading Secrets Revealed” by Robert Dorfman.

One of the reasons that I enjoy writing this blog is the ability to be able to help others out there who are interested to learn more about trading and investing. These book reviews and giveaways are a great way to do that so look forward to more of them.

Keep watching because I already have two other books on deck and once I am finished reading and putting up a review for them, I’ll be doing a draw for them as well.

To keep the karma leveling up, all of the winners of the book giveaways will write their own reviews once they are done so you can get their perspectives as well.

If you have any suggestions for a book that you’d like to nominate as a candidate, by all means, drop me a comment below. I try to keep up to date on high quality books but with the amount that keeps getting written every year, it is difficult to not miss a few gems.

My last book giveaway was Tim Sykes book “An American Hedge Fund” so with this new book it seems we are continuing a “hedge fund” theme …

“Hedge Fund Trading Secrets Revealed” by Robert ‘the Hawk’ Dorfman.

Dorfman runs the SilverHawk Fund out of Costa Rica and before that used to work for Jim Mellancamp of Genie One Capital Management. I couldn’t find much on Mellancamp or Genie One but I suppose most hedge funds are fairly secretive.

The first few chapters of the book tell the story of how Dorfman came from humble roots in Cranston, Rhode Island, thanks to a fight in a restaurant was able to attend Brown University and from there, discovered Wall Street.

If you are new to trading or investing, the book contains a lot of basic to intermediate information that you’ll find useful. I don’t think there are many “secrets” revealed about hedge funds, other than they know more and have more resources than the average retail trader.

Still even someone who is experienced and relatively knowledgeable will be able to pick up a few things here and there. For example, Dorfman talks about Thompson Financial’s AutEx, an institutional liquidity pool I wasn’t familiar with.

As well, he outlines his basic strategy:

“…we enter trades based on these institutional trading firms’ actions as reported by Thomson Financial’s incredible global, pre-trade execution and communications network called AutEx, which provides us with an in-depth view of the moves being made by over 800 institutional traders…”

His basic thesis is that “the price simply will not make a sustained move without the power of institutional buying or selling”. Which is hard to argue with. He describes in some detail how a hypthetical order from an institutional trader will be pounced on by others and result in the price being pushed against the order.

Unfortunately, there is a chapter devoted to the “Universal Law of Attraction“. I’m more than skeptical about this New Age phenomena. I don’t think it has any validity but the good news is that in this book it is only a small part and can be easily ignored.

Most importantly, there is significant portions of the book devoted to capital allocation and risk management. He talks about maximum position allocation (MPA) and describes how to calculate it. As well he discusses scaled entry for an order (that is increasing size as the trade goes your way). On the whole, while important, it is fairly basic stuff. If you are curious about similar topics of risk management and capital allocation, check out the “Way of the Turtle” by Curtis Faith.

Dorfman’s book will be a disappointment if you naively believe its title. But if you dedicated to learning more about trading and especially about how large institutional traders operate, you’ll pick up some good information.

If you would like the chance to receive a copy of Robert Dorfman’s book for free, drop me a comment below. Make sure you write your email correctly (so I can contact you in case you win the random draw!).