Trader’s Narrative

Book Giveaway
If you haven’t already, throw your name into the hat for a giveaway of:
Hedge Fund Operational Due Diligence (follow link and submit comment)

While you were watching the news about the AIG bonus dustup, hope you didn’t miss on AIG the ticker symbol. It is still kicking around on the NYSE and as a penny stock, it put in an impressive wide range day:

I have no idea why it jumped on Monday since there wasn’t really any news (other than the bonus fiasco). But a 66% jump (from last week’s close) is juicy and as a daytrader, even if you can catch a fraction of it, you’re set.

Even if we ignore Friday’s close and only take it from the gap up open on Monday to the close, it was a 36%. Not too shabby. The intraday high at the magical, round number $1.00 - something really special about round numbers that acts almost like a magnet. The more you watch it, the more you see this stuff.

You don’t want to chase a runaway train so watching for an entry point is crucial. A great, low risk entry point was available at around 10:20 AM (green arrow). Price action paused and then retraced slightly with volume dropping off. If you notice, there was some resistance at $0.60, which was then broken to the upside. This then would have acted as support. So placing a stop under it would have allowed you to define your risk levels intelligently.

No one really knew, of course, that this would turn out to be a huge wide range, trending day. But the tip-off was the incredible volume, as well as the large gap up open. AIG had already put in a bottom last week and rallied impressively already from its low of $0.33 so there was something afoot.

Coming at the heels of such massive financial frauds as Madoff and Stanford, (as well as previous hedge fund collapses like Bayou) “Hedge Fund Operational Due Diligence” is well timed.

The recent batch of fraud dwarfs the largest trading losses in history, combined, and makes it crystal clear why all investors should take due diligence extremely seriously. The author, Jason Scharfman, previously at Graystone Research (a division of Morgan Stanley), is now at Corgentum, a full service hedge fund operational risk consultancy practice.

What is operational due diligence? Usually when we think of the risks involved with a hedge fund, the first we think of are related to the market. That is, how much an investment in them can depreciate as a result of trading losses. And although this is very important, there are two more areas of risk: credit and operational.

Credit is the risk associated with a counter-party being unable to meet their obligations (cough AIG cough). Operational due diligence encompasses a broad array of risks, including more ‘human’ frailties, such as internal controls, internal/external fraud, as well as business disruptions due to external or internal factors.

This is the risk that almost every single Madoff investor ignored - that says a lot because these were, by definition “sophisticated” but they ignored all the operational red flags and handed over millions of dollars.

Scharfman’s book explains not only how to diagnose and analyze the operational risks that may be present in a hedge fund, but how to continue to monitor them. This book is invaluable if you are running or thinking of starting a hedge fund, want to invest in one (or already have) or if you work in the field of asset management.

Because it is a thorough and exhaustive exposition, going through just about everything like a manual, it makes for an excellent reference resource. While the topic can be rather dry, Scharfman brings it to life by using nuanced hypothetical scenarios which read like stories (Chapter 5).

For example, would you or should you allocate money to a hedge fund if the head trader or manager has a criminal record? How would you treat this if the manager was pro-active in mentioning it? and not? what if it was not related to financial fraud?

If you’re impatient, you can skip to Chapter Six, which has the “Ten Tips for Performing an Operational Due Diligence”:

1. Avoid meeting with the wrong people or the wrong group
2. Get out of the conference room
3. Little white lies can turn into big problems
4. Be wary of phantomware
5. Focus on documentation and negotiation
6. Read the fine print (financial statement notes, etc.)
7. Reference checking: importance of in-sample and out-of-sample references
8. Credit analysis: are funds financially viable?
9. Long-term planning: Key staff retention, succession planning, and more
10. Growth Planning: is the manager proactive or reactive?

There has always been a struggle between hedge fund managers and investors. One side wants to disclose as little as possible, to protect proprietary strategies. And the other wants as much disclosure as possible to protect their assets. There has been an uneasy relationship between the two parties because of this. The trend is now shifting to more transparency not only because of the large fraud cases that have come to light but also because of a diminishing source of funds. Investors have a stronger position to make more demands for disclosure. And with Scharfman’s book, even the smaller investors have a blueprint to follow.

There’s a lot more in the book, of course, but that should give you enough to whet your appetite. You can purchase it at Amazon, or your favorite book seller (it is published by Wiley, a specialist in finance books).

Or be one of my lucky readers to win a free copy of Hedge Fund Operational Due Diligence. To enter for the chance to receive a copy of Jason Scharman’s book for free, just drop me a comment below. Make sure you write your email correctly (so I can contact you when you win the random draw!).

If you would like to receive a free copy of Tim Syke’s book, An American Hedge Fund, leave a brief comment below (making sure you leave your correct email). I have TWO copies to send to two of my randomly chosen readers as a Christmas [slash] Hannukah [slash] New Year’s gift.

Timothy Sykes’ book An American Hedge Fund takes you through a conversational, breezy account of how he took $12,000 of Bar Mitzva money and traded it to $1 million. Although Tim peppers his book with specific trades, the book doesn’t have any charts. This is disappointing because it would have been so enriching. Maybe for the second printing

While I respect and admire Tim’s drive as a trader, I can’t help but think it was sheer luck that he didn’t completely blow up before he made serious money. Although the story takes place during the tech bubble of the late 1990’s, when turkeys flew like hawks, his complete disregard for risk is breathtaking.

The string of luck catches up to him when he sinks 33% of the capital under his management into Cygnus (now Accesso) a private company that later in the story goes public on the pink sheets. This is not only a continuation of his disregard for risk management, it is a colossal style drift, taking him from trading short term price patterns to long term investment into an illiquid holding.

I don’t recall every reading about any thought of capital allocation or money management. That is, measuring trades using R to standardize the risk that was taken to provide the resulting return.

To Prop or Not to Prop
After his initial success, while considering the options available to move him away from casual trading to a more serious undertaking, Tim decides against joining a proprietary trading firm because it “would only serve to increase [his] risk, not reduce it.”
Continue reading ‘An American Hedge Fund: Book Review & Giveaway’

Interesting article on Goldman Sachs’ “luck” in escaping unscathed from the sub-prime mortgage mess:

Goldman’s good fortune cannot be explained by luck alone. Late last year, as the markets roared along, David A. Viniar, Goldman’s chief financial officer, called a “mortgage risk” meeting in his meticulous 30th-floor office in Lower Manhattan.

At that point, the holdings of Goldman’s mortgage desk were down somewhat, but the notoriously nervous Mr. Viniar was worried about bigger problems. After reviewing the full portfolio with other executives, his message was clear: the bank should reduce its stockpile of mortgages and mortgage-related securities and buy expensive insurance as protection against further losses, a person briefed on the meeting said.

The article fails to mention that Goldman Sachs (GS) is Wall Street. They might as well own it outright. And now they’re making inroads into government where policy and oversight reside. They don’t play the game, they are the game.

But in the end, even if you practically own the place, risk and its management is the real game:

At Goldman, the controller’s office — the group responsible for valuing the firm’s huge positions — has 1,100 people, including 20 Ph.D.’s. If there is a dispute, the controller is always deemed right unless the trading desk can make a convincing case for an alternate valuation. The bank says risk managers swap jobs with traders and bankers over a career and can be paid the same multimillion-dollar salaries as investment bankers.

One of my favourite market axioms is “Discipline over conviction.” There is no point in risking ruin when you don’t have to. Coming back to play another day is a prime victory. Had Niederhoffer hired one or two risk controllers, he wouldn’t have blown up (again).

This graph tells the whole story:

Dr. Ari Kiev is a renowned psychlogist, performance expert and author. A few years ago Steve Cohen hired him to help the traders at SAC Capital improve their performance. And if you know anything about SAC Capital, you know they are already the best of the best.

Here is a video of a talk by Dr. Kiev at the New York Mercantile Exchange.

It is tough to pick out a highlight from such a fantastic video. But if I had to point your attention to any one concept it would be to the idea of setting goals and ‘creating’ your performance. Most traders are reluctant to implement this. Yet, it is integral to the performance of great traders.

Also, check out the other videos from the New York Mercantile Exchange’s archives.