Rough Trade

Sales people are “girlie” men. Traders are “real” men, even if they are women. They are the “big swinging dicks”, the “masters of the universe”.

Traders, well, trade. The key thing for the trader is to make profits. There is only one way to make money – you buy low and sell high. Sorry, forgot the second rule – sell high, buy low. Listening to traders, you get an entirely different view of their business, especially its complexity.

Traders are not noted for being literate let alone classical scholars. But when talking of trading, traders frequently turn to tracts such as Sun Tzu’s The Art of War or Thucydides’ The Peloponnesian Wars. The traders haven’t read the books of course. What they know has been acquired second hand – snippets from overheard conversations, incorrect quotations in hilarious pulp books on trading. One trader attributed his success to the following maxim from Sun Tzu: “For the impact of armed forces to be like stones thrown on eggs is a matter of emptiness and fullness.” My personal favourite (incidentally the only thing from The Art of War I can remember) is: “Draw them in with the prospect of gain, take them by confusion.”

Success in trading relies on simple rules. Overwhelming force is generally good. You just have more money than everybody else and can hang on until everybody is forced out of the game. Ganging up is effective. You just get together with other traders and fall upon a weakened animal like hyenas or wolves. Ambush is also good. You know something that the other guy does not know, at least not yet.

In the late 1990s, I was visiting Mumbai in India. The stock exchange was debating a move to electronic trading. There was resistance to the move. They invited a Nobel Prize winning US financial economist to speak at a conference seeking to win over the brokers to electronic trading.

The economist spoke eloquently and movingly of “greater trading efficiency”, “lower transaction costs”, “lower commissions”, “improved price discovery” and “greater pricing transparency”. The audience was almost in tears, from laughter. After the speech, I found myself with some brokers and the celebrated guest speaker.

“I cannot be understanding how you could have been gotten the Nobel Prize, Sir. You will be being a complete fool”. One of the brokers addressed the eminent American economist with refreshing directness. “I will be dealing in market circumstances when my clients will not be having a clue as to what the price will be being. Tata shares may be trading at Rupee 100. My client will not be knowing that factor. I will be being telling him that Tata is trading at Rupee 105. I will then be selling him the shares at Rupee 105 plus my spread of one Rupee plus my commission. He will be being most happy. I will also be being most happy. If he knew the price then he would be very unhappy. I would also be most unhappy. I do not understand why being most efficiently is good. We will be being most happy as we are. I will be thinking that Americans are being mostly stupid.”

The guest speaker looked stunned. He was at a loss for an argument. He resorted to platitudes about “efficiency” and “transparency”.

Trading depends upon being able to predict future prices. Traders invest heavily in forecasting methods. Increasingly, this takes the form of quantitative analysis involving arcane mathematical and econometric techniques. Traders are also increasing applying technology to trading. This has its own risks. One quant programmed his machine to short all insurance stocks when the word “hurricane” and “Florida” appeared on electronic new services. This may lead to some unexpected and bizarre consequences. Imagine the widespread selling of insurance shares when a newspaper reports that the highlight of Bob Dylan’s farewell concert in Miami, Florida was his rendition of “Hurricane” – his song about ex-boxer Reuben “Hurricane” Carter.

Science adds mystique and method to trading, it does not increase the prospect of success. Better still to be a lucky fool.

Human beings trade. “Behavioural finance” analyses the psychological basis of economic decisions. Daniel Kahneman, one of its founders, shared a Nobel Prize for his work. It seems people are over-optimistic about outcomes. Americans seem especially prone to over-optimism. 40% of Americans believe they will end up in the top 1% of income earners. Over optimism translates into over confidence with people exaggerating their own skill, overestimating their level of control over events and ignoring the skills of the competition.

Behavioural finance itself is evolving. One recent study showed “conclusively” that stocks with easy to pronounce names performed better after IPOs. There is now a rush to consult behavioural economists together with marketing gurus, brand consultants, feng shui experts etc in naming companies. “Conclusive” by the way in the context of research generally means that the author of the study selected data specially that haven’t to prove the hypothesis conclusively

Fascination with behavioural finance leads to some odd trading decisions. One trader confided that after a course in Kahneman’s work he implemented a new strategy. If he had a hunch or particular expectation, then he bet against it.

In the final analysis, trading is about the future. Forecasting is difficult. Traders should study the story of Croesus.

Croesus was the King of Lydia. He developed gold and silver coins creating the world’s first imperial currency. At the height of his power, Croesus decided to attack Persia. It was a pre-emptive strike. He wanted to destroy Persia before it posed a threat to Lydia. Croesus consulted the oracle at Delphi. Just to be safe, he also consulted six other oracles from Greece and one from Libya. Ever cautious, he even tested their forecasting accuracy. Each messenger consulted the oracle on a pre-determined day. Each messenger asked the oracle what Croesus was doing on the day. Croesus planned an act that it was unlikely a charlatan would be able to guess. He planned to chop up a turtle and lamb and boil them in a pot.

Only the oracle at Delphi passed the test of authenticity. Croesus plied the oracle with gifts receiving, according to the historian Heredotus “rights of first consultation without a fee”. The oracle prophesied that Croesus would “destroy a great empire”. Croesus went to war against the Persians and was defeated. The Delphic oracle had been right. A great empire had been destroyed - the Lydian empire. As he was being burnt as an offering to Persian gods, Croesus is said to have cried out to Solon. Solon had reminded Croesus years earlier: “human beings are the creatures of pure chance”.

It is a truism that trading thrives on information – “information”, “dis-information”, “mis-information”, “inside information”. It has always been that way. Financial news isn’t like normal news. In normal news, we are passive spectators to the great, the good, the evil and Paris Hilton. Financial news is about finding out information that affects the business. It shapes what traders buy and sell. It shapes the price that traders are willing to pay. The trader also wants to know what everyone else is doing. But the trader doesn’t want others to know what they are doing. It’s all a bit tricky.

This leads to a strange pas a deux between the financial press and the traders:

Reporter So, what’s going on? Trader You know, stuff. Not a lot. But stuff. You know. Reporter Any particular stuff? Trader Nah, just the usual stuff. Reporter I heard that a pretty big deal went though. Exotic. Large size. Hedge funds. Did you guys see it? Trader (extremely animated) Really! Who did you hear that from? Reporter Did you see the trade or what? Trader So, who told you? Reporter Look, did you see the trade? Bid on it? I think it’s one of your big clients. Trader Maybe. We bid on so much stuff these days. It’s hard to keep track, you know. What was it? Who did it?

Donald Rumsfeld summed it up astutely. “Anyone who knows anything isn’t talking and anyone with any sense isn’t talking. Therefore, the people that are talking to the media, by definition, are people who don’t know anything and people who don’t have a hell of a lot of sense.” That pretty much describes the exchanges between traders and the financial press.

Information, even priceless information, requires careful analysis. On a trading floor in London, the PA to the Head of FX called across with the enigmatic statement that: “The Fed’s in.” Dealers scrambled for their phones taking positions before the PA could finish her statement. The PA continued: “The Fed’s in. They’re in reception waiting for you!” Suddenly all the traders were trying to unwind the position that they had just taken. (See Euromoney (May 2006) at 8).

In the 1960s, a Canadian academic, Marshall McLulhan built a reputation on his views of modern culture. He is best remembered for the pithy phrase: “the medium is the message”. Nobody quite really knew what McLulhan was getting at. In press coverage of finance and markets, the medium is the only message. McLulhan also understood the value of the secret information that everybody in financial markets covets. “This information is top security. When you have read it destroy yourself”. ________________________________________________

The above is an edited extract from Traders Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives by Satyajit Das (2006, FT - Prentice Hall, London, ISBN 0273 70474 5) available at all good book stores or online at _________________________________________________

Satyajit Das is a specialist in the area of financial derivatives and risk management. He is the author of a number of key reference works on derivatives and risk management. His works include Swaps/ Financial Derivatives Library – Third Edition (2005, John Wiley & Sons) (an 4 volume 4,200 reference work for practitioners on derivatives). He is also the author of Credit Derivatives, CDOs and Structured Credit Products –Third Edition (2005, John Wiley & Sons) and Structured Products & Hybrid Securities – Second Edition (2001, John Wiley & Sons). He is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (forthcoming, April 2006, Pearson Education), an insider's account of derivatives trading and the financial products business filled with black humour and satire. He is also the author (with Jade Novakovic) of In Search of the Pangolin: The Accidental Eco-Tourist (forthcoming, June 2006, New Holland), an unique travel narrative offering passionate and often poignant insights into the natural world and the culture of eco-travel.