The Unlikely is Not Impossible

And sometimes it's even likely. This is a paradox I often find myself wrestling with as a trader, particularly since I like to think I approach the forex market with a statistical mindset. Why do you think I go on about Bollinger Bands so much? They're one of the more statistical indicators out there, based on a measurement of 2 standard deviations from a specified moving average. But if you trade long enough, you discover that your statistical ideas about market behavior often run headlong into the painful realities of how the market actually behaves.

What set me off on this particular tangent was a recent article in The Economist. (Seems I reference them in every other post. Such is intellectual laziness.) It was commenting on the recent volatility in world financial markets, seen in the meltdown of the Chinese stock market, the serious decline in US markets, and similar turbulence in all the other markets I don't really follow. What really got my attention were these remarks about the statistical likeliness (or rather, unlikeliness) of all this marketplace drama:

"According to Goldman Sachs, the latest jump in the Vix (a measure of stockmarket volatility) took it eight standard deviations from its average. If conventional models are correct, such an event should not have happened in the history of the known universe. Then again, the move in energy prices that caused the collapse last year of Amaranth, the hedge fund, was a nine standard-deviation event. [I wrote about the Amaranth collapse a while back, follow that link to learn more about how they screwed up.] Perhaps modellers do not know the universe as well as they would like to think."

Eight standard deviations. Nine standard deviations. These make the 2 deviations of my Bollinger Bands look painfully inadequate to accurately gauge possible market fluctuations. The key of course is that these types of events are extremely unlikely. Just like the global financial implosion triggered by Russia's loan defaults and the devaluation of the Thai baht back in 1997. Extremely unlikely events, and yet they brought Long-Term Capital Management crashing down. [Wrote about them too. Follow the link for more hedge fund meltdown fun. So, got any assets in hedge funds?]

Extremely unlikely, and yet they happened. In fact, if you look at historiy it seems inevitable that extremely unlikely events like these will happen again. So what does that make them - likely? Depending on your timeframe, yes and no (century: likely, month: unlikely). And they're definitely severe enough to include in whatever rosy model you have for trading and investment success. If you live in an earthquake zone (which I do) you don't expect one every day. But you do prepare yourself for the day when the floor starts moving. So how strong is your trading floor?

Related article:
The Economist: Grey Tuesday - An overdue sell-off flusters exchanges and sobers investors

The Trillion Dollar Bet - Lessons from Long Term Capital Management

A while back the PBS series "Nova" did an excellent show called "The Trillion Dollar Bet" on the rise and fall of Long-Term Capital Management (LTCM), a hedge fund founded by Nobel Laureates Myron Scholes and Robert Merton. LTCM placed massive leveraged trades in derivatives (hence the show's title) and then collapsed in truly spectacular fashion in 1998 following economic turmoil in Asia and Russia, and for a brief period threatened to take much of Wall Street with it. You can read the entire transcript online, and it's well worth a look - a fascinating window into how things can go wrong for even the most rigorously calculated and tested financial models.

At the heart of LTCM's implosion, like that of Amaranth Capital, were common problems that every trader should be aware of: the potential for unexpected drawdowns in turbulent market conditions; the fallibility of trading rules and signals that depend on past market behavior and unquestioned assumptions about future behavior; and taking on too much risk through extreme leveraging.

A number of scholars, experienced traders and fund managers appear in the show, and their observations are some of the most valuable insights I took away from it. Here are a few highlights:

Leo Melamed: "You can't ignore an error. Once you realize that you've made an error, the best thing is to get out of that error and start again fresh, and that's what a good trader does."

"That's an old market rule: the market will test you and do what you don't expect it to do."

Stan Jonas: "It was as though the world was behaving exactly the way it had been writ on the blackboard...And then slowly and totally unexpectedly, a change in the market dynamics began to become apparent."

"When do you admit that you're wrong, start all over again, or when do you hang on and assume that the markets will turn around in your way? That's the biggest decision we all have to make."

Roger Lowenstein: "Although their models told them that they shouldn't expect to lose more than 50 million or so on any given day, they began to lose 100 million and more, day after day after day till finally there was one day, four days after Russia defaulted, when they dropped half a billion dollars, 500 million in a single day."

Alan Greenspan: "How much dependence should be placed on financial modeling which for all its sophistication can get too far ahead of human judgment?"

Peter Fisher: "If a random bolt of lightning hits you when you're standing in the middle of the field, that feels like a random event. But if your business is to stand in random fields during lightning storms, then you should anticipate, perhaps a little more robustly, the risks you're taking on."

Related links:
Nova Transcript
Trillion Dollar Bet Website

Related topics:
A Cautionary Tale from an Incautious Hedge Fund
Taking On Excessive Risk

A Cautionary Tale from An Incautious Hedge Fund

Today's New York Times has an interesting article about a hedge fund that's just posted massive ($3 billion) losses on a bad trade involving natural gas. Apparently Amaranth Capital had a position in natural gas futures that took a wrong turn when price spreads failed to increase as expected:

"Amaranth's biggest stake was a combination bet on the spread between natural gas futures prices for March 2007 and those for April 2007. Amaranth had often bet that the spread on that so-called shoulder month — when natural gas inventories stop being drawn down and begin to rise — would increase."

Unfortunately for Amaranth the spread didn't increase, it got smaller.

Without knowing all the details, there are still a number of questions this raises that are worth keeping in mind no matter how large or small your investment:

How much leverage (trading on borrowed funds) was Amaranth using? What percentage of their total capital was at risk in this trade? Did they take too large and too risky a position based on their available funds?

Was there any kind of stop-loss in place to bail out of this trade? If not, why not? It's possible the $3 billion loss was incurred when the position hit a stop-loss, which raises the additional question, was their stop-loss in the right place?

How much personal discretion was involved in placing this trade? Was there a strong emotional investment, aka wishful thinking, that made it more difficult to exit at an earlier point before losses mounted? What statistical & mechanical controls were in place when the trade was placed and when it was exited? Or was someone's gut instinct making the decisions - in which case, their gut and its instincts should be removed from future trading ASAP.

Natural gas is a highly volatile commodity (as well as a volatile gas, though that's not relevant here) - did the traders fully appreciate, and fully calculate, the potential downsides of such volatility?

Were the fund's managers overly attached to this particular commodity - perhaps addicted to its volatility - to the extent that they failed to diversify sufficiently into other markets? To put it another way, were too many of their eggs in one basket?

These are all questions worth asking in your own trading - and if you find the right answers, hopefully you won't be facing a loss of this scale someday!

Related link:
A Hedge Fund's Loss Rattles Nerves