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

Don't Be Afraid to Start Small

Happy 2007! As I head into this new year I've been thinking about how I first got into forex, which was only a year and a half ago, and what advice I might be able to pass on to someone who's put "learn forex" on their list of New Year's resolutions. And one of the first things that came to mind is something I think it's safe to say is on every trader's mind: money.

When I got started, one of the most intimidating things about the forex market for me was the amounts of money involved. Just about any forex tutorial you come across online mentions those trillions and trillions of dollars that flow through the market every day, and if you read enough forex articles and forum posts you'll invariably come across tales of massive bets made by big currency players. And if you read enough of this stuff it's not long before your little stake of a few hundred or a few thousand dollars starts to look pretty puny. It's not the greatest feeling being a very little fish in a very big pond. How are you ever going to turn your tiny forex fund into enough money to retire early, put your kids through college, or buy that solid gold house you've always wanted, as the case may be?

My reply to such monetary anxieties is simple: don't be afraid to start small. In the long-term progress of your forex career, how much you start with is certainly a contributing factor, but it's far, far, far from being the most important one. What's vastly more important is how you manage, allocate, and trade with those funds. Here's why:

• Someone with $500 and a robust, well tested trading system, a highly disciplined approach to trading, and a risk management strategy focused on capital preservation and sustainable levels of risk, can make a lot more in the long run than someone with $50,000 and none of these virtues.
  
  
• Familiarize yourself with fixed fractional strategies for allocating your trading funds. In forex, the potential for compounding your profits is incredible. This is not the 3% in your savings account compounded monthly; depending on your trading strategy, you could be compounding your profits daily or even a few times a day. Play around with some compounding formulas on your calculator, even with very low profit margins and a small starting balance, and the results will get your attention in a hurry.
  


• Leverage: your forex broker will extend you a certain amount of leverage that allows you to make trades with amounts of money several times larger than your actual account balance. So you have more power in the market than you think. But keep in mind this is a double-edged sword, and high levels of leverage enable you to take on high levels of risk. To paraphrase Star Wars, "Use the Force [leverage] wisely, young Jedi!"
  


• Starting small means you won't dig as deeply into your savings (or even worse, go into debt), and having a more modest sum at risk will give you a lot less to worry about as you find your footing as a forex trader. Worrying less means you're less likely to panic when things go wrong. And being less likely to panic means you'll make better trading decisions.
  
  
• Remember learning to swim? The shallow end was always the safest place to get your feet wet for the first time. The same goes with forex. It's much better to learn good trading habits with a small forex fund than make a huge deposit and go doggy-paddling into the deep end on your first day.
  
  
• Your funds are a trading tool, just like your charts and the indicators you choose to display on them. Your main focus should be on using them intelligently and consistently - not on how many there are, how cool they look, or how many monitors they're displayed on.
  

How do I know all this? Well, I started small myself, and knowing what I know now (which is not a lot, but it's not nothing, either) I'd definitely start that way again.

Happy New Year - hope yours is a prosperous one!