Wednesday, April 29, 2009

Eric Rosenfeld Lecture about LTCM

If you haven't yet caught it, you should run - don't walk - over to Zero Hedge and check out this approximately 90 minute video of Eric Rosenfeld giving a lecture about the LTCM collapse back in 1998. Fascinating insider's view. The comments over at Zero Hedge, as expected, are acerbic but many are enlightening and worth a read.

I know I will be revisiting this again shortly, as I found the entire lecture interesting. While I'm sure Rosenfeld mixes and mis-uses some vocabulary and concepts, all in all I think there are definite lessons here. The biggest, of course, as we've learned in the last 2 years, is that in times of stress, all correlations go to 1. However, I want to reconsider the endogenous risks that Tyler @ Zero Hedge mentions. I'll definitely watch this again soon, maybe after my nap this morning.

I think the leverage factor, which has been widely associated with the LTCM implosion, bears added consideration. Recently, Accrued Interest made the point that leverage isn't what kills; bad investments kill. Clearly, this is true. However, leverage has the force multiplier effect and can transfer an innocuous loss into a catastrophe. Eric's lecture covers what he calls the 10 biggest myths and misconceptions about LTCM, and yes, they did hit 300x leverage at various points, according to him. However, it did not occur for the reasons you might have suspected. It adds a bit more color to the whole conversation. I know that, in my own mind, I vilified LTCM for such egregious use of leverage. Seems I was mistaken.

Finally, we're all familiar with the idea of prime brokerages frontrunning their hedge fund clients. As I think I have previously mentioned, I think there may be an opportunity for a 3rd party prime brokerage business to emerge, or even for trustees and custodial banks to subtly move into the space. State Street and Bank of New York Mellon are the obvious candidates, as they already have large custodial and administration businesses, so why not move up the value chain and entrench yourself further with you customers (for additional fees, of course). However, there's a startup opportunity in there too, I believe.

Anyway, go check it out. Good stuff for us finance geeks, anyway.

Until next time...

Thursday, April 23, 2009

The Hidden Risks of a Central Counterparty in CDSland

If you didn't catch it yesterday,'s Alphaville had a great piece about why a central CDS (credit default swap) counterparty (read: exchange or clearinghouse) might not work as well as everyone thinks it would. While I still think it necessary, it's obvious that the idea needs work. Specifically, it needs to be integrated with existing clearinghouses/central counterparties to make sure that cross-exposures are appropriately netted.

The piece also raises the point that CDS account for only 11% of the OTC (over the counter, or dealer-to-dealer) derivatives market.

Again, putting CDS trading on an exchange or other central counterparty is important, but at most only 40% of trades might move to such a central counterparty. CDS are not standardized, and standardization removes profit which is why B/Ds are loathe to do it. It needs to be done though, to bring as much of the shadow banking system into the light (along with many other moves, however, like re-splitting commercial and investment banks a la Glass-Steagall, as I previously mentioned). The more trades in a central location, the better. There will always be OTC trading, but it should be for the most esoteric and specialized -- and hopefully rare -- trades.

Monday, April 13, 2009

Trading Report: Risk Management

This report will describe the lessons learned from my experience trading DXO, the PowerShares DB Crude Oil Double Long ETN (exchange traded note). Hopefully my experiences will serve as a warning and a guideline to those of you reading this. We should always seek to learn from our mistakes, and to make new ones as opposed to making the same ones repeatedly.

After my previous experience trading DXO, I figured I could use it as a vehicle for some trading gains. I believe in the long term thesis around commodities, and oil in particular. I think that $200 oil and $5 gasoline are eventualities in the US. I chose DXO as the vehicle because of its extremely low price and embedded leverage, making it, as @marketfolly remarked "a call option on oil". Nice!

The problems with this particular idea were manifold. First, DXO is an exchange traded note as opposed to being an exchange traded fund. If, for some reason, the sponsor were to go bankrupt or some other restructuring, the holder of DXO becomes an unsecured creditor of the sponsor. That adds counterparty and credit risk to the inherent market risk. Over on the Market Folly blog, there was a guest post by @tradefast which covered some of the details of trading oil via ETFs and ETNs, including the counterparty risk issues. That guest post is a must read!

The next problem is that DXO is a double long ETN. It seeks to replicate 2x the movement of its underlying index. For example, if the index moves 1% up on a given trading day, DXO should move 2%. Thankfully, in the case of DXO, this calculation is done on a monthly basis as opposed to daily, making DXO slightly less volatile than it could otherwise be.

My first, and probably biggest, mistake in wielding DXO as a trading vehicle was to not use stops. I really have no excuse for such an egregiously stupid act, and the market punished me accordingly.
Generally, my stops on DXO ended up being far too tight, and I would get stopped out much sooner than I really had a tolerance for. Either that or I would get stopped out right before a bottom. While setting proper stops on DXO is difficult due to the high volatility, at least having them in place would have (possibly) prevented the $6000 meltdown that I experienced.

The second problem I introduced was using bad position sizing. This may be the most critical failure. Given the price range DXO was trading in at the time (January - mid February 2009), I accumulated a sizable block of shares, somewhere in the neighborhood of 6000. This represented at least 50% and probably closer to 60% of the assets in my brokerage account. What's even worse, I had this oversize position on a security which essentially acted as a call option! This increased the overall volatility of my portfolio and created more stress than anything. It was a completely irresponsible action on my part.

My third problem was failing to construct a proper trading plan."Plan your work, work your plan." Simple, right? Not if you don't create the plan! I was trading DXO by the seat of my pants, and thus, by emotion instead of trading it in accordance with the plan I constructed. This caused me to buy at bad times, sell at bad times, and generally overtrade. Overtrading is the quickest way to deplete your funds, it seems to me. But the biggest issue with failing to construct a proper trading plan - and adhere to it - was being swept up in the daily volatility and gyrations of DXO. For a security that moves as violently as DXO, with built-in leverage to boot, you absolutely must have resolve in your idea. If the facts change enough to warrant getting out of the trade, then so be it. All of that is testable against your plan, however. If the market conditions, when compared to the plan, tell you not to do anything, then you don't. If they do, then you do. The trading plans adds clarity, focus and structure to what can easily spiral out of control into a emotional quagmire.

So, all of that said, what practices can be put into place to prevent these mistakes from recurring?

First, creating a trading journal is a must. Dr. Brett Steenbarger talks about this here. There's really nothing more for me to say on the topic.

Second, no day or swing trades will be undertaken without an accompanying trading plan. Long(er) term position trades or investments (12+ month time horizons) won't require this level of detail to enter the position. There would be nothing wrong with doing so, though. The trading plan is a tool to enforce discipline in the face of emotion. Since the emotion, for me, is a much stronger factor when dealing with the short term trades, I will focus on optimizing my routines for those cases first.

Third, I have created a new rule that any trade, long or short, will be made with an accompanying stop/loss order set. Discipline is required to keep up with this one, at least until I change to a new broker. My current online broker (who shall remain nameless to protect the guilty) sucks but there's little I can do about that at the moment.

I may delve further into this topic and the specific actions I took that led to this point. Deconstructing them may be instructional. But for now, I hope this analysis is interesting and useful to someone.

Until next time...

Friday, April 10, 2009

Goal Status and Updates - 1Q2009

The first quarter was a bit of a mixed bag. On one goals, I exceeded anything I could have imagined possible. All of the others were failures, at varying levels. :( Anyway, now I have some things to refocus on for Q2.

Business: Finish writing e-book by 9 Jan 2009. Publish by 16 Jan 2009. FAIL.
Business: Make 3 contacts during Money:Tech 2009 (6 Feb 2009).
Personal: Ride a blue trail by 31 March 2009. FAIL.
Professional: Find and accept an offer for an awesome new career opportunity by 31 March 2009 (end of 1Q2009). FAIL.
Fitness: Achieve 10% body fat by 31 Mar 2009 (end of 1Q2009). SURPASSED.
Fitness: 25 dips, full extension, full body weight by 31 Mar 2009 (end of 1Q2009). FAIL.

So let's break these down quickly. Money:Tech 2009 was canceled, somewhat unceremoniously, by O'Reilly. So there was no way I was going to accomplish that goal, even though I had my registration in order and was seeking a place to stay for those days when I was informed of the cancellation.

I am moving my "ride a blue trail" goal to the end of the year. I thought I'd ridden a blue trail at Whitetail on my last trip there, but it turned out to be a green. So I decided to take a break to refresh before tackling a real blue. Well, like an idiot, I ended up riding another green 2 or 3 more times (because it was just so fun, and the conditions at season end were amazingly good). Those runs totally crushed my legs, though. I should have just ridden the blue first, but by riding the green, I totally subverted the achievement of my own goal. It just goes to show that most of the time, you just get in your own way in life. :\

I'm still not sure if I will finish the e-book. The economic/financial crisis has been dissected to death, and there will be tons more in the future. This crisis is on its way to be becoming a Harvard Business School case study! So, although my e-book sought to be comprehensive in explaining the crisis as well as delving into practical solutions for real people to survive, thrive and prosper through it's aftermath, I don't know if I can do better than what has already come out. (Or will come out in the future.) I may still do it, just for my own personal edification, but I'm unsure at this point.

With my goal of 25 dips, I came close but as my father is fond of saying, "close only counts in hand grenades and horseshoes". During my workout, I normally do sets of 15 reps of dips, but I was (until recently) doing 6 sets. That works out to 90 dips over the course of a session. So I thought the 25 in a row would be easy to do. Man, was I ever wrong! I failed at rep 17, then again at rep 22. Since I did not make it straight through, I am calling this a FAIL even though the definition of success is my own. I could rightfully call it a pass, since I did get all 25 dips. I'll move this goal to later in the year as well, and spend more time preparing.

My 10% body fat goal was my only success, but given the rather aggressive fitness goals I set, it is amazing that I reached it when I did. Actually, I made it to 8.4% body fat before the end of January, IIRC. It definitely was measured before the end of February. If you look at my original 2009 goals list, the date by which to achieve 8% body fat was 31 December. So I basically crushed this goal, and almost achieved my annual goal before the end of the Q1. I can see my sixpack coming into focus, and I haven't even gotten serious about sculpting my body yet. Talk about inspiring!

Finally, I did not find a new career opportunity. Not even close. I dither on whether to continue pursuing this goal at this time. I have other projects I would like to spend more time on, and my job suits my lifestyle perfectly well. While it often annoys the hell out of me, it's an easy job, with a solid company, decent benefits, amazing hours, and I work with people I generally like doing something I generally like. The only real problems are that I think the organization is misguided and confused, and management above my direct manager is ineffective and highly politicized.


Time to get to work!

Here's my updated list of goals for the remainder of this year:

Personal: Cook 1 meal per week by 30 Jun 2009 (end of 2Q2009).
Business: Finish unwinding my real estate partnership by 30 Jun 2009 (end of 2Q2009).
Fitness: 1 hr of cardio on the Precor EFX 556 in interval mode by 30 Jun 2009 (end of 2Q2009).
Fitness: 10 wide grip pull ups, full body weight, by 30 Jun 2009 (end of 2Q2009).
Fitness: 25 dips, full extension, full body weight by 31 Mar 2009 (end of 2Q2009).
Personal: Save $15,000 for house down payment by 30 Sep 2009 (end of 3Q2009).
Personal: Read 1 book per month (12 total) by 31 Dec 2009.
Personal: Accumulate $30,000 in emergency funds by 31 Dec 2009.
Personal: Achieve $90,000 in net worth by 31 Dec 2009.
Personal: Pay AmEx down to $0.00 by 31 Dec 2009.
Personal: Ride a blue trail by 31 March 2009.


Fitness: Achieve a visible sixpack by 30 Sep 2009 (end of 3Q2009).
Personal: Achieve $150,000 in net worth by 31 Dec 2009.
Personal: Read 1 book per week (52 total) by 31 Dec 2009.
Fitness: Achieve 8% body fat by 31 Dec 2009.
Fitness: Chest press 200 lbs for 15 reps by 31 Dec 2009.
Fitness: 1 hr of cardio on Precor EFX 556 in hill climb mode by 31 Dec 2009.
Personal: Accumulate $50,000 in emergency funds by 31 Dec 2009.

Until next time...