The Trading Game: Where Losers Can Win and Lose Again
Swing big. Lose big. Get another chance to swing big again. This concept has always astounded me, dating back to Howard Rubin’s legendary $377 million swan dive back in May 1987, the year I began my Wall Street career. Mr. Rubin was a successful young mortgage trader at Salomon, jumped ship to make real money (around $1 million per year) at Merrill, and within two years dropped almost $400 large through unauthorized trading at a time when this was real money. I remember that when this happened, Wall Street and the entire financial community was shocked. Stunned. The magnitude of the loss was simply incomprehensible. The combination of hiding such massive trades on Mr. Rubin’s part and abysmal risk management on Merrill management’s part created a toxic brew that caused the largest loss of its kind that anyone could remember. Yet somehow, some way, the fact that Mr. Rubin took a massive gamble on complex securities (PO mortgage strips, as I recall), was less than honest about his positions and lost huge, earned him a job at Bear Stearns less than six months later. Huh? Where could this possibly happen? Answer: Wall Street.
This phenomenon has been repeated again and again in the financial markets, much to my amazement. Now I fully admit that great traders can get carried out from time to time, but there is carried out and there is having a near-death experience. I’d say that if Mr. Rubin’s experience isn’t as close to death as you can get in the markets, I don’t know what is, yet he was able to get another top firm to take him on even in light of his alleged ethical and risk management lapses. And how do you explain the nine lives of Victor Niederhoffer, the man who has gone from boom to bust and back again more times than the US economy since the Articles of Confederation? From trading wunderkind on his own to being one of George Soros’s top guys to having his own firm once again, Mr. Niederhoffer’s strategy has been incredibly volatile and often very profitable, just before it blows up and forces him to close down. Yet the money comes back. Now that he closed down again after dropping 75%, even he may have to throw in the towel for good. Don’t get me wrong: it’s not that Mr. Niederhoffer isn’t an incredibly brilliant man and a legendary trader, but there is something fundamentally wrong with generating 40-50% returns for four years and then blowing up. There is always an excuse, there is always a reason. But bottom line: there are plenty of traders that make great money and don’t blow up. Yet so many that do just keep on coming back.
And what about all the Amaranth veterans (those in some way associated with the $6.6 billion melt-down) who litter the Street after the firm’s demise last year? Some of them have gotten huge books and are running massive risk, like the gents at Moore Capital who just dropped 15% in November in their Canadian book. Now these guys aren’t Brian Hunter, but there were clearly systemic risk management problems at Amaranth and the trader leading the Canadian effort was a senior guy at the firm. He had been at Moore for around a year. My question is what were his risk limits and how was his exposure being monitored? Because dropping $150 million isn’t awful when looked at in a vacuum; it depends how much capital this loss is related to and the strategy that sustained the loss. $3 billion portfolio, 5% loss, concentrated long/short equity book that runs net long, ok. I can see that. But $150 million on $1 billion in capital in a convertible bond/equity book? Something just isn’t right in this picture. Wouldn’t you think that the new guys coming from a firm with a highly questionable past, even if they are great, would have somewhat tighter risk limits than those evident in this situation? I’d think so. But hey, maybe I’m just a little too cynical.
I am not a trader. I have managed traders. And I understand that finding great traders is incredibly hard. And I also know that being able to sustain a loss, a big loss, and bounce back is a necessary ingredient for a great trader. Problem is, the mere ability to lose hundreds of millions and wake up in the morning does not a great trader make. Good risk management along with great investing have to go hand in hand. Now some volatile strategies like CTAs and super-concentrated long-only portfolios will suffer big drawdowns by their nature. But that is part and parcel of those strategies. But some of the legendary losses that have resulted in second and third chances have, to me, been reflective of fundamental problems with risk management and bet sizing. And this means that the traders may not be as great as they seem when things are good; it is only that they are taking out-sized risks to generate these returns. But it appears that Wall Street and professional investors time and time again make the same mistakes. I just don’t get it. Maybe I never will.
