Further to my thoughts on Jesse Livermore and the subprime fiasco, I thought I’d make a near-end-of-year post looking at the biggest winning trade of the year.

The trade I’m talking about is John Paulson’s shorting the subprime credit markets.

Paulson’s NY based hedge funds have made a profit of $12 billion to date on these positions. If Paulson were to take a 25 percent personal cut of the profit, his year’s trading will have netted him a personal fortune of close to $3 billion – the largest personal sum anyone has ever made from a bet on the markets.

In comparison with Paulson’s profit, Jesse Livermore’s $100 million profit from 1929 is no mean feat - worth somewhere between $1 billion and $12 billion when adjusted for inflation.

In fact, Paulson’s personal cut is likely to be lowered as he is believed to share (an unknown) proportion of his earnings with the teams of analysts and traders who help run his funds.

Even in mid-year, before his position had been fully rewarded, Paulson had joined Forbes Rich list – the list of America’s 400 wealthiest people - shooting from nowhere to No. 165, equal with Oprah Winfrey. Paulson’s current position in the Rich List is unknown but it’s certain now to be considerably higher than the more famous Winfrey’s.

In addition to making vast amounts of money, Paulson also seems to share Jesse Livermore’s passion for the good things in life. Like Livermore, Paulson enjoys sailing and – according to Bloomberg - he lives in a 28,000-square-foot, or 2,600-square-meter, $14.7 million home off Fifth Avenue

When Paulson was raising money last summer, he claimed that “in his entire career he’s never seen such a big opportunity.”

Kyle Bass, who runs Hayman Capital, a Texas hedge fund, is quoted by the Financial Times saying the short credit trade is “by far the best risk/reward position I have ever seen”. One of Paulson’s investors told the FT: “He’s really made a lot of money out of what has in essence been quite a conservative bet. There’s no doubt it’s been one of the greatest trades of all time.”

At the end of September Paulson told investors he saw “only” a further 30 to 40 percent in the trade – and it made almost 22 per cent in October.

Paulson took positions based on buying credit default swaps on mortgages. The value of these instruments increases as the risk of default increases.

Arpad Busson is another hedge fund manager with a taste for the high life. He is one of Elle Macpherson’s former partners and has been romantically linked with actress Uma Thurman. Busson’s EIM group has money with Paulson.

According to Busson the great merit of Paulson’s trade was not merely the prediction of the crisis, but also the execution of the trades. Paulson – and several other managers – constructed complex portfolios of the instruments they believed would be worst-hit, rather than just shorting an index.

Here’s a guest post from Jim Wallace. Jim noticed in one of my former blog posts that I used to teach physics. He thought I’d be interested in this summary of a BBC Radio item about mathematics in finance.

London has become an international centre for the world’s most talented mathematicians, who try to make fortunes writing financial models and trading algorithms for hedge funds and investment banks.

These mathematicians are employed as quants (Quantitative Analysts).

William Hooper says he fell in love with mathematics at university. He then came up with an idea to apply his skills to foreign exchange deals.

He analyses forex data from the previous 12 months and writes computer models to identify and quantify relationships in the data. He then writes an algorithm to make profitable forex trades based on the relationships.

Provided the algorithm is running profitably, William spends his time attempting to make it more profitable. In practice he says he has plenty of time for vacations and visits the gym – it’s a nice way to trade.

Although he would not directly say how much he was paid, William said that the general rule is that quants are paid about 20 percent of the profit they make. Typical algorithmic traders make annual profits for their banks/funds of $10 to $20 million.

William said his own model doesn’t make astronomical amounts of money – some can make sums of the order of a billion dollars per annum. These, however, are riskier models than can lose two billion the year after they have made a billion.

David Harding – who runs the hedge fund Winton Capital Management - studied theoretical physics at Cambridge. Winton trades world wide futures markets using a proprietary model based on a statistical model of market behaviour.

David Harding entered the financial sector in the early nineteen eighties, when few people thought there was any special place for mathematics in trading. That soon began to change and by the mid-nineteen eighties, increasing numbers of mathematicians and scientists were moving into trading and investing.

He says Winton Capital employs some very “improbable” types of people – people who are lacking in social skills but are very focussed researchers. Winton requires that people are clever and obsessively interested in researching areas of interest to the firm.

The lack of social skills will not suit all firms however. Many banks need mathematicians who are able to communicate their ideas to less numerate colleagues.

You can listen to the interview here:

http://news.bbc.co.uk/player/nol/newsid_7090000/newsid_7099200/7099200.stm?bw=nb&mp=wm&news=1&ms3=6&ms_javascript=true&bbcws=2

Jim Wallace

“I knew the market was going to take a hit, I just shorted it too early.”

I’ve heard too many traders say this – or something like it.

If you’re a member of the “I was right but my timing was wrong” crowd, think about these examples:

1. “I told everyone that the sun was rising in London. If I’d waited just another three hours, I’d have been right.”

2. “I told my friend I’d catch the afternoon flight. If I’d reached the airport by 3pm, I’d have been right.”

3. “I predicted a Democrat would win the election. If I’d waited eight years, I’d have been right.”

I was right but my timing was wrong. Better just say, I was wrong.

After taking a big loss on one occasion, Jesse Livermore said of his error:

“I didn’t wait to determine whether or not the time was right for plunging on the bear side. On the one occasion when I should have invoked the aid of my tape-reading I didn’t do it. That is how I came to learn that even when one is properly bearish at the very beginning of a bear market it is well not to begin selling in bulk until there is no danger of the engine back-firing.”

Jesse is saying that if you don’t get both the direction and the timing of the trade correct, then you’re wrong. You should only take a position after the market direction has been confirmed.

Jesse Livermore, one of the greatest stock traders in history, made his biggest market killings when he shorted stocks. In particular, he made $100 million (worth more than $1 billion in today’s money) when he shorted the market in 1929.

Non-expert traders should be reluctant to short stocks though, without very great cause. Here are some reasons why short trades are riskier than long trades:

Why you should think Twice Before Shorting

1. When a long goes against you, your position size falls. When a short goes against you, your position size rises, increasing your risk.
2. A rising stock market serves the interests of society’s most influential people - business owners and governments. They will lobby and legislate for conditions in which businesses and wealth creation can prosper. Notice how central banks cut interest rates when economic conditions take a downward turn.
3. Business owners and managers work hard to make their businesses succeed. Their desire to increase their profits usually results in rising stock prices.
4. The long-term charts of the Dow, S&P500 and the NASDAQ reflect points 2. and 3. The long-term direction is upward. When you short, you go against the natural, long-term market trend.
5. Long positions can result in 100% loss of your stake. Short positions can lose you an unlimited amount.

Every serious trader should have shorting as a stock trading tactic – but it’s a tactic that requires greater caution than going long.

Napoleon, when hearing good things about potential senior officers liked to ask, “but is he lucky”?

I’ve known people who have traded the markets for years with only red ink to show for it. From a technical standpoint they seem to know what they’re doing, but they are just unlucky. Or are they?

Napoleon’s question was astute because it’s possible for someone to apparently know what they’re doing but, in the heat of the battle (or in the middle of a trade) deficiencies emerge resulting in defeat. Someone who in battle or trading seems to be consistently lucky is either very good at what they do or is enjoying improbably good fortune.

When someone commented on how lucky he’d been, Arnold Palmer replied:

“It’s a funny thing, the more I practice the luckier I get.”

Unfortunately, this doesn’t seem to work for would-be traders who lose money without fail. No matter how much they practice, they can’t seem to trade consistently profitably.

Clearly the consistently lucky battlefield commander or trader enjoys an edge on his less fortunate colleagues.

Jesse Livermore - in contrast to many self-made men - was happy to put some of his successes down to luck.

Of his 1915/16 comeback from bankruptcy, and his $3 million profit, he said:

“I was very lucky. I was rampantly bullish in a wild bull market. Things were certainly coming my way so that there wasn’t anything to do but to make money.”

And

“As you may remember, I was busy ‘coming back’ in 1915. The boom in stocks was there and it was my duty to utilize it. My safest, easiest and quickest big play was in the stock market, and I was lucky, as you know.”

Speaking of luck in more general terms, he said:

“Of course, if a man is both wise and lucky, he will not make the same mistake twice. But he will make any one of the ten thousand brothers or cousins of the original. The mistake family is so large that there is always one of them around when you want to see what you can do in the fool-play line.”

Avoiding Mistakes

Jesse is pointing out that successful traders need to minimize mistakes. It’s the same in war, or in sports contests. Most battles and sports games are not won by moments of genius - these are few and far between. The contestants who make fewest errors win most contests.

The “lucky” trader is one who minimizes mistakes AND, if they do make a mistake, acts to minimize the damage by exiting from the situation quickly. In practice this means having a written plan for each trade you enter, the most important element of which is the stop-loss.

Quick Thinking

Christian Siva-Jothy was Head of Proprietary Trading with Goldman Sachs. (Prop trading is when firms trade for themselves rather than on behalf of customers for fees.)

Siva-Jothy made his name on seemingly high-risk trades he made in the immediate wake of the first airliner crash into the World Trade Center in 2001.

“The first thing I noticed on the TV was that it was a perfectly clear blue sky day. I’m a helicopter pilot and I’ve been flying for 14 years. I know that when you’ve got a plane that’s going down, you don’t aim for the tallest building to fly into.

“I immediately thought, ‘terrorist act’. I figured this was going to whack consumer sentiment… I bought Eurodollars…

Markets can be Unbelievably Slow to React

“Strangely, I think they rallied no more than 13 basis points on the day. Markets can be unbelievably slow to figure out the consequences of big events.”

The capacity of markets to react slowly to events was also noted by Jesse Livermore, who said:

“The Street paid no attention to the earthquake the first day or two. They’ll tell you that it was because the first dispatches were not so alarming, but I think it was because it took so long to change the point of view of the public toward the securities markets. Even the professional traders for the most part were slow and shortsighted.”

Christian Siva-Jothy’s Favorite Book - Reminiscences of a Stock Operator

Interestingly enough, it turns out that Christian Siva-Jothy is well acquainted with Jesse Livermore. When asked – by Steven Drobny, in The House of Money – “Are there any books that you recommend to your traders,” Siva-Jothy responded:

“My favorite book in relation to markets is Reminiscences of a Stock Operator, by Edwin Lefèvre. I’ve probably read it four or five times, and I love it every time I read it. He talks about everything, about risk, about hubris, about passion, everything.”