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running into the pit to tell their employers that the Hunt brothers’ brokerwas walking into the pit. The natural course of action would have been toimmediately buy the market, knowing full well that this broker was about tobuy everything in the pit and take the market limit up. Some clerks were toldto not even bother getting to the trader; instead, they were instructed to runto the pit and place an order to buy as many as 50 contracts if they saw himwalking toward the pit. This is one deﬁnition of understanding order ﬂow.The traders who made a fortune on the back of the Hunt brothers’ attemptedcorner were shrewd enough to understand the nature of the market andorder ﬂow and capitalize on the price aberration they knew was coming.
The exchanges, realizing that there was an attempt at a corner of thesilver supply, changed the rules, making any transaction “liquidation only.”That is, no one was allowed to establish a new position in the futures mar-ket. This was done for a variety of reasons, the most important one beingthat the members of the exchanges were the ones taking the other sideof the trades. As the Hunts were taking delivery on the silver contracts, itwas the market makers and liquidity providers who were getting squeezed.The Hunts were highly leveraged in their strategy and began to look forassistance in maintaining the price at an artiﬁcially high level. They decidedto collateralize further purchases of silver futures with silver bonds, whichthey would issue.
The story is that they were meeting with a group of Swiss bankers on oraround March 26, 1980, asking for capital to cover margin calls generatedby a break in the price of silver down to $21.62. The previous few monthshad seen the price move sharply lower, creating a ﬁnancial dilemma forNelson and William Hunt and their partners. They presented a plan thatcollateralized the loan they were requesting with silver certiﬁcates theywould structure and offer to the institution. The Swiss bankers listened tothe presentation, asked the Hunt entourage to step out of the room, andproceeded to sell silver futures. If they were planning on using silver toback a margin call, what would happen if the price continued to decline?The following day, March 27, was known as Silver Thursday. Silver movedfrom $21.62 down to $10.80, a whopping 50 percent decline in one day!Traders who continued to follow the strategy of buying the market everytime the Hunt brothers’ broker emerged found it to be a costly lesson.
INFORMATION CAN BE DANGEROUS
Squeezes and attempted cornering of markets have been around as longas markets have traded. The key is to be able to identify the move and,more important, understand when it might be over. There are a number oftraders who still look at the world in a myopic way. They feel that the only
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good information is the type that revolves around the ego gratiﬁcation thatis the basis of any attempted corner. They are constantly on watch for abuyer of pork bellies or sugar, hoping to ﬁnd a pattern that would suggesta squeeze. As narrow-minded as that type of thinking might be, these arethe traders who have been around for decades and understand the powerof good information. But there is one thing that all of them will agree on: Alittle information can be a dangerous thing!
There are times when having a little bit of information can be a recipefor disaster. In the early 1960s, the commodities markets were hit with anumber of squeezes and attempted corners. This was before the regulatoryscrutiny that exists today, and many of the commodities traded were at themercy of a few individuals who controlled the pricing. One such commoditywas salad oil, which traded in Chicago. The Allied Crude Vegetable OilReﬁning Company was controlled by a man named Tino DeAngelis. Hewas the president of the company and had formed the entity in order tobuy surplus vegetable oil from the government and sell it as an exportedproduct overseas.
Allied was borrowing millions of dollars, which it used to speculateon vegetable oil in the futures markets. DeAngelis was securing the loanswith the salad oil that Allied had in its possession, much like what theHunt brothers tried to do years later. According to the American Bureau ofStatistics, the reported amount of salad oil in Allied’s possession was largerthan the country’s entire production! But even with all the noise aroundthem, no traders understood what was happening, except one: Ralph Peters!As I mentioned earlier in the book, Ralph Peters had the one of the great-est information networks ever created by any Chicago trader. His sourcesranged from high-level diplomats to the lowest maintenance workers. AsAllied continued to buy salad oil, Peters put the network to use. He foundout that the loans that were being issued to Allied were being collateralizedwith the salad oil holdings at a facility deep in the South. He quickly took atrip to the facility to see for himself that the salad oil was there and that theposition he was in—namely, long salad oil futures—was correct.
He took some comfort in the fact that the bank examiners were there atthe same time checking on the tanks and making sure they were full. Theydid this by opening the top of the tank and dipping a stick 6 to 12 inchesdown to make sure the oil was there. Ralph located a man named Jimmywho worked the yard and became his contact for the grounds. He askedJimmy to keep an eye on the place and if he noticed anything out of theordinary—anything at all—to give him a call immediately.
Peters ﬂew back to Chicago feeling good; he had identiﬁed a squeezeand had checked on the product, which gave him all the conﬁdence thathe was in a highly proﬁtable position. A couple of days later, the phonerang and it was Jimmy warning him that something didn’t seem right. He
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said that he had been employed at the facility for over 20 years and had ahabit of banging on the tanks as he made his rounds. Being a musician, herealized that the pitch of each tank was a little different than it had ever beenbefore. The tanks didn’t sound empty, just different. Where others mighthave disregarded this as insigniﬁcant, Peters sensed a problem and spranginto action. He ﬂew down to see Jimmy immediately. He had a large chunkof his net worth tied up in the position and anything out of the ordinary wasenough to warrant an inspection.
He met Jimmy at the tanks and they discussed the situation. Theywalked around the lot and banged on the tanks together. Jimmy said thatthe only other time he could remember hearing a sound like that come froma tank was when they once ﬁlled it with water for cleaning. Peters smelleda rat. He asked Jimmy to open the tank so he could see the product forhimself. Jimmy, realizing that the $50 a week he was getting for supplyinginformation to Peters might not warrant losing his job, refused. After a cou-ple of minutes of negotiations (it was very difﬁcult to say no to Peters), theprice was $200 to open the tank for an inspection.
Looking into the tank, they saw the same thing the bank examinershad seen—oil! They dipped the sticks down 6 inches, then 12 inches, andstill nothing but salad oil. Then Peters had the idea to use a longer stick,a yardstick, to dip into the tank. As the stick came out of the tank, theylooked at each other in disbelief. Below the top 12 inches of oil was nothingbut water. Allied had put the salad oil on top of the water, knowing thatit would ﬂoat and create the impression that the tank was full of oil. Thehoax had even fooled the banks and investment houses that offered creditto DeAngelis and Allied so they could maintain their positions in the futuresmarkets. Peters jumped from the tank and ﬂew back to Chicago. He hadinformation that no one else had . . . at least not yet. He knew that he hadjust uncovered one of the largest scandals to ever hit the commoditiesmarkets, but was he the only one who knew?
When the market opened the following day, Peters dumped the entireposition to the eager buyer—Allied. Peters sold his long position and beganto get short slowly. Then the news hit. The tanks that were being used tosecure the loans for further purchases of futures contracts and physical oilwere ﬁlled with water. The loans were secured with nothing at all!
News of the scandal drove traders into a frenzy. The market began tolose all the momentum created by DeAngelis’s attempts at a corner, andAllied went under. DeAngelis went to prison for the crime, and it nearlytook down two major brokerage houses of the day. But Peters had the rightinformation. He had the network to tap into and, more important, knewwhen to use it effectively. Peters had known that a little information canbe a dangerous thing. He was shrewd enough to identify when an apparentsqueeze was taking place and had the network to let him know it was all
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a hoax. Peters’s advice all those years ago was right on the money: Knowyour market!
THE INFORMATION NETWORK
Building a network for information is, perhaps, the most powerful tooltraders can create for themselves. Everyone wants to know the right people,but how does one get to know who they are—and how to get them totalk! This is a question I ask everyday as I talk to portfolio managers andbrokers searching for a hint of what might lie ahead. I usually walk the ﬂoor,tapping into sources for information that I know are reliable. It’s easy to getinformation; it’s hard to get reliable information. I try to ﬁnd individuals whohave a vast understanding of market structure and know what it feels like torisk their own capital. It’s better to talk with individuals who risk their owncapital rather than an analyst or a technician because the emotions aren’t thesame. In order to get a feel for why a trader puts on a particular position inthe market, it’s important to understand the fundamental emotions behindthe trade. Using logic and doing homework are necessary tasks in forminga high-percentage trade, but it’s basic human emotion that drives the actualdecision.
The question that all new traders should ask themselves is “How doesone create this network of information?” After all, not everyone has accessto portfolio managers and brokers to talk with on a daily basis. The realityis that everything you might need in the way of information is availableat all times. It’s more a question of ﬁltering out the noise and ﬁnding theessential truth, As traders, or simply as human beings, we are all searchingfor the truth. Whether it be metaphysically or ﬁnancially, the search for thetruth never ends—rather, it’s a dynamic part of human behavior. But we’retaught to think critically—don’t trust everything you read! The empiricaltheory of knowledge posits that man by deﬁnition is fallible; therefore, anyknowledge attained is subject to fallibility. If that’s true, then how do weknow what to believe and what to discard as rubbish?
At a certain time in every trader’s career, the person is asked to takea leap of faith. The ultimate leap is when you put on the ﬁrst position inthe market knowing that your capital is now at risk. Information sourcesare no different. After doing the necessary due diligence, such as mentallymonitoring performance, then it becomes necessary for a trader to take aquasi leap of faith and rely on a source for information. This source mightbe a reporter on television (keeping in mind that, like Rick Santelli, manyreporters are former traders and brokers) or it might be less obvious, forexample, your local banker. It should come as no surprise that bankersoften maintain a conservative outlook on the economy but can be insightfulin their understanding of the retail public. In all honesty, your information
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source could be anyone in the ﬁnancial services industry. I take that leapeveryday when I get the information I need from my sources. If I ﬁnd thatsomeone is consistently wrong, I’ll still keep the person in my loop as longas the person’s logic is correct. Having a devil’s advocate in every group isan important part of the process. In order to truly understand the beast,then all sides of the story must be known.
Coming from a liberal arts background, the thought of searching for thetruth brought back fond memories of the philosophy and theology coursesthat were a huge part of my Loyola curriculum. The Jesuits trained us torealize that there is one absolute truth and the quest to ﬁnd that truth shouldnever end. When I encountered traders with pure mathematical minds, Ibegan to realize that there are different types of truth. The metaphysicaltruth I was trained to search for was much different from the absolute truthderived through pure mathematics.
What I mean is that in the market, there are many truths. The marketwill go up! The market will go down! Every day there is a new truth thatunfolds. This concept is an inherent part of looking for the right information.The most common misconception is that information is different dependingon when and where you are when you receive it—nothing could be furtherfrom the truth!
One thing that everyone must understand is that stories can change,but numbers can’t. Once a trade is made in the pits or on the screen, it goesout to the rest of the world and is recorded for all time. People often seethe market information they are getting as tainted statistics or they mighteven question the authenticity of the numbers, but one thing is sure: If thenumbers reﬂect recorded price history on a listed product, then they arebound to be accurate. Prices that have been disseminated to the rest of theworld cannot be altered. That is a truth. The last trade of every commodity,stock, or bond is where the market was at that time.
When I ﬁrst began doing early morning shots on CNBC and BloombergTV, the question concerned how relevant the futures are to the openingof the equity markets later in the morning. My response was always thesame: The markets are reﬂecting what traders are thinking at that momentin time. Neither reporters nor viewers seem to understand the true natureof the market: that market pricing is extremely dynamic.
NUMBERS AND TECHNOLOGYARE UNIVERSAL
I realized that numbers don’t lie when I encountered a young woman at theexchange who worked as a guide in the gallery showing groups around andexplaining the workings of the CME. Kristine Martino would lead a groupof foreign visitors and speak to them in their own language. As someone
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who was taught rudimentary Armenian at an early age, I’ve always beenfascinated with anyone who could speak several languages. Kristine hadthe ability to carry on a series of conversations in various languages with-out missing a beat, and many visitors even told her that her accent andpronunciation were perfect.
It became a habit of mine to wander up to the visitors’ gallery beforemy shots to chat with Kristine. Occasionally she would ask me to speak toa group of visitors or answer questions that were a bit more detailed thanshe was prepared to answer. She was, after all, trained in languages, not intrading. I would listen to her translate the conversation and was never quitesure whether the meaning of my comments was being expressed precisely,but when it comes to market prices, the language is universal. The languagein which you receive information on the markets doesn’t matter—numbersdon’t lie! The story itself might have lost something in the translation, butthe numbers that we were all looking at were understood by everyone. Forexample, I’ve met ofﬁcials from the Central Bank of Armenia and found thatI could not understand a word they were saying. Their Eastern Armeniandialect was so strong that I asked them to speak English. But through all themisinterpretations of conversation there stood the truth of the numbers.
One of the interesting things that has happened over the course of thetechnological revolution concerns the way people look for information. Itused to be that traders or investors could not be islands unto themselvesand hope to ﬁnd success in the ﬁnancial markets—on the contrary, the mostimportant thing any trader could have was a network of people. Humanswere the information pipeline that allowed traders to get an edge. Todaythe situation is much different. Traders can lock themselves in a room andisolate their trading from other people and ﬁnd that it’s still possible to turna proﬁt. The human factor has evolved into a technological variable. Nowit’s a question of knowing where to look in cyberspace for the needed infor-mation, as opposed to knowing the right person for the right information.But one thing remains constant: Good information must be kept a well-guarded secret. Having worked with the Japanese at Nikko, the French atCredit Agricole, and the Germans at Commerzbank, I came to understandthat information is a precious commodity. The Japanese would ﬂy tradersinto the United States so that they could spend days with us to pick ourbrains and get a better understanding of our capital market structure. Itwas astounding how they would ship people around like clockwork everythree years from Japan in order to give as many employees as possible theneeded experience in the U.S. markets.
One reason for this, as I found out years later, was that many of theJapanese workers who came to this country ended up staying here andrenouncing their Japanese citizenship. It had gotten to the point that the ex-ecutives began to fear a ﬂight epidemic among Japanese nationals working
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in America. The solution for the futures group was to maintain a culturalbarrier between U.S. personnel and our Japanese coworkers. Regardless ofthis attempt to keep us separate, I went to extremes to acquire the trust ofmy Japanese colleagues. Emulating them, I worked long hours, went outdrinking with them, and most important, I took them to play golf! This keptme in the loop as far as any vital market information was concerned, and Istill have contact with many former colleagues who are now living back inJapan.
As I look back on the various institutions that I have worked with, I ﬁndthat they were all very different in their approaches to garnering market in-formation. The Japanese were meticulous in the way they researched everyaspect of the capital markets universe. In fact, my Japanese friends had avery annoying habit of asking the same question in several different ways,drilling for a new take on a given subject. Their style was intensely interroga-tive, and they usually ended up getting the information they wanted. Anyonewho works with the French, however, realizes that when it comes to the ﬁ-nancial services industry, the French know it all. In fact, during a managerialmeeting, I asked whether I should throw out every book in the ofﬁce thathad been written on the markets. When they asked me why, I responded,“Because you guys obviously know it all!” The stereotype of French arro-gance aside, culturally they understood the need for proper informationdissemination, and they, like the Japanese, found what they needed mostof the time. Both the Japanese and the French digested the changing land-scape around them and adjusted accordingly. They both started managedfutures divisions, which kept the proﬁtability of the futures FCMs intact foryears.
The Germans were a completely different story. The overbanked andentrenched middle bureaucracy of the German system made the processmuch more cumbersome. I came to the conclusion that they just did notget it! The German philosophy was to maintain a presence without a plan.I found it absolutely extraordinary that a country that produces some ofthe ﬁnest and most efﬁcient exports is lost when it comes to understand-ing the nature of the marketplace. Much of that might be cultural. Theentrenched German hierarchy makes individualism a problem. Unlike theJapanese, who stress the collective in place of the individual, the Germanmanagement philosophy is more dictatorial. Many of the German bankinginstitutions have ﬂoundered, however, making way for a wave of modernGerman portfolio managers who are revolutionizing the investing landscapeof the entire country.
As far as I’m concerned, there are only a few places I trust for goodinformation. Having come of age in the 1960s and 1970s, I am a TV addict.Maybe that’s why I ﬁnd it so easy to go on TV and voice an opinion orbreak down an economic report. Television is where I get the bulk of my
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information. Between Bloomberg and CNBC, there isn’t much left to cover.If I don’t know what is happening abroad, all I need to do is turn on cable TVand ﬁnd the Bloomberg or CNBC feed from Europe or Asia. Sometimes I’llbe watching the Asian market report and see myself talking on tape aboutthe U.S. markets earlier that day, and I reﬂect on the fact that people arebasing market opinions on the information I provide. At a certain point Ifeel that I have a ﬁduciary responsibility to the audience of any show to givethem accurate and useful information. Business TV has become so muchbetter over the last decade that it has moved from being pure after-the-factanalysis to being an intricate part of every trader’s day. Traders risk capitalbecause of the comments made or not made by someone on one of thebroadcasts.
SEARCHING FOR THE TRUTH
There’s a ﬁne line between the entertainment of business TV and the searchfor market truth within all the confusion. It can be difﬁcult to keep in mindthat business TV is in show business, not the capital markets structure,which means it is constantly probing for accurate and fresh information.A great example is when Maria Bartiromo of CNBC interviewed the newchairman of the Federal Reserve, Ben Bernanke, at a dinner in New York.During a live broadcast from the media booth of the CME, Bartiromo toldthe world that Bernanke had commented to her on the economy. As shetalked about her meeting with Bernanke, whose comments to her had beenhawkish, the market began to tumble. In this case, TV had scooped the restof the media universe. In an age when anyone can claim 15 minutes of fameusing a camera and the Internet, the information provided by Bartiromoproved proﬁtable. Anyone watching the broadcast knew that the marketwas breaking and understood the catalyst behind the break.
Whenever I search for the real story behind a market move, I’m alwaysreminded of Bing telling me that I was giving him only half the story. I came tounderstand, years later, that information was the other half. If you’re going tomake an educated investment or trade in the market, then it becomes imper-ative to have a combination of both price action and information. The speedat which information is now disseminated makes split-second decision mak-ing a more important variable in trading. Information that used to take daysto come out of the Fed or corporate America now comes within secondsof the event. Whistle-blowers and disgruntled employees can now get on aWeb site and explain the reasons for their displeasure with a corporation.Many investment decisions have been altered over the last couple ofyears due to the explosion of the weblog, or blog. Today, if there is any
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question about the efﬁcacy of a corporate product or a problem with one thathas already been released, more than likely there is a blog out in cyberspaceready to expose and describe the problem.
The power of information is nowhere more evident than in the historyof traders charged with insider trading. Those unethical individuals wholet greed dictate their actions have realized how powerful and proﬁtablethe right information can be. Insider trading has been around since the in-ception of the market structure. How many real estate fortunes have beenmade because the property purchased by an insider ended up being worthmultiples of the original purchase price? Today, insider trading is lookedupon as the crime that it is. Anyone considered an insider who has infor-mation that might alter the price of a commodity or equity cannot act onthat information—period. There are no exceptions. It’s one of the reasonsfor the dual trading restriction in many of the trading pits at the CME. Howcan a broker ﬁll customer orders and trade his or her own account withoutthe appearance of impropriety? It was a necessary step taken unilaterallyby the CME to show the rest of the investment universe that self-regulationworks.
As the years have gone by, the exchange has done a remarkable job atmaintaining the integrity of the marketplace. Every rule change that helpeddispel the appearance of impropriety has contributed to the foundation onwhich the CME built a multi-billion-dollar corporation.
After taking into account the various methods by which traders attainthe information necessary for making their investment decisions, it becomesfairly obvious that information itself is a commodity. The commoditizationof information makes it that much more difﬁcult to separate the cream fromthe milk. It becomes a quest to ﬁnd the needle in the haystack, and for thelucky few who know where to look for the needle, trading becomes lesscomplicated. Having the right knowledge makes the landscape of tradingvery different from trading without a real understanding of the condition ofthe market. And having the technology needed to retrieve the informationis just as important. The worlds of information retrieval and technologyhave never shared a closer relationship than they do presently. The speedand reliability of the portable handheld computer makes the retrieval andtransport of any type of information very easy. Maybe one day we’ll all belike the inventor I met on my way back from London—we’ll have nothingto declare, but we’ll have millions of dollars worth of information stored ona microchip in our brains. Anything is possible!
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C H A P T E R 11
RiskManagementManaging Exposure andUncertainty
I t’s been said that risk has two basic characteristics: exposure and uncer-
tainty. Without either one, there can be no risk. Two of the biggest mythsin the capital markets are that institutions assume risk and that all riskﬂows to those entities that are well capitalized and positioned to assumethat risk. Nothing could be further from the truth! All risk ﬂows down tothe individual, regardless of the institution in question. A good example isan event that took place in 1994 and 1995 that shook the investment worldright down to its core.
In the summer of 1994, the Nikkei futures pit at the Chicago MercantileExchange (CME) became very active. The dollar-denominated Nikkei con-tract that was trading in Chicago was different from the yen-denominatedcontract traded in Osaka, Japan, or at the futures exchange in Singapore,which is called the Simex. Logistically, the Nikkei futures pit was placeddirectly behind my desk, making my operation a great access point for cus-tomers wishing to trade the product. One of the customers I handled wasa ﬁrm out of London that was a conduit for trades done by Barings, a ﬁrmfrom Singapore.
I had taken orders from a group of traders whom I had met when Ispent some time with the late Tom Mallon, a former New Yorker who trans-planted his family to the Chicago area and ended up running the MerrillLynch futures ofﬁce in Chicago. He introduced me to two men based out ofLondon who were working as introducing brokers with a mixture of retailand institutional execution business. As a two-dollar broker, I would charge$2 for every contract that my desk would ﬁll. The billing method was re-ferred to as third-party billing. In other words, we were not clearing the
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trade—another FCM, a futures commission merchant, was doing that. Wewere simply executing the orders they gave us.
I didn’t think much of the lead because the Nikkei contract was not avery actively traded product and the chance of making a great deal of proﬁtwas slim. Besides, the product was difﬁcult to service, there were only ahandful of brokers and locals in the pit, and the bulk of the business wasdone on the open. My hope was to ﬁnd a way to get the other executionbusiness that was being done in the S&P 500 and the Eurodollar pit, whichwould generate much more in the way of commission dollars.
As we entered the summer and fall of 1994, the Japanese stock marketas measured by the Nikkei 225 was trading around the 21,000 level. Thiswas a move down from the unsustainable levels that the Nikkei had beenlooking at some ﬁve years earlier; nonetheless, the 21,000 level seemedto be an area of value. I began to receive orders every morning from thegroup in London. Buy 100 on the open and keep buying throughout theday until 1,000 contracts are accumulated. Wow! I realized that would behalf the daily volume. After executing the order, and knowing the liquidityproblems that I might face, I quietly moved the size into the pit with littlemarket impact.
The orders came once a week; then after November they started com-ing almost daily until the end of 1994. The size varied from 200 to 1,000contracts, but the side of the market never changed—they were alwaysbuyers. Everything seemed ﬁne—the customers in London were happy, thepit loved the new business, and my guys on the desk were getting greatbonuses because of the account.
I knew something was wrong when, as 1995 rolled around, the businessout of the London investment banks slowed to a trickle. An account thathad once generated $30,000 to $40,000 a month in commission had reacheda point that the call to London on a daily basis was costing more than therevenue ﬂow. But I maintained the relationship, thinking that they wouldagain become the leviathan in the Nikkei pit that they once had been.
In February, I received a call from the account in London. The businessthey were doing was agency business for a third party. As a conduit, theywere not sure who the end user really was, but they had a feeling that theremight be a problem. News had just hit the markets that Barings, Britain’soldest merchant bank, had uncovered over 800 million pounds in losses. Thiswas one of the most prestigious institutions in the world, having ﬁnancedthe Napoleonic Wars, the Louisiana Purchase, and the Erie Canal. Baringswas known as the Queen’s bank.
I immediately raced to the ofﬁces, then at Nikko, and looked throughall the boxes of documents we had saved,