Like the banker and the insurance bookmaker, we may sometimes encounter plain fraud. There’s no avoiding the fact that there are dishonest brokers and brokerages, notwithstanding the efforts of the SEC, NASD, CFTC,and NFA, and we deal with these persons at our peril. However, by exercising a little care and applying a bit of economic common sense, we should beable to elude the clutches of these slimy bottom-feeders. We have a couple ofstraightforward ways to do so.The better and easier way to avoid a less than scrupulously honest broker is to know your broker personally and over a long period of time during which he has been a broker. Too obvious, you say? Perhaps, but sometraders do not seem to agree. I’ll tell you right now that I had known my present futures broker personally for 17 years before opening a trading accountwith him. Previously, I’d known my former futures broker for 19 years beforedealing with him. To date, I can’t recall any sort of trading dispute or accountproblem that wasn’t resolved more or less immediately, within the week atworst. Just as for the banker, our having personal knowledge of the peoplewith whom we deal lowers our risk. Still too obvious? All right, then tell mewhy boiler rooms and bucket shops prosper (ideally, only for a short time).A considerable number of traders and would-be traders must not share ourreasoned view here, evidently.If taking a long time to get to know a broker well is inconvenient, you’veanother good choice. The Internet is indispensable to traders, and one reason
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why is that all the regulatory agencies publish their customer complaintrecords, and their compliance and disciplinary actions involving brokers andbrokerages, online, entirely free for your inspection and use. If you’re considering opening an account with a particular broker, and this individual appears as much as once in these agencies’ complaint files within the past fiveyears, then find another broker. True, an honest broker might have beentarred by an idiotic or unfair customer complaint, but this is not our problem because we have fundamentally no way to determine whether the customer complaint was either utterly warranted or lunacy in action. Avoid thisbroker, period, unless he or she happens to be your brother- or sister-in-law,and doing so would cause severe domestic discord (in which case, goodluck!).Avoiding counterparty risk at the hands of a corrupt brokerage firm isa trickier proposition. Searching the regulatory agencies’ files is absolutelyan aid in throwing out of consideration a bunch of such firms, but we cannot apply the “one-complaint-and-out” standard here. The regulators, overtwo or three or x years, will have received customer complaints about practically every brokerage, including the most competent and straight-shootingones. Some customers appear to be born to complain. (And by some curiouscircumstance, they seem very often, in my experience, to be lousy traders,too. Odd, isn’t it?) Instead of looking around for one complaint when examining the regulators’ files, look for a pattern. Corrupt brokerages and theirprincipals usually sail as close to the regulatory winds as possible, whichtends to result in a semicontinuous stream of complaints and official actionsagainst them.Another excellent filter for undesirable brokerages is your group offriends and acquaintances who trade. Likely enough, you talk trading withthem some or a lot of the time, and it must be to your advantage to comparenotes about brokerages with other traders whom you know and respect.The old adage “investigate before you invest” doesn’t apply only to whicheverstock or bond or future you may be considering. It applies with extra forceto those with whom you may be considering employing as brokers.
Capacity Risk—It’s All Archimedes’ FaultTraders, more frequently than bankers or bookmakers, can be and often areseriously threatened by the form of capacity risk specific to trading. Anytrader who doesn’t take this threat seriously to heart and doesn’t keep awatchful eye every day for the possible approach of this risk is almost certainly doomed to failure, typically sooner than later. “Hold on here,” someof you are thinking right now, “you said earlier that capacity risk only existswhen I use leverage. Well, I don’t, I buy my stocks and bonds for cash and
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put them right away in the safe-deposit box. Why do I even want to hearabout capacity risk?”If this is what you’re thinking, or even screaming out loud at me, you’reabsolutely correct. I did say that, meant every word of it, and it’s inarguablytrue . . . but look a little deeper, please. We’re talking about trading. If youpay cash for your financial assets, the answer to your question is very simple: you’re not a trader. You sound much more like an investor. You certainlydo not care about capacity risk. Best skip on to the section about marketsbefore you blow a gasket.The efficient use of capital is necessary to success in any enterprise ofmaking money with money. Zero leverage is not an efficient use of capital,and this is easily demonstrated by observation. Who are the most steadilysuccessful at making money with money? Indisputably, they are the competent bookmaker and the prudent banker, and these folks are leveraged tosome degree all the time, sometimes quite highly. If leverage is both usefuland profitable for successful professionals, why would any trader or wouldbe trader avoid, disdain, fear, or even hate using this tool? Right you are.Traders don’t. Instead, they use the tools at hand, leverage being one, and simultaneously look for effective ways to minimize the implied capacity riskincurred thereby.As noted previously, the measure of our capacity risk is the probabilitythat, at some time in the future, we will come to have insufficient capital tocontinue trading. This is related but not identical to the well-known statistical problem called “gambler’s ruin.” Due to the comparative complexity ofthe broad markets in which we might deal—specifically stocks, bonds, andfutures—analyzing capacity risk is more difficult for us than analyzing itsstatistical cousin is for the gambler. Unfortunately, stock markets applyone set of rules governing leverage, bond markets apply a similar but notidentical set, and futures markets a different set entirely. This needlesslyprolix situation makes our efforts to evaluate capacity risk across differentmarkets a little bit dicey, because we can’t compare apples directly to apples.However, if the comparison of this risk among several markets poses problems, evading such risk does not.Foremost, we can avoid a large amount of capacity risk by insisting onusing the time-honored tactic of diversifying our capital into several activities, and by using several different trading strategies. Please note that theterm “activities” does not necessarily imply “broad markets,” plural. If oneof the set of tradable broad markets offers or appears to offer us a healthystatistical edge as compared to the other broad markets, then the notion ofdiversification should here be taken to mean only diversification amongvarious markets within that one broad market.Those who believe in the philosophy of asset allocation are probablyapoplectic at this last statement, for this concept is anathema to them. Sorry,
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but I’m not about to keep 5%, or whatever amount, of my capital in ersatz“precious” metals just on the off chance that the whole of the economicworld will melt down some day. This is just silly. Why the devil should anyone hold an alleged “asset” that has steadily lost value for decades, whetherAT&T shares or gold? Nor do I fancy clipping bond coupons and watching inflation and taxes take the bulk of the earnings. This isn’t trading in anycase, and it’s unsound investing too, in my view.
Shortening the Lever—Trimming Capacity RiskWe have a second easy and effective way to reduce capacity risk. We can,and will, steadfastly refuse to use all the leverage that any market mayoffer. It’s child’s play to obtain gigantic amounts of leverage in any of thebroad tradable markets, but it’s almost surely to our disadvantage if we dothis in our trading. One of the most spectacularly successful financial ventures in history, Long-Term Capital Management, used almost unimaginableleverage in their portfolio, by design. This organization had the advantagesof enormous capital, probably the finest assemblage of traders, analysts,statisticians, and theorists in the entire history of markets, more trading experience than you and I will acquire throughout our lifetimes, and immediate access to more complete, timely, and accurate information than we’llever see.They went bust. Even with all these advantages, which you and I canonly dream of having, they went bust. They were done in ultimately by nothing other than the capacity risk we’re discussing right now, and by keepingthe bulk of their huge portfolio in illiquid and not-very-liquid instruments.Their deliberate policy of maximizing leverage put them into a situation oneday in which they didn’t have and couldn’t raise enough capital to stay inthe game, and they couldn’t get out of their positions without incurringmonstrous losses, well in excess of their total capital. Uniquely (at least sofar), none other than William McDonough, president of the New York Federal Reserve Bank, had to convene and persuade (or dragoon) a consortiumof lenders to provide interim financing in order to allow an orderly liquidation of LTCM’s portfolio. This portfolio was so large and involved so many diverse assets that the liquidation process took about two years to complete.If, even after considering this example, the mortal danger of using toomuch leverage is still not perfectly clear, let me just embellish this point byciting the words of the late Harrison Roth. He wrote the book LEAPS (Irwin,1994), an enormously entertaining, informative, and readable discussionabout the uses of and strategies for trading long-term listed stock options(by the way, if you’re a trader and haven’t read this book, you owe it to yourself to do so). Margin requirement is the inverse of leverage, and minimum
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margin is maximum leverage, correct? He condemned the use of too muchleverage elegantly and succinctly: “Minimum margin is a sign of minimumintelligence.” And he was dead-bang right in that sentiment, then, now, andforever.If we are pure asset traders, only trading shares and bonds and physical commodities, leverage is completely measurable. When we add derivativeinstruments such as options and futures to our trading, leverage is measurable only statistically, hence only approximately. In the text, we’ll definethe amount of leverage in a trade as the actual or statistical value(s) of theinstrument(s) we trade, divided by the amount of capital we are required tohave in hand before entering the trade, minus one, expressed as a percentage. If we pay cash for an asset, our leverage is zero. If Microsoft shares aretrading at 60 and we buy 300 shares, market value $18,000, but we only commit $9,000 of capital, our leverage is 18,000 / 9000 = 2, minus 1, = 1, or 100%.By applying this definition of leverage and examining the risk profiles of thevarious broad markets, we’ll gain more useful information concerningwhich of the set of the broad tradable markets may be most advantageousfor our trading.
Which Hog Shall We Slaughter?—Selecting a MarketAn essential part of developing a successful trading methodology is to selectwhich broad market offers us a convenient and useful amount of leverage,contains fewer inherent disadvantages, and has the lowest relative levels ofstructural and external event risk. I only know of one way to make this selection, and that’s to look at each of these conditions in each broad marketin turn. Let’s do just this with a gimlet eye and see what we can discern.Checking on the amount of leverage available to us in each broad market is a straightforward proposition, and a good way to start. Using leveragein stock and bond markets is easy; we merely open up a separate accountwith our brokerage, universally called a margin account. The brokeragewill cheerfully lend us up to 50% of the market value of the shares or bondswe purchase, assuming only that we’re dealing in NYSE or AMEX or a majority of NASDAQ stocks, selected foreign stocks, or in a very broad groupof corporate bonds. This 50% level is set by the Federal Reserve’s Regulation T, hasn’t changed in decades, and allows for leverage of up to 100%, aperfectly acceptable figure.The problem when we trade stocks or bonds on margin is that the brokerage will also, even more cheerfully, charge us interest on this loan.
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Whether we finally profit or lose on a margined trade, we have voluntarily increased our contest risk by paying interest dollars to the brokerage. This increase must be counted as a black mark against these two markets regardingour practical use of leverage. Also, as always, where there’s leverage there’scapacity risk, and when trading stocks or bonds on margin, the capacity riskpoint is defined exactly and by rule. If the price of the stock or bond movesin such a way that our capital stake in our position, our equity, falls to lessthan 25%, none other than the Federal Reserve will demand more capitalfrom us. We can at that point either liquidate the position or open up thecheckbook. Brokerages, being prudent enterprises, will rarely let our account equity fall to this level, and will issue their own internal demand formore capital well before the Fed gets into the act.Trading in the futures markets offers us sizeable leverage automatically. We don’t have to ask for a loan or open a separate type of account.The various futures exchanges set down a basic capital requirement fortrading in each of their markets, thus defining the amount of leverage available to us. This requirement, usually if imprecisely also called “margin,” isfunctionally a performance bond that we post as an assurance we will beresponsible for any losses in our trading. Having set the basic capital requirement, futures exchanges then do something remarkably practical.They subsequently modify this requirement according to current marketconditions by applying a formal mathematical model to evaluate the risk ofour position(s).In the late 1980s, the Chicago Mercantile Exchange developed a formal model for approximating the level of risk in any given portfolio andbegan the practice of applying the risk thus modeled to the margin requirements for traders. This model was named SPAN®, for “StandardPortfolio Analysis of risk” and has become universally used by major futures exchanges worldwide and, interestingly, by several stock exchanges(none of them, unfortunately, American). The SPAN model was derivedfrom the work of the late Fischer Black, Myron Scholes, and Robert Merton, and is quite generous to traders in the amount of leverage it offers.Moreover, in futures trading, there is no lending of capital by anyone toanyone under any except one rare circumstance, and from this auspiciouscondition we gain a double-barreled advantage. We pay no interest on thelevered amount, and we should actually earn interest on the amount ofcapital in our trading account that is not currently applied to margin ourpositions.SPAN and SPAN-like methods of setting margin requirements, calledportfolio margining, are advantageous to traders, but embedded withinthem is yet another risk. When the SPAN parameters—the values insertedinto the various formulae in the mathematical model—change rapidly due tomarket movement or other conditions, our margin requirement will change
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correspondingly, and sometimes sizably. This is eminently reasonable because the purpose of a statistical model, SPAN or any other, is to attemptto reflect conditions in the real world. In the event of a significant increasein the SPAN requirement, whether or not the market(s) have moved againstour position(s), we will again face the choice of liquidating some position(s) or committing more capital.If a market is quiet, SPAN generates a lower margin requirement figurefor a position in that market, and a higher one if that market is unusually active. This is the problem. We traders have no reliable way to tell when amarket will suddenly become highly volatile, and when we hold a position ina market which has become so, our margin requirement might rise so sharplythat we can be hauled off to the land of capacity risk quite involuntarily. Inplain English, we can get blown right out of a position. The good news hereis that we already know how to negate or minimize this risk. Didn’t weagree a little earlier that we will not accept all the leverage available tous? If we follow this policy faithfully and use only some fraction of the maximum leverage offered, we will reduce our capacity risk radically, even cutit to zero at times.Futures markets offer us leverage without direct cost, and this is a clearpositive for trading in these markets. Stock and corporate bond marketslimit leverage to a specific but useful amount, and U.S. government bondmarkets to a higher amount (900% at this writing). The leverage available infutures trading ranges roughly from 300% to 10,000%, and varies by specificmarket, as illustrated in Table 2.1.Overall, we’ll give stocks and corporate bonds a plus here for restricting the maximum leverage available, thereby making it more difficult for anunwary trader to fall into the clutches of capacity risk. A different plus goesto futures and government bonds for the flexibility that the larger leveragein these markets grants us, with the proviso that it is completely our own responsibility to avoid abusing such leverage. We have more to enter on ourscorecard, though, and next on the list are structural risks, those native features of markets that threaten the trader’s profitability by the simple fact oftheir existence.
Asymmetry Is Poison—We Want toPlay the Whole GameSome people assume that all the markets we trade are symmetric, that is, wecan buy or sell assets with equal ease and the rules of trading are the same forall market participants. This is a reasonable assumption, theoretically. By theclassical definition, a free market is a mechanism for the exchange of goods or
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TABLE 2.1
Leverage Available, Selected Futures Markets, December 26, 2001
Contract
ClosingPrice
ContractValue
SPANInit.Requirmt
LeverageOffered (%)
Equity(%)
MarMarMar
CornChi WheatSoybeans
2.08–62.84–44.28–2
10437.5014225.0021412.50
405743810
247718142543
3.885.513.93
FebFebFeb
Live CattleLean HogsPork Bellies
70.7555.4777.65
28300.0022188.0031060.00
81010801620
339419541817
2.955.125.50
FebFebMarMar
GoldH-G CopperPalladiumSilver
279.6068.95424.004.543
27960.0017237.5042400.0022715.00
1350135067501350
197111775281583
5.078.4918.946.32
FebFebFebFeb
Crude OilHeating OilUnld. GasolineNatural Gas
21.2759.4660.672.937
21270.0024937.2025481.4029370.00
3375270027005400
530824844444
18.8712.1311.8422.52
MarMarMarMarMar
CocoaCoffee “C”Cotton #2Orange JuiceSugar #11
128346.6536.6595.507.12
12830.0017493.7518250.0014325.007974.40
8402100998700700
1427733172819461039
7.0113.645.795.149.62
MarMarMarMar
Can. DollarEurocurrencyJapanese YenSwiss Franc
62.4587.5776.7559.07
62450.00109462.5095937.5073837.50
608202520251451
10171530646384989
0.981.881.032.00
MarMar
30-Yr. U.S. Bond10-Yr. U.S. Note
100–11 100343.75103–305 103953.13
27001890
36165400
2.761.85
ContractMonth
services between an informed seller and an informed buyer, both operatingindependently and able to deal without external restraint. In the practicalworld, though, this ain’t necessarily so. In fact, it isn’t so at all. While futuresmarkets are almost perfectly symmetric, such is not the case in the stock andbond markets. This asymmetry is due to the rules governing these latter markets, and it constitutes a severe disadvantage for traders.
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Because the price of anything fluctuates over time, during some portionof the time the prices of any asset or class of assets will be going down. Ifwe trade assets during a falling market, we can generally profit only by selling an asset and repurchasing it later at a lower price, the tactic uniformlycalled selling short. If we cannot freely sell assets short when and as wewish in some market, this restriction directly implies that, some considerable portion of the time, we will have difficulty in making a profit trading ina downward moving market.In stock and bond markets, the plain fact is that we cannot freely sellshares and bonds short as a means of initiating a trade. Selling short in thesemarkets is actively discouraged by brokerages, unfamiliar to many (most?)brokers, restricted in practice by exchange and Federal Reserve rules, situationally impossible in too many cases, and all in all a major pain in the neckfor anyone except very large traders. For the ordinary trader, therefore, foryou and me, stock and bond markets are not symmetric. These markets arebecoming less asymmetric, slowly, as the popularity of “basket” productslike SPDRs, Diamonds, and QQQs, which traders can readily sell short atwill, grows over time. Single-stock futures, which debuted in the UnitedStates in the last part of 2002, have also reduced asymmetry, all to the goodas far as stock market traders are concerned.Asymmetry still persists, though, and is really very undesirable. We’veall seen price bubbles, most recently in several different groups of U.S.stocks from 1995 through about March 2000, when we watched the prices ofnumerous stocks bid to astonishing levels. Such market action is, of course,wonderful when we own shares (provided we took our profit at some point),but when the bubble ends, if we cannot even attempt, in many cases, toprofit during the long-lasting deflation of the bubble, we’ve little alternativebut to step away from the market. Regardless of whether now or any othertime is or is not propitious for selling stocks or bonds short, the asymmetricstructure of these markets is costly for us in terms of profit opportunitieswe must forego. The symmetry of futures markets, wherein we can sell shortvirtually whenever this tactic appears to be desirable, is a distinct plus factor for traders.
Your Tax Dollars at Work—GovernmentalEvent RiskIn which broad market is event risk the highest? We’ve yet to consider therole of government regarding this question. Which broad market can government tamper with most easily, and which does it they screw up mostfrequently?All the broad markets are distorted at times by arbitrary governmentaction. We can take comfort only in that it is a little difficult for government
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to mess up the stock markets, because it must do so indirectly, at least inthe United States. In stock markets, why look further for an example of political interference than the so-called antitrust prosecution of MicrosoftCorporation? I’m not particularly a fan of Microsoft products, and I’ve neverowned a single share of MSFT, but I’m not bloody blind, either. “Trusts” or“monopolies” or whatever today’s fashionable misnomer may be, are in theory supposed to be engaging in practices that damage those who buy theirproducts, the customer, the public. Well, I’ve designed computer systemsfor almost three decades, and I punch the keyboard in this pursuit for somehours every day. All I can tell you from experience is that Microsoft, whetherI prefer their products or not, has done nothing but decrease my costs andincrease my little company’s productivity. If that’s “damage,” call me OliverTwist. May I please have some more, sir?My preferences are irrelevant. What is relevant is that it is indisputablethat the government’s politically bought-and-paid-for prosecution of Microsoft immediately and adversely affected every participant in the stockmarkets, especially those who owned technology shares. If this were a solitary incident, we might shrug it off as hard luck. Of course it wasn’t, and weboth know it. Political prosecutions have happened many times before andwill again in the future. Should we even consider accepting the amount ofrisk such prosecutions represent?The bond markets can be tampered with by government action botheasily and directly. Which factors change bond prices? Certainly, the rate ofinflation, sundry economic statistics, and the cost of money are at the topof this list. Would you care to guess who controls these either broadly orabsolutely? Right you are. If we trade in the bond markets, by the way, weare also subject to a special form of knowledge risk. Bonds are a contractbetween a borrower and a lender, and the formal terms of a bond are calledits indenture. Lawyers draw up these contracts. That’s fine, and straightforward, except that lawyers are not required to write these indentures inany language resembling English. If you’re not an attorney or a CPA andyou’ve nothing better to do some afternoon, try deciphering a bond indenture. Afterwards, stand up and swear you completely understand whatyou’ve just read. Just let me bet against you, please.Futures markets have no shortage of governmentally generated risk, either. Legislatures are very fond of tinkering with futures markets throughsubsidies, tariffs, tax rates and preferences, confiscation, declarations offorce majeure, embargoes, and whatever other measures their tiny mindscan concoct. In addition, governments love to collect and publish statistics,usually with the self-important presumption that these figures actually reflect conditions in the real world, and always with the blithe dismissal ofDisraeli’s famed and accurate observation, “There are lies, there are damnedlies, and then there are statistics.” If you disagree with this sentiment, please
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ask yourself why governments revise their own statistics so frequently afterthe fact. Might it be that they know the numbers aren’t valid in the firstplace? Market participants act on them anyway, and voluntarily incorporatethis risk of governmental error or incompetence in their trading decisions.We’d prefer to minimize this voluntary extra risk, wouldn’t you agree?The governmental risks discussed above are only occasional, but theirexistence is structural; they exist because of the nature of modern government. We must also consider the unfortunately permanent and perniciousstructural risks of inflation and taxation. Inflation, after all, is only everproduced by government action—you and I, or Boeing and General Motorsfor that matter, can hardly manage to inflate the currency unless we areable to become highly successful counterfeiters. Similarly, you and I have nopractical influence on levels of taxation, unless we would care to spendtime, effort, and lots of capital to try to outbid the vast number of peoplewho attempt, sometimes successfully, to buy off the political wolves.To be fair, we should observe that when we trade specifically in futures,we are in fact trading in contracts, just as we are in bonds . . . but, what adifference! First, the terms of any futures contract are readily available onthe exchange’s Internet site or by calling the exchange or our brokerage. Bycontrast, try to obtain the indenture of, say, the NYSE-traded Inco 7.75%convertible bond maturing in 2016. Unless you’re a professional bond traderor you get very lucky, getting that indenture will take, uh, just a little bitmore effort than one phone call. Second, whether or not you know or careanything at all about, say, corn, any normally literate person will understandmost or all of the CBOT corn contract without any technical assistance, andevery competent brokerage is sure to have any required technical assistanceavailable for the asking. Third, very much unlike corporate bonds, futuresexchanges historically have almost never defaulted on the contractstraded on their floors. There are contracts, and then there are contracts,evidently.The point of all this is that, and I hope by now it’s completely clear, justas with fraud for insurance companies, governmental interference in anymarket is absolutely a condition of contest for us in our trading. Althoughgovernment is the engine of most of the structural event risk that traders encounter, we also must contend with the menace of ordinary external eventrisk to our capital and profitability.
Eight Million Ways to Lose—External Event RiskDisregarding particular markets for a moment, let’s ask which other flavorsof event risk we face. What about weather risks, droughts, hurricanes, or in-
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temperate temperatures? No one controls the weather, surely. Such eventswill occur and we must have some means of dealing with the risk they pose.What about another risk generated by the legal system, that 12 ambulatoryfeatherless bipeds with the proper number of chromosomes will decideout of the clear blue sky that something is a matter of “law” and therebyinvade our pockets when we’re merely innocent bystanders? We cannotanticipate or defend against willful morons. What about deliberate corruption, simple incompetence, or even unrealistic optimism on the part of themanagers of a company whose shares or bonds we own? Any of these eventswill vaporize some amount of our capital, too often before we can even learnof them. Which of our set of broad markets offer us active means to protectourselves to a considerable extent against these events and their kin?The answer here is clear, and it eliminates one of the broad marketsfrom our consideration. Much like insurers, from time to time we want animmediately available way to neutralize or mitigate our trading risk. Two ofthe broad markets offer us such a way, but one does not. This risk reductionmechanism is an options market, and moreover, an options market in whichwe can deal relatively easily. Options are available in the bond markets, butthey are not feasible for us to use. At this time, bond options are customizedto a trader’s particular situation and request, are for all practical purposescompletely illiquid, and are ordinarily available only to very large accounts.This situation compels me, at least, to limit my trading horizons to stocksand futures. If I cannot protect my capital by taking positive action eitherbefore or when a market moves adversely, as opposed to the simple supineaction of willy-nilly accepting a loss, I see no reason whatever to trade insuch a market. Invest in, maybe. Trade in, excepting pure arbitrage, no.We can bring matters into