Steve Hemingway

Futures trading is a bit of a game. Unfortunately it involves real money. The theory is fine: you open up highly-geared positions, depositing enough with the broker to cover your losses for an 'extremely bad' session. You can make sure that you never lose more than this by setting stop orders to close your positions whenever the price moves to a point when the losses may wipe out your margin. Alternatively you can just unwind your positions when you are close to receiving a margin call. As a last resort you can actually make the margin call - i.e. add more liquid funds to your account.

In practice you will find that whenever you liquidate a position for margin pressure reasons you will find the market rebounds with extreme violence, sometimes within minutes of making the trade. It is uncanny. Yes, I am a believer in the One True Faith of the Efficient Market Hypothesis, but I have seen this with my own eyes.

Over the last few days stock markets lurched downward in response to the impending meltdown of sub-prime lenders, and prime brokers who fund flaky hedge funds, and banks that securitize all their mortgage receivables, to clean up their balance sheet end up retaining the "toxic waste" tranche of risk right their in a note to those accounts.

My normal response would have to have panicked and liquidate, only to see my positions come back from the dead. In fact I hung on in there, except for a few interest rate hedging positions which I liquidated to reduce my margin requirement, but should have been uncorrelated with the credit problem news. I have been duly rewarded, although only to the extent of getting back to where I was last week.

The funny thing is that the financial press always reports the bad news, but almost never reports the resilience of markets in coming back after a shock. Maybe I read the wrong papers, but the FT seems congenitally disposed to be bearish. Clearly there are very bad problems in some credit markets, but it seems to me that the general outlook for the world's GDP is fairly positive.

For what it's worth I am bullish on Asia. My recent trip to China might have something to do with this. It is quite possible that HK is overvalued, but it's the nearest thing we foreigners can get to exposure to the markets on the mainland, as far as I can see.

I found this article This article is profoundly disturbing. It suggests that CAPM, the cornerstone of modern portfolio theory, is empirically falsifiable. I didn't pick this up when it first appeared, but the theory was mentioned in the current Buttonwood column in the Economist. In this latter article Buttonwood makes the comment "All this confirms what most investors who lived through the dotcom bubble must feel: investors are not always rational and markets are not always efficient. But, judging by the subprime saga, spotting those irrational moments is no easier than it ever was."

All this suggests that infrastructure funds and utilities are where we should be investing. These were attractive anyway because of their lack of correlation with equity markets, but if they produce higher risk-adjusted returns too, there should be no holding us back. I suspect that fundamentally the discipline of paying out a large proportion of profits is likely to produce a better return to investors. There may be no magic in leverage, but there is a magic in financial discipline.

The S&P500 fell 5% this week. I had a flood of margin calls, and the even more dreaded 'critical liquidity alerts' in my in-box.

The reason was telegraphed months ago. Banks are lending an incredible amount of money to dodgy hedge funds and private equity funds.

I have no idea why this happened this week. I am going to China tomorrow, where it will be very difficult to meet future margin calls.

My exposure is limited, but if I allow my broker to close my positions now I will undoubtedly have had my position closed at the bottom of the market. Whenever those damn clerks chose to place those sell orders on my behalf it will be the signal for global stock markets to rally in an uncannily co-ordinated unison.

You may think I am being ironic, or somehow not entirely serious, but this is not the case. My position (long or short) is an infallible predictor of sea-changes in bourses around the world. Sadly, however carefully I choose my investments, these major lurches in markets always serve to precipitate margin calls.

Seriously, it is a sickening feeling to see every one of one's carefully chosen-to-be-diversified positions tank in perfect synchrony.

China is a wonderful story. It has astonishing potential, a highly-educated and motivated workforce, a legal system that is rapidly evolving into something that is pretty functional in terms of protecting property rights and generally encouraging investment and entrepreneurialism, and a flattish tax that is levied at about seven percent.

My preferred way to benefit from the flow of capital into China is to buy real estate, as regular readers will know. However other assets are likely to benefit from the continued economic boom in the country. Buying shares on the Shanghai stock exchange is difficult if you are not a PRC national. Buying them in HK is reasonably straightforward, although requires one to open an appropriate account in HK.

The interesting thing is that actually some of the largest and best-run Chinese companies are listed in the USA. This page gives you a great list to get started with. You can even see the price-earnings ration (P/E) and Price Earnings Growth ratio (the price/earnings ratio divided by its year-over-year earnings growth rate. In general, the lower the PEG, the better the value.)

The market in these shares is wonderfully liquid. Execution is almost instantaneous. 50% margining is automatic with Options Xpress.

You can even access a Google spreadsheet with PE and PEG ratios conveniently sortable, here, provided by Wall Street Networks

I don't like to cut and paste whole articles from the web, but the FT's terrible website, and it's subscription policy for archives leaves me with no practical alternative. I'm sure the author won't mind!

Sir, Many investors have been taken by surprise by last week’s huge swings in the markets. But they shouldn’t have been. As Benoit Mandelbrot taught us long ago, and Nassim Taleb popularised in his recent book The Black Swan, extreme returns are far more likely and have a much larger impact on portfolios than most people usually think.

On Black Monday (October 17 1987), the Dow fell 22.6 per cent and more than erased the return earned since the beginning of the year (201 trading days). It then took the Dow another 320 days to get past the level reached the day before the crash. Although Black Monday is an extreme example, it is indeed the case that a few large daily swings can more than overturn the return obtained over a long period of time.

Between 1969 and 2006, a passive investor in the UK would have turned £100 into £1,854 (without accounting for dividends). However, an investor who missed the best 10 (20) days would have seen his terminal wealth reduced to just £979 (£596), and one who avoided the worst 10 (20) days would have seen his terminal wealth increased to £3,819 (£6,063). That is particularly shocking given that 10 (20) days are just 0.1 per cent (0.2 per cent) of the days considered.

This and other similar results have at least three important lessons for investors. First, long-term performance is largely determined by the impact of very few outliers, like those observed last week. Second, investors are very unlikely to time the market successfully and consistently. And third, much like going to Las Vegas, market timing may be exciting but is not a good way to make money.

So what are investors to do, when faced with swings like those observed last week? Nothing! They should just keep their eyes on the long term (and off the prices flashing in the computer screen), and stay the course. And if they feel adventurous enough and want to play Indiana Jones, they should even increase their exposure to the market.

After all, that is just what Warren Buffett and other savvy long-term investors do every time the market takes a big dive.

Javier Estrada,
IESE Business School,
08034 Barcelona, Spain

In passing, this shows why it's so hard to make money trading futures, and why the advice to put tight stops on all positions is absolute folly.

This article by John Gapper exposes the perverse incentives for traders in big banks and explains why Jérôme Kerviel was perfectly rational in his actions at Soc. Gen. This article requires an FT subscription, but someone has helpfully cloned it on the web here.

The perverse incentives of chief executives at large, publicly-quoted firms has led to the explosion of private equity, where the agency problem is solved by shooting the agent. Hedge funds may have some mechanisms to solve the trader's put problem. (The idea that the trader has a free option to 'sell' his position by just quitting or even being fired. This means that his incentives are asymmetrical: if his position makes a lot of money he gets a big reward whereas if they lose a lot of money his punishment is quite mild).

I saw a quote recently about liquidity. An old hand was saying that it was a slippery (!) concept that even smart new traders didn't readily grasp until they didn't have any and then it became frighteningly clear.

I think the same realisation is dawning on me and a lot of other 'sophisticated' investors concerning equities. There is a widely held view that equities are solid, 'real' assets. I even heard a guy who worked for the equities division at UBS once make the comment that he worked for the bit that traded solid shares in blue-chip companies, not flakey bonds and risky fixed-interest products. The essence of equities is that they are a residual claim on the cash flows of a company after all the other claims have been met in full. They are, thus, more junior than the most junior subordinated deferrable preference shares, and certainly more junior than the most unsecured debt.

I think that part of the problem of understanding the nature of equity comes from the idea that the shareholders 'own' the company, as evidenced by the fact that they alone have a say in who the directors are, whether a takeover offer should be accepted, and whether they wish to be first in the queue to provide more capital through a rights issue. The success of the company is evidenced principally by the share price going up, without much attention being paid to the other creditors.

The alternative view, as discussed in books like Brearley and Myers, is that, in fact, the equity holders have a call option on the assets of the company, and that the strike price of this option is the value of all the other more senior obligations of the enterprise. This is clearly the case: if bonds issued by a company cannot be redeemed, then the bondholders are given all the assets of the company instead. Of course creditors form a queue and it may be that other creditor rank ahead of the bond holders, but clearly the people at the very backmost position in the queue are the shareholders.

This explains why shares are not always a good investment in times of high inflation. The idea that shares represent 'real assets' suggests that a good purging dose of inflation, as we are probably facing right now, should be good for shares. For a company with real assets - say a large manufacturer with extensive factories it owns itself - this is probably true. The problem is that other forms of credit tend to get expensive and risky in times of high inflation, so that the head of the queue are taking more of the gross cashflow. Certainly once inflation gets a hold, creditors need to be protected against the macroeconomic uncertainty of real returns and will, overall, make their credit more expensive.

In a rising market in an environment of rapid economic growth, gearing, both financial and operational, have been sought after. The amplification of profits 'attributable to shareholders' have been welcomed by boards and investors. The fact that the variance of returns, i.e. the risk of the investment, has been amplified too has been brushed aside as an of purely academic interest. The fact that Modigliani and Miller pointed out that risk-adjusted returns to equity holders were not enhanced by gearing is never mentioned by corporate financiers or boards of directors. This is no trivial observation - the pair were given a Nobel Prize in Economics in 1985 for discovering it.

Now of course we all see how clear sighted these gentlemen were. We understand that capital adequacy ratios for banks are not there just to give structured finance experts an incentive for devising more and more Byzantine off-balance-sheet ways of holding assets. We are beginning to understand why Mssrs Glass and Steagall were not simply spoilsports. We understand that it is not an unalloyed Good Thing for companies to use all of their net cashflow in buying back shares rather than paying dividends no matter how tax-efficient and EPS flattering it might be.

We have enjoyed the party while it lasted. The hangover is going to be a severe one.

The recent meltdown in equity and other asset markets recently has left me shell shocked. I have been bearish since before Alan Greenspan made that speech about 'irrational exuberance' and have the scars to show it.

Maybe now is the time to take some short positions. The most liquid and efficient way of doing this is through the futures market. I strongly recommend Options Xpress. Their customer service is astonishing. I contacted them today to complain that it was not possible to trade the Long Gilt future on their platform. Within a matter of minutes I had received an email which I reproduce below:

Hello Mr. Hemingway,

Thank you for taking the time to contact optionsXpress today. I have good news. We are able to add you to a small batch accounts that have access to international futures. The update will be made available later today.

If you have any other questions you are quite welcome to email me directly and I would be happy to help, or you can call us at (888) 280-8020 Mon-Fri, 9:00am-10:00pm ET or click the Live Help link found on the top right corner of our site for immediate assistance. Thank you again for contacting optionsXpress and have a great day.

Angela Ortiz

Customer Service Specialist

www.optionsXpress.com

I wonder how long a UK bank would take to add me to a small batch of accounts that have access to trade futures that trade on - lets say for example - the Italian futures exchange.

Benjamin Graham, as well as his disciple, Warren Buffett, both strenuously warn against speculating, as opposed to investing, and generally define speculating as any kind of purchase of securities involving leverage. I have always wondered how to square this with the modern portfolio theory view that using leverage is simply a way of moving along the risk-reward frontier. On a fundamental level, if you really know that a stock is going up then you are going to get a bigger return on equity if you gear up. Obviously, on average, you do not, but there doesn't seem anything fundamentally malign about using some borrowed capital to spice up your return. Proprietary traders typically have a performance which is measured on an equity-free position: they have to stand a carry cost of their complete position value.

It was not until I started doing some modest trading myself that I gained a slender insight into the problem of gearing. In my view, it's not the gearing that's bad, but the margin calls. Benjamin Graham talked about a bipolar 'Mr Market' who has extreme mood swings but however crazy is feeling is always willing to trade with you, the investor. In Graham's recipe for trading success the key is to wait for Mr Market to get nearly suicidal and then take some shares off his shaking hands. When Mr Market flips and enters his manic phase, and will pay silly money for any old rubbish, sell the shares he sold you earlier back to him at a handsome profit. Sounds as easy as falling off a log, doesn't it?

Of course, it's hard to judge Mr Market's mood exactly in relation to his mood tomorrow or a year or ten from now. What may seem like a deep depression might prove to be a relatively sunny period compared to later. However, one this is certain. If you are forced to sell when the market has tanked there is no way you are going to do anything but lose money. This happens when you get that unpleasant email called a margin call. This means that the equity you've posted with your broker has evaporated and that further falls (or rises) in the value of your positions will result in him being fully exposed to the risk of you going broke. If you can't post further margin he will sell your position. I can absolutely guarantee that if you let him do this he will chose the exact moment when the market bounces right back and you will have lost everything.

So leverage is very dangerous, and there is no way of entirely avoiding the risk, but at the very least some kind protection should be put in place, whether buying options, overcollateralising, getting to a market neutral position or whatever. None of these strategies is perfect, but doing none of them is probably going to end in tears.

Goldman Sachs is "Doing God's work" according to this interview in The Times*. By this he means that GS is allocating capital in society, to the most productive uses, presumably.

I don't know exactly what is meant by this. Nature, and its wonders, is often thought to be God's work, by those religiously inclined. It is arguable that in fact evolution is God's work, or at least design, to save him too much work in designing lots of individual organs and organisms.

The problem, though, is that, actually, GS doesn't allocate much capital as such. Most of its revenue comes from trading, exploiting the bid-ask spread without taking significant positions, together with fees from traditional investment bank operations: mergers and acquisitions, together with IPO's.

Whether or not asset allocation is God's work, it should not be done by GS itself. The most it can do is produce good analysis and advice for the 'buy side': the principal investors. In fact that is not the way investment banks work. They are all income-driven, i.e. seeking to maximise the product of the average percentage fee (or bid-offer spread, expressed the same way) and total value of transactions.

To my mind, this explains why so much trading activity destroys value. The parable of the Gotrocks clan explains a lot. Buffett is always careful to avoid being too nasty to GS as they do act for him in some transactions, but it is clear to me that he regards them as fairly parasitic, if not exactly a giant vampire squid wrapped around the face of humanity.

The problem is that we, the population at large, are the Gotrocks, and we are losing out a lot to GS and their ilk. Unfortunately we rarely manage our savings directly (our pensions are almost always managed 'professionally') and we cannot choose to follow Buffett's example and avoid almost anything to do with trading.

*

I don't know how long the link to The Times article will work, as Rupert Murdoch has stated that he plans to charge for all content. A quick search should throw up the essential facts of the interview.

I regularly get called up by mysterious salesmen offering wealth beyond the dreams of avarice if only I will sign up to their brokerage and start trading on the wonderful research they will give me.

I just spoke to Matthew Taylor of Finsoul.com. He was offering tax-free investment, offshore trading, between my repeated attempts to bat him away. I think I am just too polite even to cold-calling reptiles like him.

Anyway, it's interesting to see that this operation has jumped on the Big Green Bus of companies that are working to save the planet. I suspect that a lot of fraud will be conducted under the auspices of environmental responsibility. Not that I would suggest that Finsoul are remotely fraudulent, although I may change my mind if they call me back on Tuesday as they have promised.