Float like a butterfly, Sting like a bee
A book that I am currently reading (The Quants, by Scott Patterson) follows the classic path of a Greek tragedy. Man full of hubris (in this case due to his intellectual prowess) believes he has discovered the Truth. Drunk with arrogance from his ability to extract billions upon billions of profits from the financial markets he ignores the danger signs of the greatest credit bubble in the history of mankind and winds up nearly destroying the global financial system with his greed and megalomania.
It’s difficult to fathom that some of the smartest mathematical minds in the world could become subject to the basest human emotions of a degenerate gambler, but the protagonists of this book do indeed begin to behave exactly like roulette junkies doubling down continuously until their bankroll is nearly exhausted.
One of the key takeaways from the Quants is that despite the multi-regression factor analysis, despite cupola functions and Gaussian curves, despite elegant algorithms that constantly play mean reversion between momentum and value – financial markets are at their core not logical at all, but rather psychological. In times of fear human beings will be afraid to bid a penny for a multibillion dollar company and in times of greed they will part with their last dollar on a stock that has negative net worth.
Yet the true lesson that I learned from the book is that size and leverage kill. The real reason most of these quant hedge funds got into so much trouble is that the massive scale of their positions along with the very high lever factor of up to 30:1 set them up for a colossal failure. Like dinosaurs that ruled the earth they were nearly wiped out from one cataclysmic event – the collapse of the US housing market.
In many ways their predicament made me appreciate my position as a retail trader. My exist strategy is not dependent on liquidation of thousands of securities. One click of a button and I can be in cash within seconds. This is a much underappreciated benefit that many of us take for granted. Unless we are trading more than 50M notional of currency, our size will not impact the market allowing us unimpeded entry and exit from our trade. Of course, platforms will go down, quotes will freeze and brokers will be unable to execute our orders – but those are permanent risks of trading FX and a big reason for why you should have several accounts. In the grander scheme of things however our ability to “float like a butterfly, sting like a bee” is a huge asset. In trading being small and swift is a plus.
The other lesson from the Quants is the double edged danger of leverage. Basically anything above 10:1 is ultimately financial suicide. Leverage is a wonderful drug when the trade moves in your direction but it is pure poison when the market is aligned against you. The Achilles heel of all of the quants profiled in the book wasn’t their finely tuned analytics. It was their massive leverage that forced them to cough up their positions at the worst possible time. When Bob Pisani walks the floor of the NYSE screaming that there is non-fundamental seller in a stock – he is referring to margin liquidation – a time when your ability to choose is taken away from you. The quants were the victims of that very dynamic and not even the most sophisticated algos in the world could help them then.