The Book - Beat The Dealer and Money Management

A couple of weeks ago I read the weekend edition of the Wall Street Journal and there was a great interview / article with Bill Gross and Edward Thorp. Bill Gross is the billionaire bond manager who controls the bond firm PIMCO on the West coast. Edward Thorp is the author of the book 'Beat The Dealer.' Edward Thorp was an MIT professor and wrote 'Beat the Dealer' after studying Black Jack and writing a paper about it. The book was written in the 1960s and it explains in elaborate detail how to win at the game of Black Jack. Bill Gross came across the book and studied the method then went to Vegas and applied it and won. What I found interesting is that Bill Gross who now manages about $1 trillion in assets uses some of the techniques to manage money at PIMCO. The big rule that he uses is the one about money management.

In the book Thorp teaches that unless your edge is strong to 'play' a small hand but that once the odds increase in your favor to then increase the bet size. I have read over and over again in many trading books about money management and that sizing the bet is one of the most important factors to longevity and success in the money management business. I personally believe that it is the most important factor. The reason is that if one makes bets that are consistently too large without having a consistent edge in all of those positions then the chances are very high that the trader is going to blow up. This was LTCM's problem in 1998 when they 'blew up'. No matter how strong their edge was it was not strong enough to outlast the negative forces that overtook their portfolio. Their bets were simply too large and they ran out of money before the positions came back to their favor. This was the SocGen problem with that trader Kerviel as well - position size.

Learn to size trades and you may be successful in this brutal business. Thanks to the Wall Street Journal for writing that great article and to Edward Thorp for writing that amazing book and to Bill Gross for explaining again the importance of money management. If you want an entertaining book and want to show off to your friends when you go to a casino, read Thorp's book 'Beat The Dealer'. It cost me $12. Definitely up there with some of the best $12 I have ever spent.

What Does the $13 Trillion Notional Value Derivative Contracts of Bear Really Mean?

I have previously written about counterparty risk and how the financial system is intertwined. Well Bear Stearns was one of these larger twine turners. The approximate notional value of their underlying derivatives was about $13 trillion. This does not mean that they were on the hook for $13 trillion but rather this $13 trillion represents the value of the underlying assets behind the derivatives had the derivatives been converted into that underlying asset. If this doesn't make sense then I will provide an example. Since most people understand stock options I will use that as an example. Before I begin I want to reference the Wall Street Journal for the $13 trillion. Around the week of March 17th they ran an article explaining the meaning of the $13 trillion notional value of Bear's derivative book. It helped me understand what notional value means. When large numbers get thrown around (and trillions of dollars are fairly large numbers) then people may not understand the actual risk behind these derivative contracts.

I will use the example of a call stock option. I am going to assume that the reader understands how a call option works. If not, then I may write an article explaining stock options, but that will be for another day. I will use IBM. I will also use the IBM 110 call with one week left to expiration. I will assume IBM is trading for 100 per share and there is about 1 week left before the contract expires and that the price of the call option is going to be very inexpensive. It may be 'Bid' 0.03 'Asking' 0.05. Let's say I wanted to be very daring and thought that the stock could jump over 110 by week's end or prior to expiration. Assume I am willing to risk $50,000 (note this is a bad bet as it is extremely unlikely that IBM moves 10 points higher in 1 week's time and that I am likely to lose $50,000). So I buy 10,000 contracts for 0.05 per contract. (Lets assume that there is no commission) then I have a position that gives me tremendous leverage. With a $50,000 position I now control 10,000 contracts or 1 million shares. With IBM trading for $100 per share the notional value of this position would be 1 million shares x $100 per share or $100 million dollars. Am I liable for $100 million? No. Is the entity (or counterparty) on the other side of the trade liable for the $100 million? Very unlikely, but they are liable for a portion of the contract if it went into 'the money'. For instance, if IBM went to 120 before the week's end my counterparty would have to pay me $10 million. Back to my side of the trade and what I receive. Essentially I now have exposure to the stock that if it were to clear that level of 110 that would give me leverage and exposure as if I owned 1 million shares. Notional value of a derivative assumes the full price of the underlying asset instead of just a portion of it. This is sort of what the $13 trillion of notional value that Bear was exposed to means.

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Another way to look at the notional value of the swaps market is that it represents the amount that the swap is insuring. On one side of the transaction a payment stream is often assumed. Therefor the notional value is not something that is paid out but rather just what is insured. I give credit for this further clarification to the CFA program curriculum. In recent days after reading the CFA derivatives book in preparation for the CFA exam I have a better understanding of notional value.

S&P 500 - Q1 Volatility

The number of days in which the S&P 500 had at least a 1% move in Q1 2008 was 51%. This was the largest percentage for a Q1 since 1934 and the 5th highest percentage for a Q1 in history. I read this stat in an article in yesterday's journal recapping the first quarter US equity markets.

What does this stat mean? An analogy may help explain what this means. On about 51% of the days in Q1 I felt like I was a piece of laundry in the washing machine spun around in all different directions and speeds. Not really the most pleasant of feelings. Basically this means that for a Q1, the S&P 500 volatility was at unprecedented levels and at the highest levels since the heart of the Great Depression.

$99 Trillion

$99 Trillion is the total Present Value of the funding needed today if Social Security and Medicare were to be fully funded. I caught this stat in a speech by the Dallas Fed president Mr. Fisher the other day. He was quoting recent figures from a study and Mr. Fisher was trying to bring this massive problem to the attention of those in the financial community. It seems that very few in the political world want to talk about this massive problem. The Social Security Present Value was placed at $13 Trillion and the Medicare Present Value was placed at $86 Trillion. His point was that these numbers dwarf the US's annual GDP which is around $13 Trillion and that the political will must be strong enough to attack this problem, now.

Who Has The Fed's Back?

If the Fed runs out of money, who has the Fed's back? I ask this question not to knock the Fed but rather as a question that may need to be answered. The Fed's balance sheet is about $700 billion worth of Treasuries. They have recently opened up quite a bit of that to the Street. What if the Fed over extends itself? Who has the Fed's back?

Maybe there is nothing here. I thought it might be worth exploring though. First it was just regular banks that the Fed lent to. Now it is also the Investment Banks. Interesting as the Fed has expanded its reach. I would doubt that at the moment that the Fed is extended but if it continued to expand its reach and other banks or investment banks needed its help, would the Fed be able to answer the call? Something to ponder.

3 Month Tbill Now Yields 0.51%

0.51% for 3 Month T-Bills. The Lowest since the 1950s. Amazing. I am just stunned to see this low yield. Add this amazing stat to the list of off-the-wall stats from the past 8 months. There have been so many. Wall Street stats are made to be broken. But to see so many statistical oddities happen simultaneously is the stunning part. Amazing just amazing.

The list of the Deflationary Spiral of 2007 - 2008 is getting longer by the day.

Commodities - It Was Bloody Out There

I was just re-reading an old post I wrote about the day Wheat soared 25% in one day. I said in the post that with moves like that that there had to be some real damage to a hedge fund or trader or some entity. Well with the tremendous down moves today in ALL of the commodities I think it may be safe to say that there is someone on the wrong sides of these commodity moves today. The 60 point move in the Gold futures contract was enough to create large scale pain. But with the carnage across the entire spectrum there are likely many players hurting. The forces of these moves are amazing. Silver, Oil, Gold the list goes on. Just huge moves. I don't wish carnage out there on anyone as I have been on the wrong side of many a trade. I am just making an observation. It is just from my experience that says that with huge down moves like today's some person, trader or entity is likely in very large financial pain tonight.