The New Market Wizards: Conversations with America's Top Traders (8 page)

Bottom line: If it weren’t for the bid/ask spread, would the banks make money on their trading operations?

Probably not in conventional position trading in the way you think of it. However, there is another aspect of directional trading that’s very profitable. Take Joe Trader. Day in, day out, he quotes bid/ask spreads and makes a small average profit per transaction. One day a customer comes in and has to sell $2 billion. The trader sells $2.1 billion, and the market breaks 1 percent. He’s just made $1 million on that one trade.

In a lot of markets that’s illegal. It’s called frontrunning.

It’s not illegal in the interbank market. He’s not putting his order in front of the customer’s; he’s basically riding his coattails.

So he does the whole order at the same price?

Generally, the first $100 million would be the bank’s. That’s just the way the market is.

Is there any difference between that transaction and what is normally referred to as frontrunning?

Yes, it’s legal in one market and illegal in the other.

That’s the answer from a regulatory viewpoint. I’m asking the question from a mechanical perspective: Is there an actual difference in the transaction?

The real answer is no, but I’ll give you the answer from a bank’s perspective. When I allow you to come in and sell $2 billion in the foreign exchange market, I’m accepting the credit risk and providing the liquidity and facility to make that trade. In exchange, you’re providing me with the information that you’re about to sell $2 billion. That is not a totally unreasonable rationalization.

How do you move a large order like $2 billion? How do you even get a bid/ask quote for that amount?

I’ll tell you what happens. Let’s say an order comes in for $500 million or more. The dealer stands up and shouts, “I need calls!” Immediately, among the dealers, junior dealers, clerks, and even the telex operators, you have forty people making calls. Everyone has their own call lists so they don’t call the same banks. They probably make an average of about three rounds of calls; so there are 120 calls in all. All of this is done in the space of a few minutes. The dealer acts as a coordinator—the bank staff shouts out bids to him and he calls back, “Yours! Yours! Yours!” all the time, keeping track of the total amount sold. A large bank can move an amazing amount of money in a few minutes.

When you get right down to it, virtually all the trading profits seem to come from profit margins on the bid/ask spread and coattailing of large orders. That makes a lot more sense to me, because I couldn’t figure out how the banks could hire all those kids right out of school who could make money as traders. I don’t think trading is that easily learned.

You know my pet peeve? Is
that
trading? Even at Salomon Brothers, where there’s a perception that everyone is a trader, it came down to only about a half-dozen people who took real risk. The rest were essentially just making markets. That nuance is lost on most people.

Getting back to the credit risk associated with the interbank market that you mentioned earlier, when you do a trade, are you completely dependent on the creditworthiness of the other party? If they go down, are you out the money?

You got it.

Has that ever happened to you?

No.

How often does it happen?

If a trade involves anyone who is even in question, you can ask them to put up margin.

Isn’t it possible for a bank with a good credit rating to suddenly go under?

Suddenly? No. What is the worst case you can think of? Drexel? Salomon stopped doing currency transactions with Drexel a year and a half before they went under.

Are you saying that there’s not much of a credit risk involved?

There is some risk, but does a Conti fail overnight? We stopped trading with Conti five months before the Fed bailed them out.

But someone was trading with Conti in those last few months. Were they just less well informed?

Not necessarily. They were just willing to take the risk. You can be sure that in those final months, Conti was not dealing at the market. At a certain interest rate level, you would lend any bank money. The reason why surprises don’t happen is because it’s in everyone’s interest to know when there is a problem. Therefore, credit officers are very quick to share information whenever they think a problem exists.

Do you ever have dreams about trades?

On one particular occasion, I had a very specific dream the night before a balance-of-trade number was to be released. I dreamt that the trade figure would be a specific number; the revision would be a specific number; the dollar would move up to a certain level, and I would buy dollars; the dollar would move up to a second level, and I would buy more dollars; the dollar would move up to a third level, and I would buy yet again; the dollar would move up to a fourth level, and I would want to sell but would buy again.

The next day, the trade number came out, and it was exactly the same number as in my dream. The revision was also exactly the same number. Even the price sequence was exactly the same as in my dream. The only difference was that [he pauses] I didn’t trade at all.

Why not?

Because I don’t trade on dreams or rumors. I’m a fundamental trader. I try to assemble facts and decide what kind of scenario I think will unfold. To walk in and trade on a dream is absurd. I told my assistant about my dream, and we laughed about it. He said, “The day you start trading on dreams is the day we might as well pack it up.”

As I watched the price action unfold, the market looked good at each of the price levels. Ironically, if I had never had the dream, I might very well have bought dollars.

In your conscious state, you agreed with the basic trade. Right?

Absolutely.

Was it a matter of not taking the trade because you didn’t want to appear to be trading on a dream?

Very much so. Within myself, I was very confused as to what was happening. It was a very odd experience.

Was it sort of shades of the Twilight Zone?

Just like it. I couldn’t believe it. My assistant and I just kept looking at each other. When the trade numbers came out exactly as I had dreamt, he said, “Billy, come on, where did you get those numbers?”

Has this type of experience happened to you at any other time?

That was the time that I remember the best. I had similar experiences on other occasions, but I don’t remember the specifics as clearly.

Do you want my theory on a logical explanation?

I’d love to hear it. How do you explain picking the exact number?

You work, relax, eat, and literally sleep with the markets. You have a storehouse of fundamental and technical information embedded in your mind. Let’s say that because of some unconscious clues you picked up—maybe something somebody said, or some positions you saw certain people take, or whatever—you thought that the trade numbers would be out of line with expectations. But for some reason, you didn’t want to trade on this expectation. Maybe, in this case, the expectation seemed irrational and you would have felt stupid trading on it. Maybe you don’t like trading in front of the release of government numbers because of some past negative experiences. The reason is not important. I’m just making up examples. The point is that it’s easy to envision how you might correctly anticipate an unreleased statistic and why such a projection might occur on a subconscious level.

Your projection of the market moving in a certain direction is even easier to explain. Given your vast experience, once you were right about the trade numbers, it would hardly be surprising that you would get the direction of the market right. Even dreaming about the exact price levels is not so absurd, because you have an exceptional feel for market swings. In fact, just the other day, I saw you pause in midconversation to place a buy order in a plummeting Australian dollar market at what proved to be exact turning point.

All I’m saying is that all this information is in your mind, and it may come out in a dream because, for whatever reason, you haven’t translated it into action. There is nothing particularly mysterious about it. You don’t have to believe in precognition to explain it.

You can even argue further that playing out scenarios is something that I do all the time. That is a process a fundamental trader goes through constantly. What if this happens? What if this doesn’t happen? How will the market respond? What levels will the market move to?

So you think that not backing up an expected scenario by taking a position will tend to force it out in the subconscious mind as a dream?

Sometimes—sure. I’m not speaking as an expert. I’m not a psychologist, but it seems logical to me. I’ll give you a personal example. Several years ago. I had a strong feeling that the Canadian dollar was in the early stages of a multiyear bull market. The market had a good upmove and then went into a narrow consolidation. I felt it was going to go higher, but I was already long four contracts, which was a relatively large position for a single market, given my account size.

That night I had a dream that the Canadian dollar just went straight up. The next morning I came in and, right off the bat, I doubled my position from four to eight contracts. The market went straight up. I believe the reason this projection came out in a dream was that my logical mind couldn’t accept taking the trading action dictated by my market experience. My logical side said, “How can I double my position when the market has gone straight up without even a slight reaction?” Of course, as we both know, trades that we are the most difficult to take are often the successful ones.

On a somewhat related topic, do you believe that exceptional traders are aided by accurate gut feelings about the markets?

Generally speaking, I don’t think good traders make gut or snap decisions—certainly not traders who last very long. For myself, any trade idea must be well thought out and grounded in reason before I take the position. There are a host of reasons that preclude a trader from making a trade on a gut decision. For example, before I put on a trade, I always ask myself, “If this trade goes wrong, how do I get out?” That type of question becomes much more germane when you’re trading large position sizes. Another important consideration is the evaluation of the best way to express a trade idea. Since I usually tend not to put on a straight long or short position, I have to give a lot of thought as to what particular option combination will provide the most attractive return/risk profile, given my market expectations. All of these considerations, by definition, preclude gut decisions. Having said this, there are instances when, despite all my planning, trading decisions are made that might best be described as instinctive.

For example, consider the situation when I attempted to buy the Australian dollar the last time you were here. In that particular instance, the Australian finance minister had made a statement to the effect that he didn’t care if the currency lost 10 percent of its value overnight. How do you react? Those types of panic situations are the instances when gut feeling comes into play. During the market turmoil that followed his statement, I felt that there was no way the currency could adjust even remotely close to 10 percent before large buyers would come in and push it the other way.

How far was it down at the time you entered your buy order?

About 5 percent. Even though I was already long a long-term position that was adversely affected by the news, I just felt that, over the short term, the market was bound to rebound.

How do you gauge when a panic has run its course?

I think it’s a combination of market experience and innate feel. Many currency traders operate under rules that if they lose a certain amount of money, they must liquidate the position. Those are not the type of decisions that are made rationally given the specific situation at a given moment; rather, they are general rules that have been established previously. How do you decide when that type of last-ditch selling is nearly exhausted? It’s probably largely a matter of past experience that has suffused your subconscious. In this sense, what people describe as gut feel is probably better described as subconscious market experience.