A few weeks back, I kicked off the Intelligent Investor Series as part of my weekly commentaries. Th...
A Tale of Three Traders (Part 4)
02/14/2008 12:00 am EST
Now let me tell you about a trader that worked for me briefly. The prevailing theory throughout the professional trading community at that time was that individuals who were accomplished in gaming theory generally made good traders. All of the trading managers were instructed when interviewing candidates to put a great deal of emphasis on determining if a candidate played games of strategy (chess, checkers) or played games of chance (poker or other gambling games, where they would be well versed in betting theories). We were even told to mark “inquire” if candidates visited the local horse racing tracks and liked to bet on a regular basis.
Frank was a poker player by trade, or had been before we hired him to become a trader on our currency desk. His claim to fame as a poker player was that he had made it to the finals of the World Series of Poker several years back (this was many years before ESPN became a network, so this event was fairly unknown unless you were a poker player). He interviewed well, and although he had no experience as a trader, he had a good feel for betting and odds (that’s a surprise, isn’t it?), and the management team decided he would make a good junior trader on my currency desk. He was to sit next to the yen trader, and after he learned the basics of currency trading, he was to be given a small position and loss limit and allowed to trade the cash Australian dollar. After serving about six or seven months as an assistant, I was told to give Frank his limits and see what he could do with the Australian dollar.
The Australian dollar market during the US daytime back then was a small market, so I gave him a 3 million Australian dollar limit and an intraday loss limit of $20,000. And for the first five or six months, things went well for Frank. He had a few losing months, but he had more winning months than losing months and he observed his trading and loss limits. Although the Australian banks began trading at 3 pm our time, we did not have a 24-hour cash currency trading operation at the time, so by the time the larger players in the Australian dollar market were beginning to throw around large numbers and move the Australian dollar market around, our desk was closing up and balancing our positions for the day.
Our rules were simple. Everyone had intraday trading and loss limits and you never violated them. Only senior traders were allowed to hold positions overnight, and most of them preferred to go out eating and drinking with their husbands, wives, or girl or boyfriends to watching overnight positions. This was the golden age of cash foreign exchange, and if you were a good intraday trader, between your salary and your bonus, as a senior trader, you were generally paid more than you could spend.
I was on the risk committee, and also personally did all of the execution for the bank’s largest clients, as well as the bank’s own proprietary portfolio, so I almost always had positions to watch, and tended to get phone calls all night long from around the world as the orders I left were executed or my call levels were reached. And I tended to get into the trading room at 4 am each day—two or three hours before any of the other traders wandered in. When I arrived, the huge 350-person trading room was always pitch black and I always had to wait just inside the trading room for my eyes to adjust to the darkness before walking over to my office to hang up my coat and put down my brief case and chart case on my desk.
And then one morning, I used my key card to open the trading room door and to my amazement, there was a small pool of light out in the darkness, coming from my cash currency trading desk area. I stopped at my office and dropped off my coat, my briefcase, and my chart case. Then I headed for that lone circle of light. I couldn’t imagine who had left screens on all night and I doubted the janitors knew how to turn on our built-in computer screens.
To my surprise, I found Frank on the far side of the desk, leaning back in his chair, talking to someone on the phone. I quickly paid attention to the tenor of his voice. He certainly wasn’t panicking—in-fact, he seemed in quite a good mood, though his voice was a bit hoarse. He looked up at me and gave me a smile and a wink, then went right back to his conversation. I told him quietly to come see me as soon as he was off the phone and then went back to my office to check my desk for any orders that had been filled overnight and left on my teletype machine.
A few minutes later, Frank popped in smiling. “What’s up, boss?” he asked. I told him I was shocked to see him here so early, and he sheepishly told me he hadn’t left last night. He’d been watching the action when the large Australian banks came in at 3 pm, got caught up in what they were doing, and before he knew it, there I was, walking in the door at 4 am!
I knew the answer to the following question was going to decide whether Frank was going to make it as a trader. “Frank, you watched all night long? Or you watched and took some positions all night long?”
“I watched, mostly,” he said in his now raspy voice.
“Does that mean you traded last night?” I asked him.
“I made friends with the trader that runs the currency desk at the largest Australian bank and he told me about some huge customer orders they had, so I stayed and watched, and when I saw something that looked good, I made a trade or two.” This conversation was not boding well for Frank’s future. I probably didn’t have to ask the next question—I thought I already knew the answer. But I asked it to give him the opportunity to answer it.
“How’d your trading go, Frank? Are you up or down?”
“I was killing ‘em early on, and then after Australia went home for the night, I gave some of it back.”
“How much did you give back, Frank? Are you up or down for the day—or night—or the past 24 hours?” I thought I could tell by Frank’s expression, but it was important for both of us that he tell me—and tell me the truth.
“I’m up for the night, boss. I made a lot of money early.” The way he said it told me something wasn’t quite right. I pressed on.
“So you made lots of money early after your friend gave you a tip on some customer orders, but gave some back after the Australian traders went home for night and Europe took over, right? Do you have a position now, Frank?”
“Yeah, I have a position on. I know it’s gonna come back as soon as the US comes in. My friend told me this same company has to do more this morning.” Frank was fidgeting a bit now as he answered my questions. There was something still wrong here, something other than a junior trader violating the basic rule of no overnight positions.
“How much are you up, Frank?”
“I’m up $40,000, boss.” If that was true, it would be Frank’s largest one-day trading gain since he began as a trader, but he wasn’t acting like someone that had just made more money in one day than he ever had before.
“Is that $40,000 including your current position priced at the market, Frank?”
“No boss. I’d have to calculate that and tell you the net P&L.” Now I thought I knew what was bothering me, what hadn’t come out yet.
“Frank, what’s your current position?” I looked him right in the eyes as I asked this question, and by the way he dropped eye contact with me immediately, I knew he was in dire trouble.
“Uhhh…I’m long about 75 Aussie.” He didn’t look up as he told me his position. His current position was more than 20 times his position limit.
“And at the current market price, what’s your loss on this position, including your gains from earlier, Frank?” I knew I’d be going to see the head of capital markets soon and I’d need all the facts.
Frank told me, “I’d have to go do the math, boss.” I told him to go figure out his exact loss at the current market price and to write down both that and his exact position. While he went to do that, I called my boss, the head of capital markets, and filled him in. He told me to get the facts and then come see him.
I went back down to Frank’s desk, still a small circle of light in the vast dark trading room, and looked over his shoulder. If I could understand what he was writing, he was long 122 million Australian dollars and at the current market price, he had net lost $430,000. The loss wasn’t a staggering amount, but it was more than 20 times his daily loss limit. And the position was 40 times his intraday position limit—but this was not during the day! He wasn’t even allowed to trade overnight.
“Why are you long 122 million Aussie, Frank? Your limit is 3 million Aussie.”
He looked up at me and then started to let it out: “It was going so well. Then when it turned down, I called my friend and he told me the company had lots more to buy, and as soon as the US came in, they’d start buying again. So I started adding on as it went down.”
“Frank, you don’t have permission to trade overnight.”
“I didn’t leave the trading room, so I figured it was ok. It wasn’t like I was trading from home. I just stayed late and kept trading here at the trading desk.”
“You’re down over $400,000 dollars, Frank. And your daily loss limit is $20,000. Why didn’t you just get out of your position when you got near your loss limit?”
Frank gave me a very odd stare, as if he was talking to an idiot, and said, “It’s too big a position. I couldn’t just dump over 120 million Aussie dollars once the Australian banks went home!”
I reached over Frank’s shoulder and picked up the phone to one of his cash currency brokers. “Can you give me a price on 122 million Aussie, Bob?” I asked. Bob recognized my voice immediately and told me, “Sure, Tim, but it might be a bit wide.” I told him I wasn’t worried about the spread, I just wanted a price. Sure enough, he soon came back with a bid and offer on the entire amount and I liquidated Frank’s position immediately. Then I told him to go wait in my office while I went to see my manager.
Frank had violated his position limit, his loss limit, and he had violated the rule that forbade anyone other than senior traders from holding overnight positions—which were positions when you weren’t directly being supervised by a trading manager. In my eyes, Frank had badly violated all three, and I expected that before breakfast, I would be writing paperwork for his dismissal. To my surprise, my manager told me that perhaps I was judging Frank too harshly. He argued that maybe Frank didn’t understand the difference between overnight positions and intraday positions. And though he agreed Frank had violated both his loss and position limits, he pointed out that the loss wasn’t terribly large, given the net profitability of our trading desk on any given day. We were in disagreement and decided to see his boss to get a final opinion.
My manager’s manager listened as I quickly stated the facts without giving my opinion on what to do about Frank. Then he listened as my manager in essence spoke on Frank’s behalf, suggesting that he had shown some promise and maybe this was a case of just not understanding the rules fully. His manager waited until he was done and then asked the defining question: “Do either of you gentlemen want your careers decided by allowing that young man to continue to trade?” I never got a chance to answer. My manager quietly said, “We’ll let him go this morning.” And that was the end of Frank’s career as a cash currency trader.
|More tomorrow in part 5.||Part 1 | Part 2 | Part 3 | Part 5|
Related Articles on STRATEGIES
There was no shortage of reporting last week on the long-awaited verdict for the U.S. versus AT&...
There’s a somewhat unprecedented shake-up taking place within institutional investment portfol...
On balance, we are most enthusiastic at present about investment opportunities in the U.S., explains...