The Midas Formula: Trillion Dollar Bet

[tar]

I love it ( 5 parts)

The Black-Scholes Formula - 1/5 - YouTube

 

[Jason101]

Thanks tar I enjoyed that, I will watch the rest on youtube.

Jay

 

[jthetrader]

I saw this a while back, what I wondered was how did LTCM get that much access to capital, how did they take such big positions? Surely only an idiot lends someone hundreds of $ for every $ they actually have.

Retail forex obviously has very high leverage but with retail forex traders it is usually a case of a position of $100,000 or so which can be closed with little or no slippage. If you have a $100 billion position on bonds and it falls down 2% what are the odds you will be able to liqudiate it without a risk of it falling a lot further?

And another thing, why did anyone invest with LTCM if they didn't understand what they did, at least in broad terms? It often seems that fund managers with secret strategies and abnormally high returns end up costing their investors a lot, lot more than they ever made them, e.g. Madoff.

 

[Jason101]

I saw this a while back, what I wondered was how did LTCM get that much access to capital, how did they take such big positions? Surely only an idiot lends someone hundreds of $ for every $ they actually have.

Retail forex obviously has very high leverage but with retail forex traders it is usually a case of a position of $100,000 or so which can be closed with little or no slippage. If you have a $100 billion position on bonds and it falls down 2% what are the odds you will be able to liqudiate it without a risk of it falling a lot further?

And another thing, why did anyone invest with LTCM if they didn't understand what they did, at least in broad terms? It often seems that fund managers with secret strategies and abnormally high returns end up costing their investors a lot, lot more than they ever made them, e.g. Madoff.

I don’t think it was their strategy in general that was at fault, it seems as though was a good strategy under normal market conditions. Hence the ability to attract so much investment and leverage, also the fact that these guys invented the formula for pricing options, they had a lot of kudos.

It seems as though their problem was not their system but not knowing under what market conditions their trading system would not work. They carried on taking both sides and increasing risk at a time the market was telling hedge funds to reduce risk and go to cash.

In other words they were great academics but poor traders with no real trading experience or instinct.

 

[jthetrader]

I don’t think it was their strategy in general that was at fault, it seems as though was a good strategy under normal market conditions. Hence the ability to attract so much investment and leverage, also the fact that these guys invented the formula for pricing options, they had a lot of kudos.

So they were selling options? That might explain quite a lot, perhaps the leverage was not actually cash lent to them but the potential loss if all of the options they had sold reached their strike prices.

I wonder whether there is any [legal] strategy which could exist which would allow someone to generate market beating returns on a very large sum of money irrespective of market conditions? Or would the nature of the market mean that eventually their returns and the returns offered by following the market converged thereby putting them at no advantage to the market at all? Could someone managing $10 billion say, so a very big hedge fund but not a very big bank, find a way to generate twice the S & P 500's returns, without leverage, gross of fees or would attempts at reverse engineering the strategy eventually render it useless? BTW this is assuming they returned the gains to investors at the end of each year so they started with the same amount of capital each year?

Of course one could generate alpha simply investing in the S & P or the FTSE straight up, unleveraged and engaging in the odd bit of insider trading, you would always beat the market provided the information was good, properly acted upon and acquired at a competitive price. In fact I think a certain Sri Lankan gentleman is soon to be serving time for executing that strategy to great effect over the last 20 years.

It seems as though their problem was not their system but not knowing under what market conditions their trading system would not work. They carried on taking both sides and increasing risk at a time the market was telling hedge funds to reduce risk and go to cash.

In other words they were great academics but poor traders with no real trading experience or instinct.

I once saw the strategies used by LTCM and a few other highly leveraged quant-dominated firms described as 'jumping in front of a steamroller to grab a nickel'; it seems a pretty fair description from what I know of them, or LTCM at least. As you say these guys are not traders, they don't understand the actual dynamics of the market and when you're operating with 100:1 leverage even if it is all sorted on paper you can't be sure it will be right in reality.

If the market is going to cash wouldn't the logical step be to short like mad? It sounds like a perfect scenario for any trader to be in a position yourself where you don't need to liquidate while everyone around you does, easy pickings so to speak.

 

[maxima]

As you say these guys are not traders, they don't understand the actual dynamics of the market

obviously the present people all are great traders who understand the markets.

this is the fruits of so called 'equality'. and this is why it doesnt work. hey atilla come here and tell me this is all nonsense

 

[jthetrader]

obviously the present people all are great traders who understand the markets.

Well obviously

Great traders can only be identified when they've retired imo. Look at how many 'great traders' who had been profitable for oh so long got shown up in 2008.

 

[Jason101]

obviously the present people all are great traders who understand the markets.

this is the fruits of so called 'equality'. and this is why it doesnt work. hey atilla come here and tell me this is all nonsense

They are separate points. The comparisons being made were to other hedge funds trading at that time, during the Asian contagion, rather than what has gone on since, but I agree, nothing changes while greed still exists.

 

[tar]

Interesting information here :

Long-Term Capital Management - Wikipedia, the free encyclopedia

lol @
" After helping unwind LTCM, Meriwether launched JWM Partners. Haghani, Hilibrand, Leahy, and Rosenfeld all signed up as principals of the new firm. By December 1999, they had raised $250 million for a fund that would continue many of LTCM's strategies—this time, using less leverage.[31] With the Credit Crisis, JWM Partners LLC was hit with 44% loss from September 2007 to February 2009 in its Relative Value Opportunity II fund. As such, JWM Hedge Fund was shut down in July 2009.[32]"

 

[jthetrader]

Interesting information here :

Long-Term Capital Management - Wikipedia, the free encyclopedia

lol @
" After helping unwind LTCM, Meriwether launched JWM Partners. Haghani, Hilibrand, Leahy, and Rosenfeld all signed up as principals of the new firm. By December 1999, they had raised $250 million for a fund that would continue many of LTCM's strategies—this time, using less leverage.[31] With the Credit Crisis, JWM Partners LLC was hit with 44% loss from September 2007 to February 2009 in its Relative Value Opportunity II fund. As such, JWM Hedge Fund was shut down in July 2009.[32]"

Hahaha, I may be changing my name to John Meriwether; how does the saying go, fool me once shame on you, fool me twice shame on me, fool me thrice....
:cheesy:

 

[Shakone]

LTCM made a lot of money initially. It's easy to laugh after the fact, but they were a huge firm and a very successful one for years. In 4 years with them you would have multiplied your money by 4 times. Very few companies that take risks on the market couldn't be taken out of the game given extreme enough circumstances. And many that could get carried out offer a far lower return than LTCM did.

The nobel prize winners weren't traders, they were economists/mathematicians, so I put less blame on them. They developed models and looked at arbitrage opportunities, but it really should have been up to someone with a bit more market experience to determine when that model was working or not. I'm not surprised Meriwether started another fund. Just because someone has blown up, doesn't mean investing in them is crazy. Just read Market Wizards and see how many of those blew up at some point.

 

[tar]

BTW this chart reminds me of Zulutrade's top performers !

 

[jthetrader]

LTCM made a lot of money initially. It's easy to laugh after the fact, but they were a huge firm and a very successful one for years. In 4 years with them you would have multiplied your money by 4 times. Very few companies that take risks on the market couldn't be taken out of the game given extreme enough circumstances. And many that could get carried out offer a far lower return than LTCM did.

The nobel prize winners weren't traders, they were economists/mathematicians, so I put less blame on them. They developed models and looked at arbitrage opportunities, but it really should have been up to someone with a bit more market experience to determine when that model was working or not. I'm not surprised Meriwether started another fund. Just because someone has blown up, doesn't mean investing in them is crazy. Just read Market Wizards and see how many of those blew up at some point.

Fine, but as a 'passive investor' you should not have to be concerned about whether the fund your money is with is liable to go bust at any minute, the mere fact that a fund is returning 40% a year to you (as I believe LTCM did in their first year) should be a warning sign that the manager is taking very big risks.

If I were in the position most hedge fund investors are in (i.e. net worth in the tens of millions, biggest threat to portfolio is inflation, not seeking massive returns just enough to retain the value of my portfolio) and I got 40% in a single year I would count myself lucky, withdraw the money and put it somewhere else; if you can generate 40% a year your beta must be very high.

 

[tar]

I'm not surprised Meriwether started another fund. Just because someone has blown up, doesn't mean investing in them is crazy. Just read Market Wizards and see how many of those blew up at some point.

I am surprised ! After this huge failure and after billions of $ of bailouts they reinvest in the same strategies ! what could be worse ?

 

[jthetrader]

I am surprised ! After this huge failure and after billions of $ of bailouts they reinvest in the same strategies ! what could be worse ?

Wouldn't that depend on what the strategy is? Pre-crisis you could have made a lot of money by leveraging to the hilt and going long the market, you would have been killed in 2008 but it is possible that by that point most investor's realised gains would have exceeded their initial deposit. If another bull market returns maybe it would be a good idea to do the same thing.

I don't know, I'm not an expert but I imagine that if you had leveraged yourself 10 to 1 and just gone long the S & P 500 and the FTSE between just after the end of the dot com boom and had liquidated say 25% of your gains each year and returned them to investors by 2008 they would have made a lot, lot, lot more than they put in in 2000. Am I wrong?

 

[tar]

Wouldn't that depend on what the strategy is? Pre-crisis you could have made a lot of money by leveraging to the hilt and going long the market, you would have been killed in 2008 but it is possible that by that point most investor's realised gains would have exceeded their initial deposit. If another bull market returns maybe it would be a good idea to do the same thing.

I don't know, I'm not an expert but I imagine that if you had leveraged yourself 10 to 1 and just gone long the S & P 500 and the FTSE between just after the end of the dot com boom and had liquidated say 25% of your gains each year and returned them to investors by 2008 they would have made a lot, lot, lot more than they put in in 2000. Am I wrong?

10 :1 in equities is a high leverage for a hedge fund , any pullback in the market and you are screwed ....

Investing in a hedge fund its like buying a stock or an ETF its even riskier sometimes , you wouldn't know when to enter and when to exit

Paulson braces investors for the worst | Reuters

Paulson Clients Said to Pull Less Than 10% From Two Funds - Businessweek

" a year where Paulson's flagship Advantage Fund is off 32 percent and its Advantage Plus cousin is down 47 percent "

"Withdrawal orders for those two funds, which together managed about $15 billion as of July 31, were due at the end of September "

"clients who came in at the beginning of 2008 have made 4.3 percent, according to Bloomberg calculations"

 

[Hotch]

IIRC, LTCM's strategies were fine (they were arbitrage strats). The problem was that they continued to take on investment, and became too big in the markets they were trading. Instead of refusing additional investment (like Kovner, Soros, Buffet etc), they took the extra money and went into other strategies and other markets, that's where they buggered up.

So really, the only thing wrong with the original strategies was that there wasn't an infinite amount of liquidity for them.

 

[tar]

IIRC, LTCM's strategies were fine (they were arbitrage strats). The problem was that they continued to take on investment, and became too big in the markets they were trading. Instead of refusing additional investment (like Kovner, Soros, Buffet etc), they took the extra money and went into other strategies and other markets, that's where they buggered up.

So really, the only thing wrong with the original strategies was that there wasn't an infinite amount of liquidity for them.

martingale is a great strategy but if there is an infinite amount of cash !

 

[jthetrader]

10 :1 in equities is a high leverage for a hedge fund , any pullback in the market and you are screwed ....

Okay that may have been pushing it, say 3:1, which would require a 25% fall in the market before they started forcing you to close positions.

Investing in a hedge fund its like buying a stock or an ETF its even riskier sometimes , you wouldn't know when to enter and when to exit

No, I'm saying if someone starts up a fund today which is promising to provide superior returns in a bull market you will make market beating returns. It would be a very good deal, notwithstanding the fact your beta would be very high; but if you're in the position many of those ostensibly investing in hedge funds are then that wouldn't matter. If you were opening a highly leveraged long only fund you wouldn't solicit money from individuals you would solicit it from feeder funds who wouldn't care if the firm blows up if they've had a few good years.

If you invested $100, leveraged to $400, in the S & P 500 in the five years from 2003 to early 2008 @ an average borrowing rate of 5% you would have made a lot of money. And I don't think a single fall of 25% ever occured, so you wouldn't have triggered a margin call. So if you had been carefully withdrawing 25% of your stake year on year you would be up on someone who had just invested in the S & P without leverage.

Paulson braces investors for the worst | Reuters

Paulson Clients Said to Pull Less Than 10% From Two Funds - Businessweek

" a year where Paulson's flagship Advantage Fund is off 32 percent and its Advantage Plus cousin is down 47 percent "

"Withdrawal orders for those two funds, which together managed about $15 billion as of July 31, were due at the end of September "

"clients who came in at the beginning of 2008 have made 4.3 percent, according to Bloomberg calculations"

Even John Paulson doesn't have the Midas touch

 

[tar]

Myron S. Scholes and Robert C. Merton Receive CME Group's 2011 Fred Arditti Innovation Award

CME Group Fred Arditti Innovation Award