Liar’s Poker is a book about Michael Lewis’s (author of the book) experience working in the once prestigious  Salomon Brothers investment bank. He gave an insight into the internal workings, tension and ugly side of the firm. I shall pick out the useful and amusing things from the book.

Interview for an investment banker job

I found the description of the interview interesting. I do not know if this is true. “Investment bankers had a technique known as the stress interview. If you were invited to Lehman’s New York offices, your first interview might begin with the interviewer asking you to open the window. You were on the forty-third floor overlooking Wall Street. The window was sealed shut.”

“Another stress-inducing trick was the silent treatment. You’d walk into the interview chamber. The man in the chair would say nothing. You’d say hello. He’d stare. You’d say that you’d come for a job interview. He’d stare some more. You’d made a stupid joke. He’d stare and shake his head. You were on tenterhooks. Then he’d pick up a newspaper (or, worse, your resume) and begin to read. He was testing your ability to take control of a meeting.”

Trading bonds and taking an eighth of it

He described how the Salomon trader would earn commissions through the sale of bonds. The trader will probably offer $50 million worth of IBM bonds to pension fund X through the Salomon salesman. He will take an eighth of a percentage point or $62,500 in this case. Thereafter he will convince insurance company Y through another salesman that the bonds are worth more than $50 million and this may not be true. The trader will buy back the bonds from X and resell it to Y at a higher price, and pocket another eighth of a percentage point in quick succession.

The rise of the mortgage department

Salomon Brothers was the first to form a mortgage security department in 1978. This was probably the genesis of our securitization of our mortgage loans and eventually escalate into the crisis in 2008. The fastest group of borrowers were the homeowners and “the volume of outstanding mortgages loans swelled from $55 billion in 1950 to $700 billion in 1976. In January 1980 that figure became $1.2 trillion, and the mortgage market surpassed the combined United States stock markets as the largest capital market in the world.”

Securitization of mortgage loans

“Mortgages were not tradable pieces of paper… No trader and investor wanted to poke around suburbs to find out whether the homeowner to whom he had just lent money was creditworthy. For the home mortgage to become a bond, it had to be depersonalized.”

“At the very least, a mortgage had to be pooled with other mortgages of other homeowners. Traders and investors would trust statistics and buy into a pool of several thousand mortgage loans made by a savings and loan, of which, by law of probability, only a small fraction should default.”

“Thus standardized, the pieces of paper could be sold to an American pension fund, to a Tokyo trust company, to a Swiss bank, to a tax-evading Greek shipping tycoon living in a yacht in the harbor of Monte Carlo, to anyone with money to invest. Thus standardized, the pieces of paper could be traded.”

Frenzy selling of mortgage loans

When the Fed increased interest rates in 1979, the saving and loans industry was on the verge of collapse. A tax break was passed whereby the thrifts were able to enjoy if they sell their loans. Salomon Brothers, the only firm on Wall Street to have a mortgage department, was the sole buyer of cheap loans. Naturally, it monopolized the mortgage market.

“… you did not have time to check every last property in a package of loans. Buying whole loans (that is what the traders called home loans, to distinguish them from mortgage bonds) was an act of faith, …”

Government-backed

Freddie Mac and Fannie Mae were created during this period and offered to “transform most home mortgages into government-backed bonds.” “Once they were stamped, however, nobody cared about the quality of the loans. Defaulting homeowners became the government’s problem.”

 Brain drain and rise in competition

As Salomon refused to reward the mortgage traders enough to make them stay, many of the traders left for other Wall Street banks, bringing along their knowledge, skills, experience and lists of clients. This allowed other banks to catch up on the mortgage trading business and challenge Salomon’s monopoly. The spread has narrowed and profitability began to decrease.

Creation of the Collaterized Mortgage Obligations (CMOs)

“It was invented in June 1983, not not until 1986 did it dominate the mortgage market.”

“To create a CMO, one gathered hundreds of millions of dollars of ordinary mortgage bonds – Ginnie Maes, Fannie Maes, and Freddie Macs. These bonds were placed in a trust. The trust paid a rate of interest to its owners. The owners had certificates to prove their ownership. These certificates were CMOs. The certficates, however, were not all the same. Take a typical three-hundred-million-dollar CMO. It would be divided into three tranches, or slices of a hundred million dollars each. Investors in each tranche received interest payments. But the owners of the first tranche received all principal repayments from all three hundred million dollars of mortgage bonds held in trust. Not until the first tranche holders were entirely paid off did second tranche investors receive any prepayments. Not until both first and second tranche investors had been entirely paid off did the holder of a third tranche certificate receive prepayments.”

Complicated CMOs

“…seemingly limitless number of ways to slice and dice home mortgages. They created CMOs with five tranches and CMOs with ten tranches. They split a pool of home mortgages into a pool of interest payments and a pool of principal payments, then sold the rights to the cash flows from each pool (known as IOs and POs, after interest only and principal only) as separate investments. The homeowner didn’t know it, but his interest payments might be destined for a French speculator, and his principal repayments to an insurance company in Milwaukee. In perhaps the strangest alchemy, Wall Street shuffled the IOs and POs around and glued them back together to create home mortgages that could never exist in the real world. Thus the 11 percent interest payment from condominium dwellers in California could be glued to the principal repayments from homeowners in a Louisiana ghetto, and voila, a new kind of bond, a New Age Creole, was born.”

Unethical business practice

Salomon was said to dump shares of a collapsing company to clients. “There was a phenomenon known at Salomon as a priority. A priority was a huge number of bonds or stocks that had to be sold, either because selling them would make us rich or because not selling them would make us poor. When Texaco teetered on the brink of bankruptcy, for example, Salmon Brothers owned about one hundred million dollars’ worth of bonds in the company. There was a real danger that these bonds would become worthless. Unless sold to customers, they could cost Salomon a great deal of money. Sold to customers, of course, they would cost the customers a great deal of money. That, it was decided, was the best thing to do.”

Investing lies

“He [Alexander] wanted to know why the dollar was plunging… I told Alexander that several Arabs had sold massive holdings of gold, for which they received dollars. They were selling those dollars for marks and thereby driving the dollar lower.”

“I spent much of my working life investing logical lies like this. Most of the time when markets move, no one has any idea why. A man who can tell a good story can make a good living as a broker. It was the job of people like me to make up reasons, to spin a plausible yarn. And it’s amazing what people will believe. Heavy selling out of the Middle East was an old standby. Since no one ever had any clue what the Arabs were doing with their money or why, no story involving Arabs could ever be refuted.”

Create warrants to transfer risks

“Risk, I had learned, was a commodity in itself. Risk could be canned and sold like tomatoes.”

“My client wanted to take a big risk by wagering a large sum of money on German bonds rising. He was therefore the “buyer” of risk. Alexander and I created a security, called a warrant of a call option, which was a means of transferring risk from one party to another. In buying our warrant, risk-averse investors from around the world (meaning most investors) would be, in effect, selling us risk… The difference between what we paid cautious investors for the risk and what we sold it to my customer for would be our profits. We estimated these would come to about seven hundred thousand dollars.”

Investment strategy – Seek secondary and tertiary effects

There was one useful strategy described in the book. A trader named Alexander whom Michael Lewis followed.

“… in the event of a major dislocation, such as a stock market crash, a natural disaster, the breakdown of OPEC’s production agreements, he would look away from the initial focus of investor interest and seek secondary and tertiary effects.”

“Remember Chernobyl? When news broke that the Soviet nuclear reactor had exploded, Alexander called. Only minutes before, confirmation of the disasater had blipped across our Quotron machines, yet Alexander had already bought the equivalent of two supertankers of crude oil. The focus of investor attention was on the New York Stock Exchange, he said. In particular it was on any company involved in nuclear power. The stocks of those companies were plummeting. Never mind that, he said. He had just purchased on behalf of his clients, oil futures. Instantly in his mind less supply of nuclear power equaled more demand for oil, and he was right.”

After he made a killing in oil, he shifted his attention to potatoes.

“Buy potatoes,” he said. “Gotta hop.” Then he hung up.”

“Of course. A cloud of fallout would threaten European food and water supplies, including the potato crop, placing a premium on uncontaminated American substitutes.”

One more example, what if Tokyo had a major earthquake? What are the secondary effects?

“…what Alexander would do is put money into Japan on the assumption that since everyone was trying to get out, there must be some bargains. He would buy precisely those securities in Japan that appeared the least desirable to others. First, the stocks of Japanese insurance companies. The world would probably assume that ordinary insurance companies had a great deal of exposure, when in fact, the risk resides mainly with Western insurers and with a special Japanese earthquake insurance company that’s been socking away premiums for decades. The shares of ordinary insurers would be cheap.”

“Then Alexander would buy a couple of hundred million dollars’ worth of Japanese government bonds. With the economy in temporary disrepair, the government would lower interest rates to encourage rebuilding and simply order the banks to lend at those rates. Japanese banks would comply as usual with their government’s request. Lower interest rates would mean higher bond prices.”

“Also, the short-term panic could well be overshadowed by the long-term repatriation of Japanese capital. Japanese companies have massive sums invested in Europe and America. Eventually they would withdraw those investments, turn inward, lick their wounds, repair their factories, and bolster their stock. What would that mean?”

“…to Alexander, it would suggest buying yen.”

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Finally, the book is on sale at major bookstores! Over the past year, I have interviewed 8 traders in Singapore and recorded their wisdom into this book. Besides the book, you get to watch hours of interviews online! Thanks to Eileen of Moolah.asia and Aktive Learning who had helped to make this happen. Click here to buy

The Genesis

You would find familiarity to Mr Propwise’s “Secrets of Singapore Property Gurus“. This is no coincidence as this is indeed an appropriate sequel to his book since both are based on interviews. I was pretty inspired by “Market Wizards” series of books where Jack Schwager interviewed traders of various techniques and perspective. It gave a good insight into the minds of traders. I was thinking, “why don’t I do the interviews myself and get to hear from the experts directly!” I shared my idea with Eileen and she agreed to do this project together. She arranged the interviews and did all the video recording and editing, while I was work on the questions and writing. When the project was completed, we approached Aktive Learning who was willing to take up the publishing.

The Gurus

Stocks

Keane Lee is the founder of the T3B system. I have personally learned from him and I am still applying his teachings. He was the first person who taught me how to short the market. He was interested in the financial markets at a young age and without someone guiding him, he took 10 years to be proficient in trading. He believes in using a mechanical system to trade the markets so that emotions can be removed. He said,

“If there is one secret , I would say it is to let go of the emotional attachment to your money.”

Forex

Yeo Keong Hee is a forex trainer at Adam Khoo Learning Technologies Group. An IQ score of 156, there is no doubt in his intelligence. His excellence in academic put him in a good corporate job. But he did not like the corporate culture and he decided trading was a good alternative. He quit his job after he had achieved profits that were greater than his salary for three consecutive months. He said,

“You need to use your analysis tools in a way which is different from the majority so that you are not part of the herding instinct.”

Binni Ong is the co-founder of TerraSeeds Market Technicians. Every master was once a disaster. She started dabbling in the stock market for his mother and lost $100,000 at the age of 17. She was able to trade her way back to return the money to her mother and live on trading income. She said,

“We do not want to look for a short term or quick way to make money. We want a sustainable way of making money.”

Nicholas Tan is a forex trainer and author of several books. He learned his trading from his previous job as a bank trader. With his 13 years of experience in the bank, He had handled $20-30 million positions in the bank and had been in the market in times of financial crises and wars. He decided to trade on his own in 2002. He said,

“The important thing is not going after the profit, but it is about looking after your losses. The profit will take care of itself as long as you take care of your stops.”

Clarence Chee is a forex trainer at T3B. A former accountant turned trader. He started trading in bucket shops with his friend who was a professional forex trader. As he had handled currency conversions in his previous job, it became natural for him to trade forex. He said,

“Money is a by-product once you become a good trader.”

Futures

Tom Yuen is a SGX trainer. He was a SIMEX trader for 13 years until it was closed. He was trading on the same floor with the infamous Nick Leeson at that time. A disaster in the past as well, he lost all his money in year 2000. He had to sell his motor-cycle and put together $30,000 to continue to trade. He recovered to his normal trading after two to three months. He said,

“Do not spend a lot of money trying to buy and learn magic systems, as the answer lies within.”

Patrick Lee is a SGX trainer. He writes a blog – Risk Management. Also a former SIMEX trader and a good friend with Tom Yuen. He is one of the ex-floor traders who transit to electronic trading successfully. A scalper by nature, he trades in the arcade during market hours. He makes about $1,000-$1,500 per day, in 17 out of 22 trading days. He said,

“I can decide how much money I want to make. But the market may not allow you to make that amount of money and you have to accept that and probably take a day off.”

Options

Dave Foo is the chief trainer at Thomas the Coach. His method is the most unique of all – non-directional trading. Since most options expire worthless, he can make consistent profits by selling options. He had his fair share of losses during 2008 but was able to resume trading after two months of break. He said,

“This is what I mean by non-directional trading – the market can go up, down, or sideways, and I can still make money.”

I have also included a chapter at the end of the book to consolidate the common points shared by the interviewees. This book is good for people who intend to venture into trading, to help you find out what trading is like and if you are suitable to do it. This book is also good for people who intend to attend the courses offered by these trainers. You can have a better understanding about their background, their philosophy and approach to the markets. This book is good for traders too. You can gather new ideas and approaches to the market and add another weapon into your arsenal! And do not forget to view the videos once you purchased the book!

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What Your School Never Taught You About Success Mindset

1. What do successful people share in common?
2. Learn how the rich think to become rich
3. Increase financial literacy to increase wealth!
4. A powerful concept that can help you achieve wealth and riches
5. Use your time and money wisely and wealth will naturally follow
6. Robert Kiyosaki’s definition of assets and liabilities are wrong
7. 5 laws of money that would pull money towards you
8. 7 strategies to fatten your purse
9. How to go from “Money Not Enough” to being financially free?
10. Why studying hard and working hard no longer guarantee success

What Your School Never Taught You About Financial Planning

1. Painful lessons from the Asian Financial Crisis
2. Common misconceptions taught in financial planning books
3. Common mistakes made when filing income tax
4. How to decode housing loan packages?
5. SIBOR versus SOR for home loans
6. How to choose a housing loan for property investment or home purchase
7. Why is there always not enough money?
8. 5 tips to successful retirement planning
9. Yes, you can retire a millionaire!
10. Golden tips on managing your money
11. Common mistakes in getting insurance cover
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13. Why is insurance planning crucial in overall financial planning?
14. Do we really need to write a will?
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1. Investment strategies you know will no longer work
2. Is there a difference between gambling and investing?
3. Learn how to invest from the richest investor
4. What the schools taught you about investing may be wrong
5. Stocks – it is when you sell that matters
6. Learning all about investing in Exchange Traded Funds
7. Investing in properties through a Real Estate Investment Trust
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10. Stock investing versus property investing, what are the differences?
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• Why Traded Endowment Policy is getting increasingly popular

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5. Do not miss out this money making opportunity!

Learn to Earn touches on basic investment with a lot of explanations about capitalism, history of stock market and how should one approach investing. It is a good book to get one  thinking why invest in the first place and you would ask yourself a lot of fundamental questions. And the main message was to encourage people to invest in stocks.

Here’s the main points:

Shareholders do not get sued

Shareholders do not get sued, “It [a corporation] can be sued, as can its managers and directors, but the owners – the shareholders- are protected. They can’t be sued in the first place. In England, companies put the word “limited” after their names. This indicates that the liability of the owners is limited, just the way it is in U.S. companies… This is a crucial safeguard of our capitalist system, because shareholders could be sued whenever a company made a mistake, people like you and me would be afraid to buy shares and become investors.”

Do not get enticed into manias

Citing examples of Mississippi Company and South Sea Company, Lynch warns about getting into a mania. “Whenever crowds of people bet their life savings on a hopeless projection, it’s called a “mania” or a “bubble.” The pattern is always the same. Frantic investors pay ridiculous prices in order to get in on a spurious opportunity, and sooner or later, the prices come crashing down.

Companies should focus on business trends

Lynch stressed that it is the small things that kill businesses and not the big things like global warming, nuclear war, currency war, etc. he small things that he referred to was competitors changing their way of operations. He quoted the example of A&P grocery store company where it thrived during the Great Depression. The company actually expanded its operations. But the competition changed the operating concept to self service store where customers can roam around and pick up items from the shelves (it used to have a counter clerk to pick up items upon request from customers). A&P followed suit and open up big supermarkets and rode the boom after WWII. “Depressions they [companies] can handle, wars they can handle, the hole in the ozone layer doesn’t bother them, but competition can do them in.”

On U.S. debt

Lynch was already concern about the debt that U.S. government is accruing (the book was published in 1995). “That’s how the government congratulates itself for cutting the deficit while the deficit continues to grow. This year, it adds, say, $200 billion to the debt and calls it a “reduction” because last year it added, say, $250 billion to the debt. Really, it’s no reduction at all. It’s another $200 billion, plus interest, that our children and our children’s children will someday have to pay. The debt will continue to mount until the government stops using the credit card and spends only what it collects in taxes.”

Why bond with longer maturity pays higher interest?

“The longer it takes for bonds to pay off, the greater the risk that inflation will eat up the value of your money before you get it back. That’s why bonds pay a higher rate of interest than the short-term alternatives, such as CDs, savings accounts, or the money market. Investors demand to be rewarded for taking the greater risk.”

Why most people lose money in stocks?

“When people consistently lose money in stocks, it’s not the fault of the stocks. Stocks in general go up in value over time. In ninety-nine cases out of one hundred where investors are chronic losers, it’s because they don’t have a plan. They buy at a high price, then they get impatient or they panic, and they sell at a lower price during one of those inevitable periods when stocks are taking a dive. Their motto is “Buy high and sell low,” but you don’t have to follow it. Instead, you need a plan.”

Investment timeframe

Lynch is an advocate for long term investing and he felt most people held their investments for too short a period. “Twenty years or longer is the right time frame. That’s long enough for stocks to rebound from the nastiest corrections on record, and it’s long enough for the profits to pile up.”

Treat stocks investment as a marriage

I have heard the market adage “don’t fall in love with your stocks” but Lynch suggested you should stay in the marriage, “…this is a marriage we’re talking about, a marriage between your money and your investments. You can be a genius at analyzing which companies to buy, but unless you have the patience and the courage to hold on to the shares, you’re an odds-on favourite to become a mediocre investor. It’s not always brainpower that separates good investors from bad; often it’s discipline.” He emphasised again, “People are always looking around for the secret formula for winning on Wall Street, when all along, it’s staring them in the face: Buy shares in solid companies with earning power and don’t let go of them without a good reason. The stock price going down is not a good reason.”

Why buy and hold?

The reason why he emphasised on buy and hold is because most gains from the stock market were made during short periods of time and you do not want to miss such movements. “During a prosperous five-year stretch in the 1980s, stock prices gained 26.3 percent a year. Disciplined investors who stuck to the plan doubled their money and then some. But most of these gains occurred on forty days out of the 1,276 days the stock markets were open for business during those five years. If you were out of stocks on those forty key days, attempting to avoid the next correction, your 26.3 percent annual gain was reduced to 4.3 percent.”

It is okay to make mistakes

Do not expect every stock you buy to be a winner but you can still come out ahead. “Warren Buffett has made mistakes, and Peter Lynch could fill several notebooks with the stories of his. But a few big winners a decade is all you need. If you own ten stocks, and three of them are big winners, they will more than make up for the one or two losers and the six or seven stocks that have done just OK.”

It is not a zero-sum game

Is investing a zero-sum game such that one man’s gain is another man’s loss? Lynch explained, “[p]rofit is a sign of achievement. It means somebody has produced something of value that other people are willing to buy. The people who make the profit are motivated to repeat their success on a grander scale, which means more jobs and more profits for others.”

Stock price is determined by earnings

This simple point – that the price of a stock is directly related to a company’s earning power – is often overlooked, even by sophisticated investors…. This is the starting point for the successful stockpicker: Find companies that can grow their earnings over many years to come.”

A note on mergers and takeovers

“The most successful mergers and takeovers are those in which the parties involved are in the same line of work, or att least have something in common.” In other words, acquisition should fulfil strategic interests to the company.

Defining correction and bear market

“When stock prices fall 10 percent from their most recent peak, it’s called a “correction.” We’ve had fifty-three corrections in this century, or one every two years, on average. When stock prices fall 25 percent or more, it’s called a “bear market”. of the fifty-three corrections, fifteen have turned into bear markets. That’s one every six years, on average.”

Why you should not time the market

“Far more money has been lost by investors trying to anticipate corrections than has been lost in all the corrections combined.” “If you kept all your money in stocks throughout these four decades, your annual return on investment was 11.5 percent. Yet if you were out of stocks for the forty most profitable months during these forty years, your return on investment dropped to 2.7 percent.”

Do what you love

“Find something you enjoy doing and give it everything you’ve got, and the money will take care of itself. Eventually, you reach the point where you can afford to spend the rest of your life at the side of a swimming pool with a drink in your hand, but you probably won’t. You’ll be having too much fun at the office to stop working.”

I like the last point

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When the infamous Long Term Capital Management (LTCM) got into trouble, I was too young to dabble in the financial market. In retrospect, I would love to find out how this mammoth hedge fund got into trouble. Hopefully I can learn their mistakes without paying for them. There was readily a book written by Roger Lowenstein, “When Genius Failed“.

All-star team

LTCM is a hedge fund that was formed by an all-star team. Spearheaded by John Meriwether, who was already an experienced trader and a bright star in Salomon Brothers. He was assisted by 2 Nobel prize winners and highly acclaimed professors, Myron Scholes and Robert C. Merton. The core group of traders was led by Larry Hilibrand, Victor Haghani, and Eric Rosenfeld, and all of them have the experience and credentials to back them up.

LTCM trading method

Myron Scholes and Robert C. Merton received the 1997 Nobel Prize for Economics for articulating the Options pricing model with mathematical calculations. The fundamental strategy of LTCM trades was mean reversion or to put it simply, their theory states that prices cannot move away from the average price for too long. LTCM started off with bond trades, where they find bonds that are mis-priced. For example, we can look at one of the first trades that LTCM did. The US government issued 30-year bonds and another tranche of 30-year bond 6 months later. However, the initial 30-year bonds became illiquid as more people kept it for the long run. And big institutions are not willing to own the less liquid bonds and preferred to buy the newer 30-year bonds instead. This is not logical to LTCM as the risk between the two is the same. The government is equally likely to redeem the bond in 29.5 years and 30 years. A difference of 6 months is minute. However, the market priced the bonds differently and the interest for the 29.5 year bond yielded 7.36% while the 30 year bond yielded 7.24%. This is where LTCM will buy the cheaper bond and short the dearer bond, to believe both prices would converge to the mean.

The need for high leverage

But there is a problem. There is little money to be earned. “Twelve basis points is a tiny spread; ordinarily, it wouldn’t be worth the trouble. The price difference was only $15.80 for each pair of $1,000 bonds. Even if the spread narrowed two thirds of the way, say a few months’ time, Long-Term would earn only $10, or 1 percent, on those $1,000 bonds.” As such, the only way to earn a decent return was to leverage as much as possible. LTCM was borrowing billions and they were able to negotiate with the banks without putting up any collateral. Usually the collaterals will limit the amount you can borrow, but in this case, LTCM could borrow as much as the banks are willing to.

Stellar performance

LTCM did very well in the initial years. In 1995, LTCM earned 59% before fees and 43% after fees. “[A]t the end of 1995, it was leveraged 28 to 1. Take away the leverage, the return is only about 2.45%. But investors would always see the 59% return and the stellar performance attracted more money and banks were more willing to lend LTCM just to build good relations. The all-star team backed by credible theory will not fail in Wall Street’s opinion. As their capital grows, it was harder for the traders to find converging trades. Especially competition from other hedge funds and banks made the converging trades disappear faster than usual. LTCM began to engage in directional trades, buying equities and other asset classes. There is a price for getting too big.

Shit happens

“[T]he professors calculated that Long-Term would lose at least 5 percent of its money 12 percent of the time (that is in twelve of every hundred years). The letter went on to state the precise odds of the fund’s losing at least 10 percent, as well as 15 percent and 20 percent.” The problem is you cannot apply mathematical formula on humans. The pull of gravity and molecules do not change their minds like humans do. That is precisely the wrong footing of trying to quantify the market and assume humans will act rationally all the time. “A rose-coloured world had suddenly gone dark, discoloured by Russia, Japan, even the Clinton-Lewinsky scandal. In every market, investors wanted only the safest bond. In the United States, it had to be the thirty-year Treasury; in Germany, the ten-year Bund. All over the world, people were buying safer (lower-yielding) bonds and selling riskier (higher-yielding) ones, pushing the spreads between such bond pairs ever wider. Minute by Minute, Long-Term was losing millions.” And all of the sudden, what used to be uncorrelated instruments became highly correlated – they fall together. No diversification is safe and LTCM was not spared. All of LTCM trades were losing money. In a single month, Aug 1998, LTCM lost 45% of their capital.

The value of $1,000 invested in LTCM, the Dow Jones Industrial Average and invested monthly in U.S. Treasuries at constant maturity. (Taken from Wikipedia)

The Bailout

LTCM was in a bad shape that it had to be bailed out. Warren Buffett offered to buy the fund but it was rejected by Meriwether as it was too low, and the latter with his team had to leave the management. The Fed pulled the bankers of Wall Street together in a concerted effort to bailout the fund. The Fed did not want to use public money to save LTCM. The banks, who had stakes and loans to LTCM, feared the huge hedge fund would create a ripple effect to the financial industry if it was allowed to fall. Hence, they reluctantly throw good money after bad to rescue LTCM. The traders felt they were limited by the governance imposed on them. The fund no longer produce the spectacular results it used to have. LTCM closed in 2000. John Meriwether with the same team of traders created a new fund and it crashed the same way it did in the last financial crisis in 2008.

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1. Top Hedge Fund Managers
2. What are Bonds?
3. Fooled By Randomness by Nassim Taleb
4. Inside the House of Money by Steven Drobny
5. How to buy Singapore Government Bonds?

Here are the maxims from Nicolas Darvas in the book:

“Brokerage commissions are the primary reason for the existence of the organised stock exchanges; without the brokerage commission, there will be no Wall Street casino.”

“…dividend or no dividend, the stock of the corporation will continue to be traded in the market. And the truth of the matter: it will be traded largely on the basis of the buyer’s estimate of how much he may subsequently sell it for. This is speculation, this is the gamble.”

“Business is one thing; stocks are another. As I had seen, an industry or a corporation can boom while its stock busts, and it is possible, as far as I could tell, that the same thing could happen in reverse.”

“A share of stock, whatever the relationship it may have to the corporation that issues it or the industry that it represents, has no intrinsic value other than the amount that it will fetch in the market, based on the simple law of supply and demand.”

“I never sell a stock while it is rising. Why get off a winning horse? And it never hold one that is declining. Why stay with a loser?”

“Timing was the important thing, and had nothing to do with fundamentals or even with “growth” as such; it had to do with the behaviour of the stock on the market.”

“It is anticipation of growth rather than growth itself that makes for lively speculation and big profits in the so-called growth stocks.”

“I found that the best places to look for the tip-off to the market is in the market.”

“My only sound reason for buying a stock is that it is rising in price. If that is happening, no other reason is required. If that is not happening, no other reason is worth considering.”

Darvas called himself a techno-fundamentalist, and these are the things he look out for:

Technical:

• Box system
• Volume
• Historical Peak Price Related to Present Price
• On-stop Buy-Order

Fundamental

• Capitalization
• Industry Group
• Expected Earnings

Related posts:

1. A Random Walk Down Wall Street by Burton Malkiel
2. What is the difference between Cum-Dividend and Ex-Dividend?
3. Warren Buffett – “I’d be a bum on the street with a tin cup if the markets were always efficient.”
4. Investment & Trading Report Card – May 11
5. My Encounter with Rights Issue

In this book, Dave briefly explained what are Options and even show you the procedures to place orders. What is interesting and very different from most trading books, is that he advocated the selling of Options. Instead of being a buyer of Options, you actually assume the role of a financial institution when you sell Options. No other instruments are able to let you be the house, where the odds of winning is on your side.

Why sell Options?

Options consists of time value and at the expiry, it becomes worthless. Statistically, 80% of the Options expire worthless and hence, you win most of the time as an Options seller. Time is on the side of Options seller. If you look at the time decay of the Options in the figure below, you would notice that the rate of decrease in the Options price increases as it gets closer to expiry.

He termed  Options selling as non-directional trading. Simply because you do not need to get the direction of the price to win. The price can move up a little, move down a little or stay stagnant, and you can still win as an Options seller. This further increased your probability of winning.

Dave’s method

He uses a method called “short strangle” where he sells a pair of Options (one out-of-money put Option and one out-of-money call Option). He would sell the put Option at a lower price and a call Option at a higher price. This create an upper and lower boundaries and as long as the price stays within this zone until expiry, the Options seller would win. Using a probability calculator (available at his website), he would calculate the probability that the price will stay within the zone and he would only sell the Options when the probability is 90% or higher.

Even though the probability can be very high, the price may still move out of the range in a very bullish or bearish market. Hence, he would need to adjust the trade accordingly. If the trend is bullish and the call Options that he sold becomes a losing position, he would close it at a loss and sell another call Option at a higher price. On the other hand, his put Option will be making money and he will sell another put Option to collect more premium. In other words, he is basically shifting the price boundaries to capture the price within the zone. He may just decide to take the loss and not adjust the trades if the trend is really strong.

My thoughts

I really see Options selling as the only way for you to be the house or “bookie” as Dave put it in his book. In SGX, only the banks and financial institutions can sell Warrants to you. You can only buy call and put Warrants but you cannot sell them. Why are the banks doing this? There is only one reason – they continue to earn money from the retail investors by taking the other side of the trade. As long as they manage the risk at the system level, it is a profitable business.

I would also expect the profits to be very consistent. Unlike directional trading, especially at a longer time frame, your account fluctuates up and down with the market. There is no consistency. Selling Options would allow you to earn cash flow slowly. You would not get fantastic results in one trade, like 100% in one trade. You probably can make 5% consistently. But that is how casinos win money. They take your $1 bets consistently to build their empire.

Related posts:

1. Options – A simple analogy
2. Handbook on Forex Trading by Nicholas Tan
3. You can lose money even if you select the right stocks
4. Capital is key to Profitable Trading
5. Recording your trades

Brent Penfold believes that there are universal principles that are applicable to all traders, regardless of which trading systems, time frame and instruments you trade.

A typical journey of a novice trader

I found his descriptions of a novice trader’s journey accurate as I can relate to some of them. The novice trader will lose money in the beginning as he interact with the market. Many traders give up at various stages as they fail to accept the losses. It takes a lot of self awareness and acceptance to learn the ropes of trading. Here is the typical journey:

• React to news and tips
• Begin a trading education
• Switch methodologies
• Switch gurus
• Switch markets
• Switch time frames
• Switch client adviser
• Blame psychology

Imagine you have to go through this to learn more about yourself and the market? And meanwhile you made these mistakes, you are constantly losing to the market. Not easy I would say. Brent thinks that the turning point to become a profitable trader is when you learn to apply money management rules to minimise your losses.

Brent has 6 universal principles of successful trading.

#1 Preparation

He thinks that the first principle is about preparing your mind to have the right perspective of the market. The belief to plant in your mind is that the market will put up many obstacles to prevent you from profiting. Since you are bound to lose, make sure your losses are small. The best loser is the eventual winner.

#2 Enlightenment

He believes all traders must have 0 percent for “Risk of Ruin”. Risk of Ruin is the probability that your accumulated losses are so huge that would make you stop trading. You can find “Risk of Ruin” calculators online to do your calculations.

Second, you must understand that it is the expectancy of your trading system that matters. It is not the accuracy. Casinos use a slight positive expectancy to win over the gamblers. The edge of a trading system is positive expectancy. You can find out more about expectancy here.

Third, the more opportunities you can trade, the more money you can make for a period of time. Your trading system must allow sufficient trading opportunities.

Fourth, the trading system must be simple. Brent said it must pass the McDonald’s test – the trading system is not good if a teenager cannot understand your method. Ultimately, trading is about identifying resistance and support, do not complicate it further.

Fifth, you must search opportunities that are contrarian to the crowd, since 95% of the traders lose.

Sixth, test your system backwards but not to the point of tweaking it such that you curve fit it perfectly according to the past data.

#3 Trading Style

Here are some of the key characteristics of various trading styles and time frames:

• Short-term swing trading (time-frame: days to a week, small capital, small drawdowns, high accuracy)
• Medium-term swing trading (time-frame: weeks, small capital, medium drawdowns, high accuracy)
• Short-term trend trading (time-frame: days to a week, small capital, small drawdowns, low accuracy)
• Medium-term trend trading (time-frame: weeks, small capital, medium drawdowns, high accuracy)
• Long-term trend trading (time-frame: months, large capital, large drawdowns, low accuracy)

Brent believes that each trader must find the style that best suits his capital size and personality – tolerance level for drawdowns and accuracy of the system.

#4 Markets

Brent favours the Futures market. Some of the good attributes of a market or instrument are:

• Price and volume transparency – Reflect the true price and volume
• Liquidity – healthy demand and supply so that you can buy and sell easily
• Zero counterparty risk – good governance to enforce honoring of trades
• Volatility – you need decent volatility to make money
• Growth – the market volume must be able to accommodate your increased position as you grow as a trader

There are a lot more attributes stated in the book. You should trade an instrument that satisfy most of the attributes.

#5 Three Pillars

To him, there are three main pillars to trading:

• Money Management
• Methodology
• Psychology

Money Management – The chapter on money management is simply the longest chapter in the book. I cannot describe it in detail and I urge you to read the chapter as money management is one of the most important component to successful trading. Brent explained the various money management methods and ran tests with the methods. Based on the results, he found that the “Fixed Percent” and “Fixed Volatility” had the lowest “Risk of Ruin” but they are not suitable for small accounts. The methods suitable for small accounts are “Fixed Risk”, “Fixed Capital”, “Fixed Ratio” and “Fixed Units”. There are pros and cons for each method and Brent has stated them clearly in the book.

Methodology – Brent talked about mechanical and discretional trading. He advise that it is easier to start with a mechanical approach when you are a new trader, as it would provide structure and consistency to your trading. As a Elliott Wave and W.D. Gann trader for 15 years, he shared his disappointment in predictive indicators. he also discourages the use of technical indicators like moving averages and stochastic. To quote, “most indicators are derivatives of price that contain adjustable parameters. Consequently, they represent second-hand curve-fitted information.” To him, traders should focus on price and volume and use tools like breakout analysis and market profile. He also emphasised the importance of having a system that is objective. There are not 2 ways to interpret the data.

Psychology – Brent suggests we should manage our greed, fear, hope and pain. He even has a list of affirmations to manage his psychology from time to time.

#6 Trading

This Principle is about learning the mechanism of trading. The different types of orders that you can use to your advantage.

In the final chapter, he interviewed 15 traders for a piece of advice. In conclusion, I think this is a good book for all aspiring traders and existing traders who are having problems with their trading. If you are able to understand and apply the principles in this book, you would be able to become a successful trader.

You can buy the book here.

Related posts:

1. Questions you would be asking successful investors and traders
2. Trading Profits in relations to Time and Accuracy
3. Capital is key to Profitable Trading
4. Long term investment is as risky as short term trading
5. 3 Biases That Affect Your Trading

Matthew Schifrin is a Forbes editor and in this book, he interviewed 10 individuals who are relatively unknown, yet made a lot of money from the stock market.

Not in order of merit, below are the people and their rules of investing. These rules would give you an idea what these investors are looking for. It may help you kick start to make some rules on your own. You may find that some of the rules contradict between the investors. Most importantly, you have to choose something that you believe in and test if it works. I am not doing justice to the book by lifting these rules, you should read the book to understand the background, so as to correctly apply to your situations.

Chris Rees – Value investor

• Companies should have low debt (less than 50% of equity)
• Only consider tangible assets when calculating value of a company
• Be realistic with future earnings growth
• Sell when the price hits your estimated value of the company
• Sell when the risk increased, regardless if it is due to market, sector or the stock itself
• Sell when the stock takes up a larger percentage of your portfolio due to the rise in its price
• Sell when there is a better alternative stock with lower risk and higher potential returns

Bob Krebs – Options seller

• Do not be egoistic with the market
• Sell when 20-day MA crosses below 50-day MA
• Do not invest for dividends
• Concentrate on a few stocks and do not diversify too much
• Close your Options position before expiry to lock in profits

Mike Koza – Value investor

• Look for stocks with prices that are depressed temporarily
• Take time to do your own research
• Do not completely trust the company figures
• Look for a positive change in the stocks, not buy just because it is cheap
• Sell when intrinsic value to price goes below 1.25

Kai Petainen – Quantitative investor

• Price-to-book value less than 5
• Positive return on assets
• Positive return on equity
• Debt-to-equity less than 30%
• Low P/E ratio relative to market and industry
• Price near 1 year high
• Revenue grows 10-40% in the past 5 years
• Low F-Score (Piotroski’s metric)
• Low interest in shorting the stock
• Institutional buying
• Insider buying
• Avoid hot stocks
• Sell when the price drops 20% or drop off his top-50 list

Alan Hill – Micro-caps investor

• Follow the smart money and go with the flow
• Research and follow up with the leads
• Each stock should not take up more than 7% of the portfolio
• Minimize losses

Jack Weyland – Biotech stocks

• Find companies with temporary setbacks
• Buy when selling has exhausted and accumulation has begun
• Biotech companies must serve an unmet medical or healthcare need
• Avoid companies where there is a high interest in shorting them
• Use inverse ETFs to hedge when market is toppish
• Allocate maximum of 15% to one stock
• Do not show favor to any stock
• Cut losses when necessary

Randy McDuff – Value investor in global markets

• Look for stocks ignored by analysts
• Look for companies with monopoly, duopoly or oligopoly
• Focus on EBITDA than PE ratio
• Invest in what you know is not sufficient. Expand your knowledge through thorough research

Andrew Swann – Commodities stocks

• Gold stocks have high volatility and you must be able to stomach it
• Research thoroughly before committing a large investment
• Avoid leverage and invest with money you do not need
• Follow the smart money
• Invest in things you understand
• Be patient as companies take time to execute a plan
• Do not get attached to a stock

Justin Uyehara – Trend trader

• Be flexible and responsive to market changes
• Listen to the market
• Do not be too greedy, take your profits

John Navin – Uses Elliott Wave

• Buy stocks at support and sell at resistance
• Use 20-, 50- and 200-day MA to form bullish and bearish sentiment
• Avoid hot stocks with great stories
• Use stop losses to get you out if the price drops 5%
• Sell 1/3 if the trade has 25% profit and another 1/3 at 50% gain

Related posts:

1. The Warren Buffett Way – Robert Hagstrom
2. 4 Reasons why you cannot invest like Warren Buffett
3. The Winning Investment Habits of Warren Buffett & George Soros by Mark Tier
4. Rethinking Warren Buffett
5. My Formula! Seminar by Thomas Matthew