
What I Learned from Losing $200M - pmcpinto
http://nautil.us/issue/31/stress/what-i-learned-from-losing-200-million
======
lordnacho
Shortly before the crisis broke, Naseem Taleb came to the office to meet me
and my colleagues. Hilarious character, and irreverent. He told us
calculations were stupid and reminded us about ludic fallacies, narrative
fallacies, and so on.

My colleagues still contrived to lose $250M over about 8 weeks, blowing up the
firm and the investors. One investor lost his job immediately because of it.
The money was lost in very obvious way, somewhat similar to what this guy was
up to, a big options trade gone wrong, in a market that was not big enough for
the biggest fish to escape.

What's sad is people understand the basic statistical principles. You don't
know if the future will be like the past. Things move together in a crisis.
The more independent tests you make, the more confident you can be in a
result. (Ie if you can guess a daily coin flip right 55% of the time, that's
better that being able to guess an annual coin flip 80% of the time.) And so
on. But somehow investors are almost blind to everything other than recent
return.

~~~
chubot
Yeah, but it's totally rational, if you look at it another way. The potential
upside is that I make $250 M or $2 B dollars and reap some kind of bonus,
right? And the downside is that I lose my job and somebody ELSE loses the $250
M.

If you don't care about anything other than yourself, why _wouldn 't_ you make
that bet?

I don't think a lot of the traders are purposely thinking this, but the
incentives are set up so that people who act this way are rewarded and start
to dominate the decision making process.

~~~
hkmurakami
I wonder how much of an analogy we can draw to raising outside capital to fund
your own venture.

~~~
lordnacho
Fund:

You get paid if nothing happens, traditionally 2% but probably lower on
average these days. If things go well, you get 20% of the high watermark
profits. If they go south after that, you don't pay it back. You're always
paid in cash.

VC:

You get paid a salary that's below what you'd probably get in an established
company, plus you get equity. But the investors will typically try to get
preferred stock, in case things go badly (liq pref). If things go well, you
can sell some shares at each subsequent round, but of course you have less
after each. And some of the investors will want board seats, which means a
degree of control.

------
neil_s
Can someone explain like I'm five, the trades the author made and how he
turned it around to be so profitable? My understanding so far:

In 2008, he made a promise to buy Mexican Maya oil in 2009, at the 2008 price
of Maya. The Mexican government presumably pays him some fees for handling
this risk for them. In addition, if the price of Maya goes up in a year, he
pockets the difference.

However, if the price of Maya goes down, he still has to buy at the higher
2008 price, but can only sell the Maya on to others at the lower 2009 price.
To protect against this risk, he bought 'options' \- the right, but not the
obligation - to buy WTI and Fuel (amongst others) at some strike price. This
is where I get lost. How was he reducing his exposure by selling Fuel, had he
bought options at some super-low strike price, thus letting him earn a profit
when he exercised those options and sold the Fuel?

Then, what restructuring did he do with the Mexican government in a way that
could benefit both Mexico and him?

He had also short-sold WTI - he had bet on WTI prices going down, by promising
to sell it in 2009, at a 2008ish rate, allowing him to buy it cheaply off the
market and fulfill his promises. This, I understand.

Then, he "accumulated a massive position in Maya", which "strengthened
significantly" compared to his hedges. Does this mean that the price of Maya
was recovering faster than the other oils that he had bet against, so he was
able to sell his Maya at a profit?

~~~
ScottBurson
> To protect against this risk, he bought 'options' \- the right, but not the
> obligation - to buy WTI and Fuel (amongst others) at some strike price.

That would be a "call" option. He presumably bought "put" options, which carry
the right to _sell_ at a specified price. Then when the market price fell, he
could buy at the market price and sell at the strike price, pocketing the
difference.

A call option is a bullish bet; a put option is a bearish one.

I don't know how the restructuring worked.

> Then, he "accumulated a massive position in Maya", which "strengthened
> significantly" compared to his hedges. Does this mean that the price of Maya
> was recovering faster than the other oils that he had bet against, so he was
> able to sell his Maya at a profit?

That's how I read it.

------
jbverschoor
I think the guy would be more upset losing $50K of his own money.

~~~
d23
You don't think losing $200m of someone else's money hits you like a ton of
bricks? Being in the industry he is, I think he could handle a $50k personal
loss. It wouldn't be fun, but it wouldn't be life-ruining. Presumably, when
the magnitude of this loss hit him, he assumed his entire career was over.
That's a lot more than $50k in earnings, not to mention the personal and
professional humiliation.

~~~
nickpsecurity
Exactly. Plus, the title doesn't imply it's his money. The second you find out
his job you know he lost $200 million of others' money. The number plus losses
by those who trusted his skill let the impact sink in.

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swingbridge
A lot of traders have the "illusion of confidence," in fact most of them do.
They have good year or two and think it's the result of skill rather than
luck. That confidence causes them to place riskier bets which then implode.
Hedge funds follow this curve all the time... that's why you hear about
massive profits one year and then next year the fund implodes.

Beating the market (after fees) over and over again is something only a small
elite can do. Most of the rest of the finance industry is full of people with
vastly inflated views of their own abilities.

------
csomar
The thing is, people believe these guys because they come up with
sophisticated stuff that looks like science fiction. It's science fiction,
then it must bring lots of money, right?

This stuff works this way:

1\. I come up to you and tell you that we can make risk-free* money by
insuring (simplified all the BS) the price of oil for the government of
Mexico. Isn't that sweet?

2\. I come to the government of Mexico and tell them that they can forget
about price variation and the risk of it going down. We are going to insure it
for you!

So what happens?

1\. The price goes up, or stays the same. We make money. I become rich. You
make some interest on your capital. We celebrate. I write about it. I write a
book about it. How we made lots of money and beat the hell out of the market.

2\. The price goes down, really down. You lose money. You lose your capital.
Your money simply disappears. I don't celebrate. Maybe I consider changing
careers. And sure thing, I'll write about it. "How it all went wrong". And
yeah, I still become rich.

well. Quite a world we live in.

~~~
codeismightier
Not quite -- this guy didn't naked short a put option on Maya crude. The plan
was to dynamically hedge the position -- putting on a trading strategy that
continuously neutralized the first partial derivative of the payoff function.
The problem was the the second partial derivative was left unhedged -- oops!
To put it technically, he was delta hedged but not vega hedged. Thus when
volatility spiked he lost money. Even worse, he insured 2/3 of Mexico's entire
production, so when things got bad there wasn't even enough liquidity to
maintain the delta hedge.

A better plan would be to come up with some sort of vega hedge using WTI
volatility. WTI vol and Maya vol are correlated so some sort of partial hedge
should have been possible, but it's very tricky. This is why other banks were
not interested. It sounded like he was either too lazy or arrogant to believe
he need to vega hedge and it blew up in his face.

~~~
JumpCrisscross
> _To put it technically, he was delta hedged but not vega hedged._

Delta, the first partial derivative on price of the Black-Scholes model of
option pricing [1], is the rate at which the price of an option changes in
relation to the price of the underlying asset. For example, a call option with
delta=0.25 requires one own 1 unit of the underlying for every 4 options
(keeping things simple) to be perfectly hedged, _i.e._ indifferent to changes
in the price of the underlying. If you are running a leveraged operation,
delta-hedged means well-hedged.

Unfortunately, as the price of the underlying changes delta changes. Yes, one
can describe this relationship in terms of volatility (as the price changes,
volatility will spike, which in turn feeds into the value of delta). But it is
simpler to describe it in terms of the second partial derivative on price,
gamma. Gamma is the rate at which delta changes in respect of price.

Non-derivative assets are delta=1 assets; for every dollar change in the price
of AAPL the price of AAPL changes one dollar. Duh. Buying and selling delta=1
products helps one hedge delta. Gamma, being a second derivative, is non-
linear. That means only non-linear products will aid you in your game against
it. Options, and option-like products, are really the only ones with
"gammaness".

Big operations gamma hedge as much as they can while trying to keep their
delta contained. For example, if you sell 100 puts, you would keep yourself
delta-hedged while you try to profitably buy 100 puts. Provided the price
doesn't wiggle around too much, this works.

This strategy is problematic, however, if your counterparty is Mexico. Mexico
wants LOTS of options. If you can't give Mexico LOTS of options, Mexico can't
bother dealing with you. So you tend to want to provide Mexico with LOTS of
options because LOTS of options commonly means LOTS of profits (and LOTS of
fees).

But the market doesn't have a bunch of people buying and selling LOTS of
options. Just lots of options. So whereas one might usually be 20 or 50 or 70
percent gamma-hedged, when one just booked LOTS of options, 2% seems like a
pretty good rate for the first week after the sale. Sucks to be you if Libya
or Iran or the Sauds decide crash the party in that time.

[1]
[https://en.wikipedia.org/wiki/Black–Scholes_model](https://en.wikipedia.org/wiki/Black–Scholes_model)

~~~
kansface
Thanks for the explanation! The assumption that volatility is a random walk
strikes me as a very poor model when shit goes south. I would guess people use
more sophisticated models in practice? Do you know of any good books on the
subject?

~~~
qihqi
"Volatility is the wrong number to be plugged into the wrong formula (BS) in
hope to get the right answer."

------
dgreensp
I would say the author had an "illusion of competence" rather than an illusion
of control. In this case, at least, experts could have explained to him what
he was doing wrong in objective terms before the crisis; he just didn't have
perspective on his level of inexperience.

------
wobbleblob
"What I learned from losing $200m"

It looks like a blank page to me. Is the site down or is he trying to tell us
he learned nothing?

~~~
limaoscarjuliet
I got a blank too and that was what I thought :-) Voted!

------
ryporter
I think that this trader's recovery had a lot more to do with skill than
others are giving him credit for. His key insight was the following:

 _" It occurred to me that Mexico might be willing to restructure its
deal—selling us back the option it owned, and buying a new one—in a way that
would lock in billions of profits for the country, while giving me a much
needed windfall too."_

Many traders (especially inexperienced ones) suffer from a bias to sell their
winners too quickly, so that they can lock in the satisfaction of making a
winning trade. By putting himself in the other side's shoes, this trader was
able to find one of the few ways out of his predicament.

------
tibarun
It all sounds like astrologists gambling in a casino with millions of people's
lives on the line.

------
lintiness
as an independent trader through the crisis (and now), i can relate to the
debilitating stress of watching the financial system unwind. the enormity of
the trades these fools made and make still astounds me, and it's all a product
of lazy / greedy regulators. that kind of leverage can't result in anything
long-run outside of short term over-compensation and incentive to over bet,
leaving the country and the world to pick up the pieces.

all of this started when investment banks were allowed to raise public money.
if they were still private partnerships, you wouldn't see near the reckless
risk taking we did and do.

~~~
D-Coder
"it's all a product of lazy / greedy regulators."

Uh, I think it starts with greedy traders. If they weren't so greedy, the
regulaters wouldn't matter.

~~~
mbrock
You kind of have to assume they will be maximally greedy, though. That's the
game.

------
the_cat_kittles
fun read, though the whole thing feels like a humblebrag

------
Zigurd
_" The derivative I’d sold was an option, but it worked just like an insurance
policy."_

That sums up the whole derivatives implosion.

Never mind that a rocket scientist had calculated that the foreseeable maximum
downside was $30 million, this is why the insurance industry has relatively
high capital requirements. Ibankers were writing exotic insurance contracts
and, only because they were not called insurance, they were also flauting the
capital requirements.

Those who claim "it's complicated" are making excuses. The ibankers running
these deals should have been jailed for violating insurance regulations.

~~~
CapitalistCartr
I'm not sure I'm reading you right, but I think you mean flouting instead of
flaunting.

~~~
Zigurd
You got me just before I corrected it. I don't even know how I typed
"flaunting."

------
puppetmaster3
The model in US is you privatize the wins, and tax payers pick up the loses.
Is very very nice.

Shall I link the Feinstein speech where she said on senate floor that 80% of
voters _DONT_ want to bail out these gamblers? Than she voted to bail them
out, against 'by the people'.

So if you can't beat them join them: win I win, lose you lose. Hello wall
street, I'm all yours, need me to code up your derivatives, I'm there.

(I wonder what candidate running for office is against this? I know one, I'll
vote for that one. Hint: You can tell since the corporate media hate on him.)

------
akie
Google's cached version:
[http://webcache.googleusercontent.com/search?q=cache:C81GXUo...](http://webcache.googleusercontent.com/search?q=cache:C81GXUoqJbwJ:nautil.us/issue/31/stress/what-
i-learned-from-losing-200-million+&cd=1&hl=en&ct=clnk&gl=us) (scroll down
quite a bit to read it)

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maxlamb81
If only he had read The Black Swan by Nassim Taleb when it came out in 2007.
It would have made him question all these faulty assumptions.

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cpncrunch
Website isn't currently working, and google cached version takes a few mins to
load.

~~~
ikeboy
try [https://archive.is/YdW7p](https://archive.is/YdW7p)

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laurentoget
I felt too queasy to read the whole thing. Does he ever realize that his
playful gambles caused millions of people's live to be ruined?

~~~
antod
Maybe you should have read the whole thing. His customer (the Mexican Govt)
netted $6B out of the deal in the end.

~~~
fulafel
It's a zero sum game either way.

------
glxc
salivating to know what the number is.. enough to retire, apparently

