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What I Learned from Losing $200M (nautil.us)
153 points by pmcpinto on Dec 25, 2015 | hide | past | web | favorite | 53 comments



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.


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.


Well, this is exactly what happened. One astute investor asked the only really important question (have you got your own money in this fund?) and managed to avoid the calamity. Everyone else got soaked.

Actually, if you speak to traders for any length of time, this kind of thinking comes out. The standard on the options trading floor is this:

I can buy options, and make money only if there's a crisis.

I can sell options, and make money most other years.

If I buy, and all the other desks sell, and there's a spike, all the money I make will be lost by the others.

If I sell with everyone else, and there's a spike, we can all say we did what the other people did when we are looking for a new job.

If I buy and there's a normal year, I'll lose and everyone else will gain, I'll look like an idiot and get fired.

-> Sell options, and act like you know when to get out of that position.


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


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.


Probably. But honestly, not losing your investors capital is priority #1. tl;dr Don't do stupid stuff like this.


> not losing your investors capital is priority #1

Recent evidence suggests otherwise.


> You don't know if the future will be like the past. (...) But somehow investors are almost blind to everything other than recent return.

Maybe because I come from the "wrong" side of the Berlin Wall, but as a guy who was only a kid when he saw a thing that was supposed to last forever (i.e. Communism) fall to pieces in less than a year it always surprises me when I see these predictions made for 20-30-40 years in the future, all promising a 5% or 7% return like there won't be any new World War, any new nationalizations on a continental scale (see Russia after 1917 or China after 1945) or no new Spanish Flu.


Yeah, I don't believe in long-term predictions unless they're predicated on human nature itself. That never seems to change. So, in IT, economic principles like squeezing more ROI out of investments, backward compatibility, lock-in, and ecosystem effects were good indicators of what would stick around & how it would change. Past that, it was a bunch of crap shoots all thrown onto same table overlapping.


Said company suddenly going out of business is more black swan than anybof those things


If the revolution comes, you lose regardless of your investment strategy.


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?


> 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.


> if the price of Maya goes up in a year, he pockets the difference.

No: he sold an option, so the buyer can opt to do nothing; he benefits by just the price of the option.

As time went on he bought options in other things, trying to approximate his risk in Maya crude as if it was a blend of those other things. Those options are commonly traded, so are much cheaper than the premium he charged for the Mayan option which was very specialised.

> what restructuring

He bought an equal and opposite option from the Mexican government for billions more than they paid for the first one.

This gave the Mexicans a cash profit, and zeroed out his risk.

Why was it profitable? Presumably the billions they gave the Mexicans were less than they'd actually made from the hedges, and much less than the option was really worth.


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


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.


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.


Yea the title should really be "what I learned from losing $200 million of other people's money"


Except he actually ended up making (the other people) money.


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.


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.


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.


> 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


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?


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


You just figured out how the 2008 crash happened :-)


For all their supposed mathematical basis, in reality a lot of these models are based on curve fitting ultimately.

Assumptions are made and treated almost as axioms. Things like "Russia will never default on its debt". Well they did, and so bye bye Long Term Capital and nearly bye bye most of the worlds financial markets.


So nobody should sell insurance, because it's risky?


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.


"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?


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


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.


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


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.


if they were still private partnerships, you wouldn't see near the reckless risk taking we did and do

Taleb makes that point, and many others in the same vein. What do you think of Taleb's books?


fooled by randomness is his finest. black swan's a rehash for money.


"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.


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


If he had called the regulators timid and weak, and perhaps lazy, it would make more sense.


fun read, though the whole thing feels like a humblebrag


"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.


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


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


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.)


Google's cached version: http://webcache.googleusercontent.com/search?q=cache:C81GXUo... (scroll down quite a bit to read it)


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.


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



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?


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


It's a zero sum game either way.


But does his gambling real ruin people's lives? How direct is that connection?


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




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