It’s the Hour for Foxes, Not Chickens! Reflections on a 25 Year Trading & Sales Career

It’s the Hour for Foxes, Not Chickens!Reflections on a 25 Year Trading & Sales Career CQF Alumni Lecture September 10, 2014 Edward Talisse Chelsea Global Advisors

In This Business You Are Either Bored or Scared… • Bull Markets – most of the daily price action is sideways to small down days and some grinding up days • Bear Markets- most of the daily price action is small ups, sideways and only a few big down days • Focus on one to two markets or market segments at most; three to five discrete positions at one time • Downtime can lead to overtrading – use spare time to improve , personal growth comes at the point of resistance • Trading decisions can be based on skill, empirical evidence, rules (Algos), advice and impulse

An Infamous Example • Annual implied S&P 500 volatility ~ 13% - directly observable • That is a little less than 1% per day (.13/sqrt252) • A daily decline of 20% is approximately a 24x sigma event • Theoretical probability of a 20% decline is on the order of once every • 2*1076 years. Excel Check: = 1/(1-NORMSDIST(24)) • Empirical probability of that happening is about .000132, since it happened once (1987) in the past 30 years (1/(30*252))

A Question for the House • You get hit (buy) in $100m of a moderately liquid 10y corporate bond • You bought the bonds 50bp below the screen mid market; so you have a + $500k MTM gain. Is this a trade you want to do? • Broker markets support sizes of $ 1-3m in this issue, so it will take at least one week to unwind, maybe longer • Obviously you have rate and spread risk plus a host of other worries • What do you do to lock in the $500k unrealized gain?

Another Question • Its 8:29 am in NYC / 13:29 in the UK. The market is waiting on important economic release scheduled in one minute • A Hedge Fund is on the line and asks for your offer in 10,000 Treasury Bond contracts right now…(DV01 is about $1.5m per bp… it’s a big trade) • The exchange stack is very thin given the timing • You can sell the contracts 30 cents higher than the current offer (Block Rules) • Do you want to do this trade?

Fake Empires • Stock Market Crash 1987 • ERM Crisis 1990 • Bond Market Bloodbath 1994 • Tequila Crisis 1994 • Asian Financial Crisis 1997 • LTCM and Russian Default 1998 • ENRON and other scandals 2001 • Global Financial Crisis 2008 • SocGen Trading Loss 2008 • UBS Trading Loss 2011 • Euro Sovereign Bond Crisis 2011 • London Whale Episode 2012 “Never attribute to malice that which is adequately explained by stupidity.” Hanlon’s Razor

Financial Crisis – Lessons Learned • Price signal stops working, quantity signal emerges • Liquidity requires both an ability to transact quickly and price continuity • When you can’t sell what you want, you sell what you can • The markets will recover, but the rules will change • Nagging questions remain: Why did it happen and who is to blame? • Ex-post judgments will be imposed on ex-ante trading decisions

The Gnomes of Switzerland • BASEL III initial capital constraint of 6% of RWAs plus countercyclical and TBTF buffers raise requirement to about 11% • Sovereigns are zero risk weighted; a bank can purchase $100m of an Italian BTP @2% and pay a $2m dividend or it can …. • Loan $100m to a BBB Italian corporate at 6%; if the bank makes the loan it must raise $5m of additional capital ((11% less 6%)*$100m) • Which transaction do you think the bank prefers? • Know the rules: accounting, tax considerations and capital

How Dealers/Traders Make Money • Liquidity provision • Risk transfer and transformation services (maturity and collateral) • Inventory management and hedging • Preferential access to certain markets e.g. Primary Dealers, IPOs, New Issues etc.. • Proprietary trading, where permitted

How Traders Compete for Business • Price – be the low cost provider of liquidity • Content- have the best information and ideas • Reputation and consistency – strong balance sheet and credit worthiness • Sell customers what they need, rather than what you have • Pre and post trade services

Capital and Money Management • Assume market is fair and outcomes are random • Trader A starts out with $50 • Trader B starts out with $500 • The probability that B ends up with all of A’s money after n tries is about 91% (500/550) • If you bet $1 at each try, then the contest should be over by n= 25,000 (50*500) or much sooner.

A Small Edge Makes a Big Difference • 50-50-90 Rule • Edge is defined as certainty of outcome • 5% edge results in a win ratio of 52.5% (.05+.5*.95) • However, even with a 20% edge, you can be wrong 40% of the time! • Very few instances of a consistent and repeatable edge

The Brazilian Straddle • Take a large, limit long or short directional position hedged with a one way ticket to Brazil • Poor position sizing decisions, either too small or too big, are costly mistakes • Position size must vary with conviction and be closely managed • The position is more important than the price • Remember, there are only two times in life when you’ll need money…now and later!

Flow Trading vs. Structured Trading • Flow • Commoditized products • Usually liquid, high turnover • Two way price action • Complete markets • First order risks – e.g. delta • Structured • Bespoke products • Usually illiquid, low turnover • One way price action • Incomplete markets – use proxy • Higher order risks e.g. Vega Flow products can easily behave like structured products in times of market stress e.g. CDS.,Repo, Basis

The Long and Short of Market Making • Long • Capital and balance sheet • Technology resources • Distribution and franchise • Trader's option- but limited • Short • Adverse selection • Liquidity • Serial correlation of flows • Management’s option

The Long and Short of Hedge Fund Trading • Long • Start long +2% • Informational symmetry • Unconstrained style (mostly) • Unlimited upside • Short • Start short ERP ~5-7% • Fast money outflows • Asset Correlation • Bid- offer spread

The Best Way to Keep Your Job • Make money $$$ • Be client friendly • Build the franchise • Have original ideas • Be user friendly – to the Salesforce, Research and Support • Remember PnL profile is convex- an extra $ of income in times of high profits is worth less than extra $ income in times of low profits

A Traders Best Friend: The Drift • “The market does not articulate its positive insights while negatives are front and center. We appreciate that it is disconcerting to read the morning newspapers regarding global strife, corruption, inhumanity to man and nature and still have and optimistic outlook.” Birinyi Associates • 32 year bull market in bond • Strong positive drift to equity risk returns • Total Factor Productivity continues to improve • Know the long term distribution of returns in your chosen asset class

The Easiest Way to Lose Your Job • Over trading • Overconfident • Arrogant • Exceeding your mandate – not sticking to assigned products • Being too difficult to manage- overly complex and opaque strategies • Ignoring implicit and explicit trading costs e.g. brokerage, market data capital and financing (CVA, DVA, FVA)

Trading and Emotions Do Not Mix Well • Diverts attention from reason and judgment • Can damage a relationship • Can damage your reputation • Can be used to exploit you • Are contagious and difficult to overcome • Almost all mistakes have technical and emotional components

Delta One Culture • ETFs, ETNs, Equity Swaps, Total Return Swaps, Index Trackers, ADRs • Assumes a linear symmetric payoff with little or no tracking error • Sizeable latent basis risks • No inherent mathematical certainty that the basis must remain near one • Delta One works until it doesn’t

Buckling Under Like Roosevelt at Yalta • Mark to market rather than mark to model • VaR budget and limit framework • Significant drawdown – defined as about 3% of YTD budget • Position size is too big given daily trade volume – good examples are trading U.S TIPS or emerging market debt in local currency • When your boss tells you to cut the position, cut the position • Firm exhaustion is usually stronger than your passion!

Before They Make You Run • It’s a job, not a career • Be prepared for the inevitable • Letters can help: CQF, CFA, MSc Fin • Next Step: Buy Side, Hedge Fund, Investment Advisor, Consulting and Management • Lifelong learning is critical –talent is not equally distributed by nature, nor can it be conferred by rank or title- you must work hard

Life of a Salesman • “For a salesman, there is no rock bottom to life. He don’t put a bolt to a nut, he don’t tell you the law or give you medicine. He is a man way out there in the blue, riding on a smile and a shoe shine…and when they start not smiling back, well that’s an earthquake.” Willy Lowman • Clients prefer to trade with their friends or with a machine • Between Scylla and Charybdis • At least you can sleep at night – someone else has the position

What Do Clients Really Value? • Information • Liquidity • Confidentiality • HFT – Hassle Free Trading • Access to the entire franchise; be a client advocate • Intermediaries, i.e. sales people, at their core are incentivized to ensure that some informational asymmetry persists indefinitely.

Why do Clients/Investors Trade? • Risk Sharing • Speculate on private information • Balance savings versus consumption- cash flow considerations • Tax Planning • Thrill seeking • You will be a better trader if you understand the client's and your own motivation for trading

Clients and Econ 101 • Clients have differing elasticity responses to changing prices • Client indifference curves vary widely • Financial assets often behave like “Giffen Goods” – higher prices usually increase demand • Prices can be real, nominal and relative • Price Makers- know the fundamental price better than the dealer • Price Takers- usually leave orders to get filled at closing prices • Price Seekers- will call multiple dealers to search for the best price

Client Meetings • Use Client Meetings to: • Build Trust • Share ideas and information • Develop network • Understand their constraints • Sell the Firm, the Division, the Desk and yourself! Lecture On Track Trader/Sales Participation Off Track Snooze Client Engagement

Risk: More Than Price Volatility • Demand for client fund withdrawals increase • Failing to meet endowment spending policy goals ~ 5% • Cash flow deficit to satisfy existing liabilities and commitments e.g. taxes, insurance claims, etc… • Tracking error and unintended style drift • Loss of purchasing power • Legal and reputational consequences

More On Risk • Perceived Risk ≠ Desired Risk ≠ Actual Risk • “The principle of ever changing trends works to force quick and drastic changes of resulting sequences when the public happens to get wise to a wining idea.” Robert L. Bacon, Secrets of Turf Betting • Be aware of apparent precision • Exposure does not equal experience • There is excess even in moderation • Only bear risks for which you are paid to manage

Lloyd Pye: Everything You Know is Wrong Vocational Training • Risk Seeking Behavior • Biased Expectations • Portfolio Pyramiding • Markets are Incomplete and Frequently Jump • Insider and Outsider Prices • Real Wealth Matters • Deterministic + Random + Manipulation Classical Education • Risk Neutral Behavior • Rational Expectations • Portfolio Optimization • Markets are Complete and Continuous • Law of One Price • Nominal Wealth Matters • Deterministic + Random

It Works in Practice but Does it Work in Theory? • The slaying of a beautiful hypothesis by the emergence of an ugly fact • Statistical malpractice is more prevalent than you think • You may be Apollonian, but markets are often Dionysian • Core competencies can easily become core rigidities • Theory only recognizes reality reluctantly!

If Two Wrongs Don’t Make a Right, Try Three! • No Lack of available trading styles • Combine two or more strategies to create your own hybrid strategy • Most flow traders follow either a momentum or contrarian approach • Need to develop your own toolkit and signals: process > decision • There is no need to invent new ways to lose money, the old ones work just fine

Accidents of Survival • Arbitrage models versus forecasting models- parameter estimation • Carry A. Nation – a radical prohibitionist who often used a hatchet- there is no free lunch; Long Carry = Short Volatility • Delta hedged ≠ margin neutral • Widespread use of VaR models dampen volatility…until it explodes • “Borrowing dulls the edge of husbandry”- Hamlet

The Bold Action: No Survivors • “Bold actors do not survive. Their very existence is a threat to the establish order. Neither private nor public institutions can long tolerate the maverick who takes it upon him or herself to save the day. And although it is often true that the bold often save the day, for the continued preservation of the institution and the meek within it, the bold player must be sacrificed.” Mossad Agent • Intransigency is not a defense against failure • Survival lacks glamour but has other benefits • The outhouse is not far from the penthouse

Statistical Malpractice Redux • "The government are very keen on amassing statistics. They collect them, add them, raise them to the nth power, take the cube root and prepare wonderful diagrams. But you must never forget that every one of these figures comes in the first instance from the chowky dar (village watchman in India), who just puts down what he damn pleases.” Josiah Stamp, 1st Baron • Simpon’s Paradox - When big data goes bad… sometimes conclusions from a large data set are exactly the opposite of conclusion from the smaller sets. • “Be suspicious of anything brought forth without suffering.”Alejo Carpentier

Voltaire’s Bastards • “Among the illusions which have invested our civilization is an absolute belief that solutions to our problems must be a more determined application of rationally organized expertise. The reality is that our problems are largely the product of that application.” Jonathan Saul • Science predicts outcomes in a natural system under controlled conditions; Economics (trading) is an artifact of human imagination and human belief systems. • No isolation of the ‘root cause’ of market behavior is possible. The evaluation of the market based on ‘root cause’ reasoning does not reflect a technical understanding of the markets but rather the social and cultural need to attribute forces or events for each outcomes.

References Cook, R (1998). How Complex Systems Fail. Cognitive Technology Laboratory Richardson, D. (2001). Natural Systems . University of Texas Saul, J. (1993). Voltaire's Bastards: The Dictatorship of Reason in the West Grant, J. (2014). Grant’s Interest Rate Observer NACUBO-Common Fund Study of Endowments Countless colleagues, mentors, instructors , friends and families. “I have nothing, I owe a great deal and the rest I leave to the poor. ” Rabelais

Biography Edward Talisse is a global capital markets professional with more than 25 years of experience gained at Morgan Stanley and UBS. He is Chartered Financial Analyst, a holder of the Certificate in Quantitative Finance and a Certified Public Accountant. He is currently completing his Masters Degree at The State University of New York. Edward has worked as a rates trader, a hedge fund sales person and in a chief operating officer capacity for Morgan Stanley’s Global Interest Rate Products Group until July of 2013. Prior to returning to New York in 2013, Edward spent most of his career working outside of the United States including long assignments in London, Paris, Tokyo and Hong Kong. Edward founded Chelsea Global Advisors LLC, an independent investment management and research firm, in 2013. He publishes a weekly market newsletter and is a frequent contributor to various financial publications.

Chelsea Global Advisors, LLC Chelsea Global Advisors, LLC is a market research and strategic advisory firm based in New York City. The Firm is in the process of becoming a Registered Investment Advisor in the State of New York. The Firm follows an empirical, evidence based approach to analyze global capital market conditions and make asset allocation recommendations. In addition, the Firm provides advice and solutions to solve the many complex challenges facing buy and sell side participants in the areas of capital optimization and operational efficiency and responses to emerging regulations. The Firm also cover the developments in the global capital markets by offering insights and investment ideas in our Weekly Investment Newsletter. The Firm is led by Edward Talisse, Managing Director and Chief Executive Office. Contact: edward.talisse@chelseaglobal advisors.com http://www.chelseaglobaladvisors.com 1. 347. 618. 1891 1. 347. 939. 9488

It’s the Hour for Foxes, Not Chickens! Reflections on a 25 Year Trading & Sales Career