Monday, June 28, 2010

Fractal Finance, Part II

In Fractal Finance, Part I we saw that fractals can be useful in describing complex, seemingly chaotic patterns in nature.  We also saw how Wall Street took advantage of the same advances in information technology that made the study of fractals possible starting in the 1980s, to come up with computer-driven black-box trading schemes.  For example, index arbitrage strategies were widely blamed for the Black Monday crash of October 1987.

Wall Street is always on the look-out for new "angles", opportunities to better skin a cat in a place already full of very sharp razors.   The sheer quantity of money moving around attracts very bright individuals, at least the variety who get high on making as much money as possible with the seat of their pants and the money of others. Wall Street is also home to some of the hugest and most ruthless egos to be found anywhere, resulting in a kind of kindergarten for genius gunslingers, but that's material for a subsequent post.

Unlike what most people may think,  professional traders don't usually make huge "straight"  up-and-down bets;  there's  simply too much risk involved. They leave this type of activity to end-user speculators and investors (e.g. hedge or pension funds), and mostly involve themselves in market-making and arbitrage.

Market-making is the workaday, mundane function of providing secondary market liquidity in return for a thin "spread" profit between bid and offer prices. This is the foundation upon which rests most trading revenue and is the training ground for all junior traders.
The real action, however, where whiz-kids can and do make a difference playing with the firm's own money, is in arbitrage and arbitrage-related activities, where profit margins are modest but risk is usually well-defined, small and manageable.  The trick there is to identify new "angles"  and take advantage of them early on, when profit margins are still fat, i.e. before other players get a whiff of the action and pile in too.

(If you are not familiar with arbitrage and risk, Richard Bookstaber's A Demon of Our Own Design is an excellent and enjoyable book, written by a true insider. Also, see the personal note at the end of this post.)

The basic principle of arbitrage is simple: if A=B and B=C,  then by definition  A=C.   Financial arbitrage is, of course, more complicated than simple math since it involves a variety of different risks, ranging from simple execution risk (the ability to complete a trade as planned), all the way to counterparty risk (an entity on the other side of the trade fails).

The basic elements common to all arbitrage operations are:
  1. The amounts of money involved are very large.  Since profit margins are small a lot of capital must be applied in order to make a decent return, in dollar terms.
  2. Trading is very active.  Again, because of such small margins, which can appear and disappear within minutes, if not seconds, traders have to pounce on them fast and often.
  3. Heavy leverage is always used to boost returns.  Twenty-to-one is considered conservative, fifty-to-one is standard and 200-to-one is not unheard. (Or was, we now live in the Age of De-leverage).
And where do fractals fit in?  Where is self-similarity in markets?

One does not need to study price charts in major, liquid markets for long to realize that they look very similar in all time frames.  Do this: take the daily chart of any reasonably active stock or commodity and start narrowing the time frame, i.e. reduce the time unit to hourly, 30-minute intervals, 10-minutes and so on.  You will see that fluctuation patterns are, more or less, similar.  Now, expand the time frame by looking at weekly, monthly, etc. charts.  Again, similar patterns.

 S&P 500 - One Day Chart  (Friday, June 26 2010)


 S&P 500 - One Year Chart

The study of patterns is not new in markets, of course. It has been going on for ages as technical analysis, wave theory, Fibonacci trading, etc. What is new, however, is the massive size of computing, communications and network capacity now being applied to markets, causing trading to become unrecognizable when compared to even ten years ago.  It is estimated that  an astonishing 70% of all volume in U.S. stockmarkets is now driven by so-called "high frequency" trading, where buy and sell orders are generated by algorithms residing in black-box computers,  taking advantage of arbitrage opportunities between the prices of shares, indexes, trackers, futures and other derivative instruments.

In Part III I shall present my conviction that such developments are detrimental to the overall health of financial markets and, indeed, the entire real economy.

________________________________________________________

I first heard of the words arbitrage and arbitrageur in 1981 during the Mobil - Marathon - U.S. Steel takeover battle. At the time, I was in grad school getting my Master's degree in ChE - and mentally a million miles from Wall Street though a stone's throw  away.  

I was introduced to David P., a major-league arbitrageur at the time, who tried to explain what he did.  I found it all extremely boring in those, my early Joe Engineer days:  oil prices were setting new records and Wall Street was flat on its back.  It wasn't until several years later that I realized who David really was. Or, for that matter, who one Carl Icahn was, whom I had met at one of David's parties and, having never heard of him until then, cheekily asked: "And what do you do for a living?"  I still blush at my ignorance.

24 comments:

Arnould said...

Who is Carl Icahn?

Hellasious said...

He, he.. that's what I thought too. But then again, I was only 20something...

OkieLawyer said...

Off topic:

Europe’s Fiscal Dystopia: The “New Austerity” Road to Neoserfdom

By Michael Hudson


The bizarre pretense for government budget cutbacks in the face of a post-bubble economic downturn is that it will help to rebuild "confidence." It is as if fiscal self-destruction can instill confidence rather than prompting investors to flee the euro. The logic seems to be the familiar old class war, rolling back the clock to the hard-line tax philosophy of a bygone era – rolling back Social Security and public pensions, rolling back public spending on education and other basic needs, and above all, increasing unemployment to drive down wage levels. This was made explicit by Latvia's central bank – which EU central bankers hold up as a "model" of economic shrinkage for other countries to follow.

It is a self-destructive logic. Exacerbating the economic downturn will reduce tax revenues, making budget deficits even worse in a declining spiral. Latvia's experience shows that the response to economic shrinkage is emigration of skilled labor and capital flight. Europe's policy of planned economic shrinkage in fact controverts the prime assumption of political and economic textbooks: the axiom that voters act in their self-interest, and that economies choose to grow, not to destroy themselves. Today, European democracies – and even the Social Democratic, Socialist and labour Parties – are running for office on a fiscal and financial policy platform that opposes the interests of most voters, and even industry.

The explanation, of course, is that today's economic planning is not being done by elected representatives. Planning authority has been relinquished to the hands of "independent" central banks, which in turn act as the lobbyists for commercial banks selling their product – debt. From the central bank's vantage point, the "economic problem" is how to keep commercial banks and other financial institutions solvent in a post-bubble economy. How can they get paid for debts that are beyond the ability of many people to pay, in an environment of rising defaults?

The answer is that creditors can get paid only at the economy's expense. The remaining economic surplus must go to them, not to capital investment, employment or social spending.

This is the problem with the financial view. It is short-term – and predatory. Given a choice between operating the banks to promote the economy, or running the economy to benefit the banks, bankers always will choose the latter alternative. And so will the politicians they support.

Debra said...

Interesting post.
Is Wall Street on the look out for new... angles or new... angels ??
Putting together today's reading with your post yields...
Barzun's take on how Louis XIV controlled the insatiably greedy and insubordinate nobles (any parallel with our time is purely fortuitous...).
Louis created a court which was an elaborate pageant. The ambitious, testosterone driven nobles were subjugated by Louis's personality, his natural authority to the point where they competed... WITH EACH OTHER for one of his smiles, or a nod of the head.
And while they were ruthlessly competing with each other for honors, appointments, etc, well, Louis, he imperturbably (for a long time) ran the country and let them play in their schoolyard.
Methinks CONTROLLING the self designated aristocracy is probably easier... in a monarchy where power is not spread out as thin as it (theoretically..) is in our "representative" republics.
I would give anything to have a copy of Jerome Kerviel's testimony on his financial shenanigans as a trader/gambler. According to him the upper level management of the Société Générale was aware of what he was doing. Of course, I say...
When everybody is gambling, well, gambling looks rather normal, doesn't it ??
Using the algorithms to MAKE our behavior conform to the mathematical models, instead of having our theories describe what happens ?
Parr for the course.

mon said...

Good read Okielawyer,

This is the true absurdity of the world.

Instead of allowing the people more able to afford the hit, the bankers and their investors, the government hits the working class and "consumers" for higher taxes (eventually) and social program cuts.

In the end a steep contraction in private sector investment and a 1930's style jobs program and will look so much more humane than what the power brokers did.

OkieLawyer said...

In the end a steep contraction in private sector investment and a 1930's style jobs program and will look so much more humane than what the power brokers did.

GDP = C + I + G + (Ex - Im)

mon said...

C, I, and G:

Oranges, peaches, and apples.

Not equivalent fruit.

Apples have an huge advantage in shelf life, especially with a huge refrigerated warehouse named the Fed. And the Fed is charging $0 rent.

Hellasious said...

If I may throw my 2c into the GDP discussion: the classical formula for calculating GDP is, in my opinion, outdated and thus woefully inadequate in describing current facts "on the ground".

For one, resource depletion is becoming a serious consideration, i.e. we can no longer view the Earth as a boundless basket of raw material that require only the application of industry (energy) to turn them into usable goods. In other words, entropic (2nd Law of Thermo) considerations MUST enter into the equation, somehow.

For another, climate change, pollution and habitation/species destruction has proceeded to such a degree that so-called "external" costs MUST also be accounted.

It is imperative that we start counting beans in a different way, before we all end up in the soup.

H.

OkieLawyer said...

For one, resource depletion is becoming a serious consideration, i.e. we can no longer view the Earth as a boundless basket of raw material that require only the application of industry (energy) to turn them into usable goods. In other words, entropic (2nd Law of Thermo) considerations MUST enter into the equation, somehow.

For another, climate change, pollution and habitation/species destruction has proceeded to such a degree that so-called "external" costs MUST also be accounted.


Yes, but don't both of these require the "G" part of the formula to be increased in order to create the efficiencies needed in energy?

mon said...

Resource depletion:

Another reason why contraction is preferable to inflation and bubble mania.

Yes Okielawyer, but without vision and guts to pull it off "G" is just another destructive element in the mix.

We need people in leadership offices to present the unfortunate "reality" to a population of fantasists that believe god put our oil in the terrorists backyard, and its OK to kill an ecosystem to keep alive a fantasy world view.

Debra said...

Benediction is an important part of the economy.
But you gotta be careful just WHERE it's going to kick in.
Our culture, for example, has misplaced benediction. It is exponentially multiplying in areas that are bringing us down...

Hellasious said...

Re GDP

"G" stands for government spending. I fail to see how this accounts for resource depletion and/or environmental degradation.

I believe we need to scrap the entire GDP formula, indeed the whole notion, and come up with something more current to describe human activity and its effects.

It's a tall order, I grant you..

Best,
H.

Debra said...

Yeah, Hell, after all... WHO said that our models were sacred ??

OkieLawyer said...

The reason I say that we need to use more government spending is because private industry does have the capital -- or is unwilling to deploy it -- to build renewable energy systems. Only the government has the capital base from which to draw on to build a new energy infrastructure.

We have 10% unemployment and adequate financial resources to put into place; it just isn't being utilized.

Private corporate interests in the U.S. only look to the next quarter to show immediate profit rather than accept that in the short term there will be capital expenditures to develop profits in 10 years, which is the turn-around time for most renewable energy projects.

I can also tell you that the "common wisdom" of the people I have talked to over the years (the ones that watch Fox News) are being told that renewable energy cannot be built due to "environmental" and "animal rights" concerns. In other words, the meme is being spread that wind and solar farms cannot be built due to environmental regulations to save some animal from extinction kind of thing. (In reality, I suspect that said projects were tanked due to astroturf "environmental groups" fighting it. I also would not be surprised if some of the environmental studies didn't have a predetermined outcome to make the case that "darn, we just can't switch to renewable energy."

I think we make a grave mistake when we insist that any development must come from private industry. The policy of switching to renewable energy is a societal good and we have millions of unemployed workers who could be deployed rather quickly to begin working on said project. (I actually think we need to reactivate the old Civilian Conservation Corps and Works Progress Administration to employ the millions of workers already counted as "long term unemployed" and the millions who are about to follow them soon.)

Hellasious said...

I see what you mean Okie..

Still, I very much doubt that focusing on Roosevelt-era remedies will do anything for today's situation.

Let's see..

1. In 1930 the federal government was tiny, by comparison to now, and could be expanded greatly - and was.

2. Ditto, government debt was tiny and was ballooned to enact Keynesian policies.

3. There were no serious environmental/resource constraints. Quite the reverse, actually, as the Age of Oil was just gaining momentum.

4. The concept of socialism/communism was quite new and untarnished then, thus making massive government intervention more acceptable to the voting public. Obviously, this is not the case now.

I believe we must create a combination of market-based and tax incentives to "force" private industry towards renewable energy and sustainability.

...and, of course, The Greenback as monetary policy (smile).

Best,
H.

Debra said...

One of our current problems, I think, is the confusion in many people's minds over the difference between socialism and social cohesion.
My impression of the mother country is that social cohesion is at zero level. Bye bye the social contract when social cohesion gets to zero level.
Rampant, uncontrolled individualism and social cohesion are incompatible.
And I think that our language works in such a way that the opposite pole of the atomic, unfederated, unbelieving individual is... the totalitarian mass.
The one implies the other. You can't have the atomized individual without creating at the same time the totalitarian mass to which the idea "individual" is opposed.
I think that the government needs to get taxation going again. To reinvest it as an idea. (yeah, and not having our taxes pay for empire's little wars would be a good idea too).
I also think that... belief follows practice, and that practice does not necessarily follow belief.
So... that means that I see NO VALID REASON why private corporations can determine any collective course on these issues WITHOUT wholesale handing over POLITICAL LEGITIMACY to the PRIVATE corporations.
Are you sure that's the world you want to live in ?
Not me.
The semantic opposition private/public is vital to maintaining the meaning of BOTH "private" and "public".

mon said...

Tax incentives and credits are the way to go. Both political parties can get behind incentives instead of the collective "5 year plan" concept.

Its a win, win, win. Direct the tax breaks to the projects that will counter global warming, encourage creation of jobs, cut down on oil imports, and pave the way for the next technological advancement. Whether new battery systems, high speed mass transit, wind, tide, or solar schemes.

OkieLawyer said...

Hellasious and mon:

Here is my problem with your proposal(s):

During the Wall Street meltdown in 2008, we saw the taxpayers provide working capital to the Wall Street financiers, while they paid themselves bonuses from the taxpayer's largesse. We called it "the privatization of profit and the socialization of losses."

I would rather it be that we provide the direct working capital and the taxpayers get a share of the company equal to the capital that was put into the project / company. Then, if the private company wants to buy out the taxpayer's (government's) interest, they should be allowed to do so at market rates.

For the last three years, I have been working in the private industry that would be affected by a lot of the necessary building brought on by government spending. We have talked among ourselves about how there is ten years worth of critically needed infrastructure installment, repair or replacement from bridges, to dams, to railroads to energy grids and pipelines. No amount of "tax incentives" will provide the needed capital to complete all of these projects (and private industry doesn't want to pay for it, anyway).

On some of these, perhaps, there could be a private-public partnership. But, I, as for one, don't want to simply give them the components of profits without something in return.

We have become accustomed to this: as in the case wherein some sports stadium is built by taxpayers in order to draw in some sports team, other tax breaks are given and the owners leave for another town as soon as the tax credit ends. The team owners profit handsomely with no risk. We used to have this archaic notion that any successful enterprise should entail risk on behalf of those who seek to profit from the venture. I guess that has gone by the wayside.

OkieLawyer said...

Off topic, but one that readers here will appreciate:

Think the Gulf Spill Is Bad? Wait Until the Next Disaster

Military bombs are classified by weight such as 500, 750, and 1,000 pounds, while financial bombs have interesting labels such as CDO (collateralized debt obligations), ABS (asset backed securities), and CDS (credit default swaps). While they sound exotic and sophisticated, when put in everyday language, a CDO is simply debt sold as an asset. And CDS, or swaps, are simply a form of insurance. Since the insurance industry is strictly regulated and the bomb factories producing CDS did not want to comply with insurance industry regulations, they simply called them “swaps,” rather than insurance.

...

The problem is that approximately $700 trillion of these financial time bombs are still in the system. While people watch the BP disaster in the Gulf, few people are aware of the other BP -- the financial bomb production -- that is still going on. If this derivative market begins to collapse, we will see another disaster.

Most of us know there is not enough money in the world to fully clean up the Gulf. The same is true with the $700 trillion derivatives market. If just 1% of the $700 trillion derivatives market goes bust, that is a $7 trillion disaster. The entire U.S. economy is only $14 trillion annually. A 10% failure, equating to $70 trillion, would probably bring down the world economy. As with the BP Gulf disaster, there is not enough money in the world to clean up the next disaster.


Hat tip: Some Assembly Required (A favorite blog of Thai, by the way)

Hellasious said...

Re: Derivatives

Some data:

According to the bank for Int'l Settlements (BIS - the central bank for central banks) as of 12/2009 there were $614 trillion gross notional in all OTC derivatives outstanding. Their market value was $21.6 trillion.

By far the largest category was interest rate swaps (IRS) with a notional of $450 trillion and $14 trillion in market value.

To the degree that IRS is used for hedging cash flows and liquidity exposures they are extremely useful - indeed, necessary in modern banking and corporate finance.

For example: a bank makes a 10-year fixed-rate loan to a customer, but must pay its depositors a variable rate that may change at any time. Thus, it is exposed to the risk of a sudden rise in short rates.

Hellasious said...

...and it all makes sense.

Obviously IRS has to do with debt, and since debt exploded upwards in the last 20 or so years, IRS outstanding shot up too.

I will say it once again: the REAL derivatives' menace is uncovered CDS, i.e. CDS bought/sold as a pure speculation with no underlying asset to protect.

Such should be made illegal, for government bonds at the very least.

mon said...

I agree with you about the "...infrastructure installment, repair or replacement from bridges, to dams, to railroads to energy grids and pipelines." Okie. I would even add that the oil in the ground should belong to the people of a country and fees paid to the corporations for its extraction.

All of these projects should be sold as strategic necessities to our future wellbeing. Not only smart advertising but I believe it is true.

Where I think governments fall short is the exact research and development needed to provide new revolutionary technologies, such as electric or hybrid vehicles, wind or solar energy. Exactly what direction and particulars should we invest in? The market still has a place in determining these efficiencies.

Debra said...

As long as people confuse "socialism" with "social cohesion", I don't think we will be able to FUND the infrastructure.
Please tell me how... tax CREDITS put REAL money (lol) into the government's paws ? I have never understood this...But I'm kinda dumb around the idea of money as DEBT anyway...
You know, over here, at the end of Jean Monnet's New Deal in France, there was an IDEAL of PUBLIC SERVICE.
All those words are important.
The idea of an ideal cemented a feeling of MISSION in the people working TOWARDS the PUBLIC GOOD.
Service : working in such a way as to be OF SERVICE. That's light years away from turning a trick (oops, I meant a buck...).
And PUBLIC. Public versus... private, of course.
CDS= bombs ? in what language ? A metaphor works as long as people accept it, and pass it on.. I'm not sure I want to accept THAT metaphor.
But the 7 trillion dollars is an apple to the Gulf spill orange.
They are not on the same.. PLANE.
Confusing the planes makes the problem worse, I think.
Sooner or later we're going to have to face up to.. DEBT FORGIVENESS in this society.
Or take our money out, as an idea.

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