Friday, August 12, 2011

Dual Review of Floored & The Futures: The Rise of the Speculator and the Origins of the World's Biggest Markets

The Futures
Forbes writer Emily Lambert tells the history of Chicago's trading markets in The Futures: The Rise of the Speculator and the Origins of the World's Biggest Markets.

Chicago was built for trading. Fort Dearborn was built beside the Chicago river in 1803 to protect the fur trade. The Board of Trade was formed in 1848, but the futures contract was born in October 1865 when traders created contracts for delivery of standardized grades and amounts of grain on standardized dates.

In 1897, a trader named Joseph Leiter cornered the wheat market and trapped Philip Armour short. He offered to settle with Leiter for $4 million, but Leiter got greedy and refused. Armour broke the corner by bringing wheat to Chicago from Minnesota, using ice-breakers to keep the water open. Breaking the corner turned Leiter's paper winnings into a massive loss.

I think the lesson is the same as the Hunt brothers': quit while you are ahead. The Hunts turned a several billion dollar gain into a loss of equal magnitude. They should have closed out the silver trade when Tiffany's took out a full page ad in the New York Times to complain specifically about the Hunts and their silver corner. From that point on, the ratio of feathers collected to honking noises could only worsen.

It was interesting to see how many of our descriptive trading terms come from the pits: scalpers, position traders, and spread traders (the smartest and most consistently successful).

An ongoing theme in The Futures is that the exchanges were continually rolling out futures contracts in new products, first with more agricultural commodities like cattle, and then on to financial - purely abstract - products and derivatives like stock indices and interest rates. Always, they needed to establish a market for these new contracts, because the traders themselves and the exchanges and clearing firms make their money off of volume.

As Lambert describes it, they needed to "entice people to trade" the new futures contracts, so "if no customer sent in [trading] business, they traded with each other" to give the appearance of a bustling market! That is called painting the tape!

When the options contracts were launched, the mathematical pricing models like Black Scholes were only just being developed. At first, traders carried sheets of paper with computations prepared in advance to assist with pricing. Traders who could do the calculations mentally without looking at the sheet were at an advantage because they could quote prices and react more quickly. I wonder if this is where the hedge fund bias in favor of quantitative skills at the expense of other skills originated?

One other funny thing: people thought that ranchers would use the cattle futures to hedge. Instead, they were "eager gamblers" who would speculate wildly, doubling down on cattle prices by owning futures in addition to their herds. This is where the phrase "Texas hedge" comes from!

4/5; adding a half point for brevity.

Nature's Metropolis: Chicago and the Great West
The Plunger: A Tale of the Wheat Pit
The Great Salad Oil Swindle

To complement The Futures, I watched a documentary called Floored about the floor traders in Chicago who are struggling to stay relevant now that futures are traded electronically. I never realized that the floor traders are all lower middle class. The ones that become successful try to live a caricature of success: smoking cigars and throwing money around.

What is hilarious is the quant firm that they visit. It consists of superdorks! Very quantitative, made up of nuclear physicists, etc. I always feel the presence of a lot of people in the market that are rubes, not streetsmart: they take government data releases at face value, for example. I think it's the quants.

Also - the floor traders have such a long, bullish bias. Like the ranchers who "Texas hedge", they seem to be always long the contracts that they trade and get caught in the crashes.


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