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Even the brightest minds can be vulnerable

Tuesday 06 November 2007 05:12PM

Mr Niederhoffer has made his career out of trading on the futures markets and also writes options on futures contracts. The  New Yorker profile, perhaps unkindly, quotes the author and derivatives trader Nassim Taleb as saying that Mr Niderhoffer is “his own worst enemy. One of the most brilliant men I have ever met, and he wastes his time selling options – something nobody can have any skill in - and it leaves him vulnerable to blowing up”.

Mr Niederhoffer certainly has reason not to like years ending in seven. In 1987, when he was working with George Soros, he regularly played tennis with him. Both men lost heavily during the October stock market crash of that year. In his book Education of A Speculator, published ten years later, Mr Niederhoffer, himself a former national squash champion, recalls how while his own tennis game suffered as a result of his losses, his partner seemed completely unaffected by having lost $1 billion or so the previous day.

Although he survived that trauma, it was Mr Niederhoffer’s misfortune to finish his book – an eccentric mixture of life story and reflections on the art of trading - just as his investment career was taking a disastrous lurch for the worst. By 1997, having parted company with Mr Soros, he was running his own funds and making big returns, only to come a cropper with a huge and disastrous unhedged bet on the Thai stock market shortly before the market crash and currency devaluation that triggered the subsequent Asian crisis.

It was, Mr Niederhoffer admitted later, not a smart move. Thailand was not a country he had ever visited, he had no stops in place on his trades, his positions were too large and too illiquid, and the brokers effectively put him out of business when he could not meet his margin calls. The analysis of price movements and trading patterns that underlie his general trading approach was faulty and unreliable, he says now, given Thailand ’s relatively short market history.

Having clawed his way back from that disaster, and building up a new business with a few hundred million dollars invested in his new hedge funds, it seems that nemesis has now struck again, although the precise details of what went wrong this time round are not immediately clear. The simplest explanation may be the most obvious one, which is that Mr Niederhoffer, who combines a PhD in finance from the University of Chicago with a voracious interest in gambling in all its forms, is hooked on risk.

It is not uncommon, he notes in his book, for his trading to produce gains and losses of as much as 25% in a single day.  What successful traders need to succeed, he says, is the confidence that comes from high self-esteem, or, if you prefer it, “insufferable arrogance”.  Yet elsewhere in the same book, he notes that all the great champions in sport are humble about their abilities. “During the ten years that I traded for George Soros, I never heard him speak once about a winning trade. To hear him talk, you’d think he had nothing but losers. Conversely, listening to the biggest winners, you’d think that they had nothing but winners”.

Who can doubt that this is good advice?  To this day nobody is more quoted by stock market traders than the US trader Jesse Livermore. Yet this is a man who went bust at least three times, suffered repeated bouts of serious depression, married several times and ended up committing suicide in a New York hotel. The moral seems to be: if you have a great talent for trading, don’t boast about it. Markets can be unforgiving places for investors and traders alike.

Have embraced quantitative risk techniques, nobody can doubt that, in aggregate, modern financial markets are a safer place as a result. Yet, as in 1998, with the demise of Long Term Capital Management, the travails of quant funds during the summer market turmoil are a pointed reminder that a quantitative approach has its limits.  Even the brightest minds, as Keynes noted, are vulnerable to animal spirits running away with their own success; and models are only as good as the probabilities they represent.

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