Market Anarchy, The Day Atlas Crumbled

FX Market Outlook

In order to understand why Ayn Rand is dead wrong, you simply have to watch the opening sequence of “The Last Boyscout". Granted this particular piece of Bruce Willis's oeuvre isn't exactly Citizen Kane, but it does capture in stark terms the unfortunate consequences of playing a game without any referees. As the camera descends on rain splattered football field we see a grim, troubled fullback running down filed with the force of a locomotive. As he is approached by the opposing team he whips out a gun shoots his would be tacklers on the spot, opening the way to an unfettered path towards the end zone where he promptly sits on one knee, puts the gun to his head and blow his brains out.

Ridiculous as it is, this scene from the Last Boyscout has always stayed in my mind as an apt metaphor for the pitfalls of an unregulated market. Imagine if football or soccer had no referees. If just one player amongst many decided to use a gun to help him score a goal or a touchdown. Could this type of a game survive for more than a few seconds? Of course not. In order to be productive and effective, all social human activity must have rules. More importantly those rules must be enforced uniformly by a disinterested third party if the game is to stay honest and last. Otherwise all games will simply devolve into a variation of the Last Boyscout.

That's why I strongly disagree with the philosophy of Ayn Rand (Alan Greenspan's intellectual guide) while admiring her call for individual freedom. It only takes one thief amongst a group of a thousand honest men to destroy all the benefits of a free market system. Every economic transaction is in essence an exercise in trust. I pay you money and you perform a service. But performing a service has a cost. It requires, thought, labor, work. What if I just took your money and performed none of those tasks? Wouldn't my profit margins be much greater than my competitors? If I could get away with the scam long enough I could grab all the market share and dominate my sector. Sound crazy? Think AIG selling CDS insurance for $5 premium per $1000 face value with the money entrusted to them by annuity buyers. (Yes I know that is not EXACTLY what they did - that that was the EXACT effect of their actions) Now that some of those bonds are bankrupt they have to pay out $995 in claims which they do not have. Can one even make a moral argument as to why the management of that organization should not be sentenced to life in prison? After all we put away bank robbers for life for stealing as little as $10,000. The crimes of AIG were exponentially greater.

The point of this rant isn't really about my lust for vengeance. The crimes of Wall Street are already water under the bridge. Capital has been lost, lives have been ruined and now it just a matter or recognizing reality. I wrote two weeks that on Wall Street you either eat your losses or your your losses will eventually eat you. Hank Paulson, ever the Goldman Sachser that he is, refused to honor that rule and the end result is a complete and total stock market crash despite his best but misguided efforts to throw good money after bad with TARP.

So what should policy makers do now? Recognize the absolute and abject failure of unregulated free market and fix the real problem. Contrary to popular belief unregulated free markets are not always the most efficient solution. Countries that rely on private toll roads and the US healthcare system are just but two examples of utter and absolute failure of free market to deliver a quality product at a low cost to the greatest amount of people - a key measure, I would argue, of our progress as a society.

In finance this failure of the free unregulated markets has manifested itself in the vast shadowy over the counter derivatives market for MBS, CDO, CDS and a host of other alphabet soup products whose notional trade value now exceeds $550 Trillion - 10 times the Global GDP. In what now seems like a quaint memory but was in fact the foreshadow of things to come, the hedge fund LTCM nearly brought the financial world to ruin with its reckless trading in 1997. On the other hand in 2005 another hedge fund Amaranth Partners also blew up gloriously on bad energy trades, but its collapse scarcely caused a ripple. What was the difference? LTCM trades were all made over the counter without any supervision or transparency. Amaranth trades were all made on a regulated centralized exchange - the NYMEX - where a careful clearing enforcement system made sure that all the counterparties were paid their due.

On Friday, I wrote the following words,"Given these apocalyptic scenarios, consensus is building amongst the G-7 policymakers to centralize the two largest over the counter markets - LIBOR and CDS which have come to a grinding halt, as counterparties no longer trust each other and credit is cut off to a trickle. The centralization of clearing for these two key markets (much like equities on NYSE and NASDAQ and futures on CME) would go along way towards alleviating the fear that has paralyzed these two key markets. Centralized clearing would effectively guarantee counter party risk and provide much better price transparency perhaps enticing bargain hunters to make some bids. Global policymakers however must move fast, as investor confidence is being drained by the moment and markets are unlikely to stabilize and function well without some centralized structure. For FX, the bottom line is that risk on remains the dominant trading theme of the day and high yielders will continue to be pressured until some semblance of order returns."

Next week the markets may well bounce. Carry could rebound from it grossly oversold levels. Traders could breath a sign of relief. But none of these cosmetic events will fix the underlying problem of global finance - lack of transparency and security capital. Instead of burning yet more trillions of dollars of taxpayer money global policymakers should bring in over the counter market under an exchange regulated umbrella - a solution that would be far less expensive and far more efficient for us all.

The Art of Managing Luck

So this was an interesting week in the FX market to say the least. As I write this Dylan Radigan is running a piece on CNBC entitled Violent Volatility Vortex as he points to the the fact that VIX has now hit 70 on an intra day basis while the DOW has plunged below 8000 for the first time since 2003.

For FX traders the equity market has been the only market that matters because the one and only driver of trade in currencies has been has been risk. On Thursday we had the Aussie rise 500 points as risk assumption returned temporarily and on Friday it plunged that much and more as risk aversion came back with a vengeance.

How does one trade in this kind of a market? Obviously very carefully. This week I reduced my size to half my usual amount and that decision probably saved me from more pain than anything else I could have done. When markets go wild you have only two choices - get smaller and survive or bet big and blow up.

But while getting small controlled my risk it did not bring me profit. I spent the first half of the week trading back and forth on my levels setup but my chart looked more like target practice poster from a gun range - riddled with as many losses as wins. The volatility was so vicious that I would often have a trade move well on its way to my profit target only to turn violently and stop me out for a loss. After getting smacked around by the market like that for about 10 times in a row, I stopped and looked for a better way. Ironically the key to success lay right in front of me.

Instead of trading single entry single exit, I adopted the BKT approach of trading 2 units one with a short profit target and one with the long one and lo and behold the level's setup became much more profitable. Once again I realized that in trading being partially right is much better then being absolutely wrong.

One of the biggest myths in trading is that if you just use a 2-to-1 reward to risk ratio you need only be correct 50% of the time to be wildly profitable. True in theory. In real life however if you trade with 2 to 1 r/r ratio you will likely be only correct 2 out of 10 times maybe even 1 out 10 times. Little wonder then why novice traders become bewildered when this hackneyed advice from trading books does not work. Markets never make it easy. They rarely go up in a straight line. They nearly always retrace and that's why as a trader you need to able to take what they can give rather demand you just due. The game of trading is really the art of managing luck and this week proved that point in spades.

Here is the video of this week's trades

Boris Schlossberg
BKTraderFX