Reflections of a Trader

Ralph Shell, Forex review group analyst and one of our main contributors, discusses his reflections on the big risk takers of yesteryear such as Victor Niedorhoffer.

A book, written by Victor Niederhoffer, called The Education of a Speculator, was published in 1997. I had met Niederhoffer on the Chicago Board of Trade floor some time during the 1970’s, and was later aware he used Refco, a company I was affiliated with for almost ten years, to clear some of his trades. Naturally I was interested in his book.

While reading the book, I was fascinated with the amount of risk he assumed, especially when trading currencies. At the CBOT I had known quite a few traders that would put on their ‘going home trade’, a position big enough to make so much money that they could leave Chicago and go back to their rural roots. A few did make the big score and move on, however they usually returned, after finding that the simplistic beauty of the idyllic pastoral scene was over rated. There were many more that lost it all, went broke, and then either got a new sponsor, or failing to find one, moved on to a different career. Yes, there also had been a few who, unable to confront financial disaster, chose to check out of this life.

Some of the big successful traders are brilliant in their analysis, fearless when assuming huge positions, and arrogant to a fault. This combination of traits makes for big hyperactive traders that make and lose fortunes in mere weeks or days. The brokerage houses who clear the big traders accounts assume big risks, but make fat profits as long as the trader does not ‘blow up,’ meaning lose all their trading capital. Shortly after reading the book, my suspicion that Niederhoffer’s aggressive trading could lead to a financial debacle, came true.  According to a story in Wikipedia:


“On October 27, 1997, losses resulting from this investment, combined with a 554 point (7.2%) single day decline in the Dow Jones Industrial Average (the second largest point decline to date in index history), forced Niederhoffer Investments to close its doors.”

Professional traders have long used the options market to enhance the profitability of their trades. Instead of buying options, however, they write or sell them. Warren Buffet became one of the world’s richest men by selling insurance, and a writer of a stock option is like the insurance company. With Refco as his broker, Niederhoffer sold massive quantities out of the money S& P puts, collecting the premiums. (S and P puts give the buyer the right to sell at a contracted strike price. As the market crashed the value of the puts increased.) Niederhoffer, who had sold the puts, was then long the stock market.  As the market sold off the puts appreciated in value. As the market picked up momentum to the down side, the volatility of the market increased, further enhancing the puts value. The losses mounted as puts were priced ‘market to market’ at ever increasing values.

When market conditions are calm, the option seller hopes the time value loss of the options will diminish, melting away like an ice cube on a steamy summer day.  On October 27th 1997 that was not the case.  The Dow Jones Industrial average plunged 7.2%, the second largest point decline in the history of the index.  In turbulent market conditions such as experienced that day, there is gut wrenching tension and fear in the air.  Should a broker filling a small order in the pit make a mistake, he can have a loss larger than the average worker’s yearly income, and a big loss can lead to bankruptcy, and a forced change of professions.

Refco long had the reputation as a rough and tumble, no nonsense clearing broker.  They sought and encouraged the big traders to trade big numbers.  In this way they received more commissions. Their pit brokers often had company exchange memberships. Because the company owned the memberships, Refco paid their brokers a lower rate to fill the orders in the pit. Often these were younger less experienced brokers, but Refco account holders knew this when they were opening accounts. There is generally a reason for the lower rates.

As the market worked lower that fateful day, the losses mounted for Niederhoffer, until the margin clerk, at the direction of top management blew him out of the trade.  Traders can sense, like blood in the water, when there is a financially wounded account, and they naturally front run the market compounding the losses. This is not unusual. When the troubled trader voluntarily or involuntarily capitulates, that is usually the end of the move.

Niederhoffer was indeed blown out of the market by Refco, leaving Refco with a multi-million dollar debt. One of the adages of trading in Chicago is ‘the definition of a manipulated market is one in which you are wrong’.  When you think that the market is some giant conspiracy in collusion to take your money, it is time to see a shrink, take a vacation, and perhaps reduce the proof of your beverages. True to form, Niederhoffer sued the Chicago Mercantile Exchange and floor traders in the US District Court of Northern Illinois, claiming they worked in collusion to drive the market down, increasing his losses.

The saga of this big bad trade did not end with the law suit. Refco management, stuck with millions of losses from the Niederhoffer trade, chose to hide the debt. Phillip Bennett, president of Refco, concocted a scheme to borrow the money from a hedge fund in Summit, New Jersey, who then loaned it to a Refco Holding Company who loaned the money back to Refco. Each quarter the loan plus interest would be paid back in such a way as to fool the auditors. This deception continued for years even through the period when Refco went public. Deception, in this case the deliberate withholding of information, deliberately overstated the value of the company and was a clear violation of SEC rules. Eventually the heightened scrutiny once Refco became public, uncovered this scam. This resulted in the demise of Refco and criminal charges brought against some of its management.

There are several lessons that we can take home from this trading narrative. Obviously, just because you can write a book about speculation, does not mean all of your trades are going to make money. And just because you can write a book about trading does not mean your trading techniques are suitable for others. More importantly, trading so large that you are in danger of blowing up your own account, and taking others with you is not a sound financial plan. Part of the problem may arise when the fund manager or pool operator gets a management fee, and a percentage of the profits, but does not participate when the trades lose money. Currencies, commodities, and the writing of options is very high risk/reward. Combine high leverage and volatility with massive positions and you have a set up to make or lose fortunes. As we all know, not every trade makes money of course, but the bigger you trade, the more visible your position.  When you are putting on a position traders love to ride your coattails, racing the market, taking advantage of the momentum.  If the position turns against you, traders who were racing your orders when you were putting the position on are now going the other way.  If they have a sense you want to come out of your big positions they will scalp the market in front of you.  Should the market sense you are financially wounded, as the market goes against your position, the traders will be like a flock of buzzards circling a dying critter, continuing until the trade has been liquidated.

The education of a trader is not something you can take a few cram courses in and quickly move to the big time. There is no graduation, there are no diplomas, and the courses never end. One of the things that take time to learn, is how to deal with your emotions, especially when you have large positions. Risk management is a topic the successful trader never ignores. It is much better to increase the size of your positions, only after you have taken some money out of the market. Traders who tried to ‘double up to catch up’ usually did not last very long.

Your objective is to make money. Yes there may be some trading contests that offer a prize for performance within a specific time frame, but that is the exception.  Beware! The market makers always want you to trade more.

Many successful traders have acquired skills that improve with age. Years ago I met an elderly Texan, a member of the Chicago Board of Trade who had a bullish view of the wheat market. He was aware that I had worked at the Kansas City Board of Trade and my company, at that time, was a clearing member of Kansas City. Eddie Byers, then about 85 years old, thought we were on the verge of a global bull market in hard wheat, the kind traded in Kansas City. He opened an account with my firm and told me to buy 100 contracts, 500,000 bushels, of December wheat futures. The months went by and the market went sideways. Come December, he rolled his 100 contracts forward to next year. This continued for two and a half years with Eddie always rolling the trade forward. Finally global conditions tightened, the Russians had a crop failure, the Canadians were sold out and the Australian crop was short, a confluence of bullish factors. The wheat market turned higher, but unfortunately Mr. Byers’ health was failing.  About half way through a big multi dollar wheat bull move Mr. Byers, then about 88, passed away. His account was liquidated according to exchange regulations when we received notifications of his death. His assistant said he checked the market two days before he passed on, and was elated about the wheat price. Another feature about trading, there is no age limit.


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