A friend of mine linked to a blog post from Ivan Krstić about a massive short squeeze on Volkswagen stock back in October of 2008. Ivan does a great job of explaining what happened (so read that first), but I wanted to build upon the story.
Porsche vs. Traders
Basically, a bunch of hedge funds were betting on Volkswagen’s stock price being too high for Porsche to buy it out. So they added short positions on Volkswagen in anticipation of the price falling. At the same time, Porsche was buying up Volkswagen shares, purportedly up to 75% of them, almost the entire available float. This caused a short squeeze, and the price of the stock skyrocketed from its normal trading range of €200-450 or so to over €1k on October 28th.
Certain investors got creamed by this manipulation — part of me wonders how stuff like this is legal for businesses to engage in aggressive trading — but Porsche must’ve made a bundle from it. The price has since then floated back to its normal range.
But since any short trade is selling borrowed stock, it is classified as a margin trade (i.e. you borrow money from your broker in order to buy/short stock, usually at 2x your cash level but in some cases up to 10x, which caused the massive speculative bubble burst among some of the big banks last year).
Therefore, if the price increases and you don’t have the margin to cover the shares, your broker can force you to cover or add more capital. That is why some players couldn’t just ride out the short squeeze until it was over.
Said Ivan Krstić:
“On paper, Porsche made between €30-40 billion in the affair. Once all is said and done, the actual profit is closer to some €6-12 billion. To put those numbers in perspective, Porsche’s revenue for the whole year of 2006 was a bit over €7 billion.”
I remember reading a headline about this and wondered how it could have happened…but the EU has some weird relationships between different same-country companies. I didn’t look further into it.
I remember reading a similar story in Ben Mezrich’s “Ugly Americans: The True Story of the Ivy League Cowboys Who Raided the Asian Markets for Millions”, a fine re-telling of American finance guys traveling to Japan to play the markets there in the 1990’s. I don’t remember all the details but basically everyone in town thought a deal between two organizations was going to happen on a specific date, so everyone traded the same way on it. The subject of the story, however, reasoned that since he couldn’t actually find anyone involved in the deal, then it must not exist. He changed his firm’s position on it and made a ton of money when no deal happened on that date.
Warfare, stock market-style.
The Volkswagen story came back last week when one of the speculative traders, Adolf Merckle, tossed himself under a train in an apparent suicide. Merckle himself lost about €500mil on the Volkswagen trade, reportedly, while his family’s holding company owed €5bil to banks. Obviously Merckle’s financial story was spiraling out of control and he couldn’t take it anymore.
This is what makes investing, speculative trading, gambling, playing poker, anything involving rapid changes in cash levels so dangerous and oftentimes deleterious to one’s psychological health.
Most people might now think of the recent Madoff scandal reflexively. But that wasn’t trading or addiction to gambling; such a Ponzi scheme is a one-off affair and people got burned, but it was a consensual affair with some degree of complicity, and it’s doubtful that you’ll see much more than some sheepishness as a result of the investigation. As my girlfriend pointed out to me, Madoff doesn’t even feel remorse after the fact. More of an “oops” than an admittance of personal failure.
It’s not entirely clear what caused Merckle to commit suicide (it might not have been the Volkswagen trade at all, as his “empire was falling apart”), but certainly there’s a parallel between the lives and deaths of Merckle and a famous trader, Jesse Livermore.
Jesse Livermore was a stock trader back at the turn of the 20th century. He famously shorted the market in 1907 and in 1929 and made millions of dollars (good in today’s terms but phenomenal back then). He has turned into a trading legend and Edwin Lefevre’s pseudo-biography of him, “Reminiscences of a Stock Operator”, is considered a must-read in the trading canon.
He went bankrupt a few times. He also ended up losing big on a cotton trade gone wrong. Eventually he blew his brains out.
Merckle and Livermore were individual men, trading fantastic amounts of capital. It is one thing to lose a hundred dollars in Vegas, but quite another to lose what would be a massive setback ($500mil) for an entire company, let alone one person. What I think compounds the psychological damage is to place a trade, which is usually an expression of your opinion on a matter, and then have it go against you. Not only was Merckle wrong, he was also $500mil wrong. The market told him in no uncertain terms that he made a bad decision.
Traders often deal with this by justifying their trades. “Oh it’s going down, and my shares are losing money, but I know eventually it will go up.” And they ride it all the way down. Eventually the price plunges quickly, causing traders to panic and sell…at which point a bottom comes in, at least temporarily. But the traders got swept out because of emotion and fear.
It is almost impossible to rewire one’s brain to not react this way — which is why good traders are so hard to find.
So at some level, for many traders, successful trades are not just making money for them, they are also verification of traders’ sense of worth and identity. If you make a bad trade and lose a lot of money off it, not only are you poorer but you also question your own worth. I know this because I felt the same way on some trades I made.
Which is one reason I don’t trade anymore… I’m a lousy trader. But I’m a somewhat decent investor, and I try to stick just to that.
Scale is a consistent theme within these narratives. That is, small traders tried to play a game against a large firm on the basis of the firm’s decision-making, and so the firm held all the cards (and all the shares). The small traders got burned.
But another phenomenon has caught my interest: there’s so much capital out there that individuals can retire overnight. We are all just one NYTimes best-seller or Billboard album or accidental event away from being a multi-millionaire who can coast for the rest of his life on the winnings. Trillions of dollars float around the world, and we need only capture a million or two of that to be “rich”.
This is great for those who are keen enough to go out and grab it, but it also doesn’t scale well because individuals cannot handle much of the pressure that comes with the large swings of capital. We are used to paying $5-15 for a meal, and we may forego that extra $1 for bacon on our burger. But we might at the same time be in a business like poker or trading where we regularly win and lose $50k in a few minutes, and rarely think about what that $50k actually represents in terms of actual worth. I don’t know if most human brains and nerves can deal with the swings, as Matt Damon’s character in Rounders points out (forward to 4:36 or use this link to go right there).
Now individuals (with 100% liability) are competing with large firms who have limited liability. This provides huge opportunity and huge risk. Will individuals encounter psychological problems with scaling in, competing against an integrated economy, and dealing with the fallout?
Some manage it well; celebrities like Britney and Lindsey handle it poorly. And people like Livermore and Merckle end up in grizzly failure piles of suicidal detritus.
In the future, we will all be empowered as individuals, but with that comes a lot of accountability and responsibility. If we can’t deal with it individually (or build in social safety nets and cultural/social communities), then it will consume us.