Carlos The Emerging Market Trader

Within the bank Carlos was the emerging-markets reference. He could produce the latest economic figures at the drop of a hat. He had frequent lunches with the chairman. In his opinion, trading was economics, little else. It had worked so well for him. He got promotion after promotion, until he became the head trader of the emerging-market desk at the institution. Starting in 1995, Carlos did exponentially well in his new function, getting an expansion of his capital on a steady basis (i.e., the bank allocated a larger portion of its funds to his operation)—so fast that he was incapable of using up the new risk limits.

The reason Carlos had good years was not just because he bought emerging-market bonds and their value went up over the period. It was mostly because he also bought dips. He accumulated when prices experienced a momentary panic. The year 1997 would have been bad had he not added to his position after the dip in October that accompanied the false stock market crash that took place then. Overcoming these small reversals of fortune made him feel invincible. He could do no wrong. He believed that the economic intuition he was endowed with allowed him to make good trading decisions. After a market dip he would verify the fundamentals, and, if they remained sound, he would buy more of the security and lighten up as the market recovered. Looking back at the emerging-market bonds between the time Carlos started his involvement with these markets and his last bonus check in December 1997, one sees an upward sloping line, with occasional blips, such as the Mexican devaluation of 1995, followed by an extended rally. One can also see some occasional dips that turned out to be “excellent buying opportunities.”

It was the summer of 1998 that undid Carlos—that last dip did not translate into a rally. His track record up to that point included just one bad quarter—but bad it was. He had earned for his bank close to $80 million cumulatively in his previous years. He lost $300 million in just one summer.

What happened? When the market started dipping in June, his friendly sources informed him that the sell-off was merely the result of a “liquidation” by a New Jersey hedge fund run by a former Wharton professor. That fund specialized in mortgage securities and had just received instructions to wind down the overall inventory. The inventory included some Russian bonds, mostly because yield hogs, as these funds are known, engage in the activity of building a “diversified” portfolio of high yielding securities.

When the market started falling, he accumulated more Russian bonds, at an average of around $52. That was Carlos’ trait, average down. The problems, he deemed, had nothing to do with Russia, and it was not some New Jersey fund run by some mad scientist that was going to decide the fate of Russia. “Read my lips: It’s a liqui-da-tion!” he yelled at those who questioned his buying.

By the end of June, his trading revenues for 1998 had dropped from up $60 million to up $20 million. That made him angry. But he calculated that should the market rise back to the pre–New Jersey sell-off, then he would be up $100 million. That was unavoidable, he asserted. These bonds, he said, would never, ever trade below $48. He was risking so little, to possibly make so much.

Then came July. The market dropped a bit more. The benchmark Russian bond was now at $43. His positions were underwater, but he increased his stakes. By now he was down $30 million for the year. His bosses were starting to become nervous, but he kept telling them that, after all, Russia would not go under.

He repeated the cliché that it was too big to fail. He estimated that bailing them out would cost so little and would benefit the world economy so much that it did not make sense to liquidate his inventory now. “This is the time to buy, not to sell,” he said repeatedly.

“These bonds are trading very close to their possible default value.” In other words, should Russia go into default, and run out of dollars to pay the interest on its debt, these bonds would hardly budge.

Where did he get this idea? From discussions with other traders and emerging-market economists (or trader-economist hybrids).

Carlos put about half his net worth, then $5 million, in the Russia Principal Bond. “I will retire on these profits,” he told the stockbroker who executed the trade.

The market kept going through the lines in the sand. By early August, they were trading in the thirties. By the middle of August, they were in the twenties. And he was taking no action. He felt that the price on the screen was quite irrelevant in his business of buying “value.”

Signs of battle fatigue were starting to show in his behavior. Carlos was getting jumpy and losing some of his composure. He yelled at someone in a meeting: “Stop losses are for schmucks! I am not going to buy high and sell low!” During his string of successes he had learned to put down and berate traders of the non-emerging-market variety. “Had we gotten out in October 1997 after our heavy loss we would not have had those excellent 1997 results,” he was also known to repeat. He also told management: “These bonds trade at very depressed levels. Those who can invest now in these markets would realize wonderful returns.”

Good Trading,

Nassim Nicholas Taleb

- From Fooled By Randomness, Copyright © 2004 by Nassim Nicholas Taleb. Reprinted by arrangement with Random House.

Editor’s Note: Nassim Nicholas Taleb is a literary essayist and mathematical trader obsessed with the problems of uncertainty. His interests lie at the juncture of philosophy, mathematics, finance, and the social sciences, but he has stayed extremely close to the ground thanks to an uninterrupted two-decade career as a quantitative trader in New York and London. Watch out for Taleb’s forthcoming book - called The Black Swan – due to be published in Spring 2007. Check the RandomHouse website for updates or to purchase a copy of Fooled By Randomness