CHAPTER 13

Volatility and the Crash of 2008

Trading remotely from the apartment in Grand Island, in the slow but progressive bear market of early 2008, I developed a strategy according to Jared's strategy development models that capitalized on the daily volatility of the currency markets that had become increasingly effective over the summer of that year.

The actual details of the strategy I employed are much less important as a lesson for beginner traders than the mindset behind the development of the strategy. The strategy itself was an exploitation of a relatively transient edge that no mathematically inclined long-term system developer would consider to be extremely robust. And that was not the purpose of the strategy. Never once did I consider using this particular strategy to build equity over the next 10 years. Rather, the strategy took advantage of short-term relationships between assets that existed at the time and could be exploited to take regular profits, day in and day out, for a short period of time.

A variation of high-volume scalping had remained a staple strategy of mine at the time, and my own development was used almost entirely as a supplemental income that I never intended as a long-term staple of my arsenal. As long as the strategy is designed so that losses are contained, and a set of criteria is included to prevent long-term bleeding of losses, there's no harm in employing a technique that was built entirely to extract profits from a transient market phase.

One tenet of my strategy had been the assumption that volatility would drop in the summer and would be higher by September and October. While predictions of a market crash were not rare, it could be said that some of the warnings were regarded with the same skepticism as the type usually reserved for conspiracy theorists. This was not part of my consideration in developing the strategy. My assumption was that volatility would increase, in which direction I did not know or care.

After all, as proprietary traders, we are in the business of making profits in both bull and bear markets. We bet on up moves by taking long positions and we bet on down moves by taking short positions. In theory, a company like CTNY should be unaffected by something like a major stock market crash.

To satisfy any curiosity, the strategy that I employed over the summer of 2008 relied on the volatility of the major currency pairs at the open of the U.S. equity markets at 9:30 Eastern time. Unlike the equity markets, the foreign exchange (or Forex) market is open all day from Sunday evening (Monday morning at the start of business for Australian banks) to Friday afternoon (close of business at New York banks). While the market is often said to be open 24 hours, the truth is that it's a rotation between the world's major market centers (primarily Australia, Japan, England, and the United States) that account for the majority of its institutional trading volume. At the start of business for the banks in New York at 8:00 Eastern time, many of the major currency pairs involving the U.S. dollar would make their first move within the first half hour. Due to correlations between the currencies and the major equity markets, there is another jump in volatility around the open of the U.S. equity markets at 9:30.

In the summer, however, the tendency in the currency markets is to establish the majority of its range during this period of increased volatility. After the jump, there is often an opportunity to layer a few orders in the opposite direction of the initial moves and catch a relatively predictable 50 percent retracement of the initial move. The reason for this is likely to be a combination of the lack of real volume in the summer months combined with the fact that many of the larger market makers in the interbank foreign exchange market tend to be placed into a counter-trend exposure by those daily moves and must find a way to flatten out their exposure. With relatively low volume market environments, their process of flattening out their exposure would push back a fair bit and in some cases even reverse the trend. Of course, this was the theory but I hadn't cared about the reasons as much as the fact that it simply worked and made money for me, and for the firm, each and every day during that period.

It should also be worth noting that whether you capture such moves in the currency market using the listed currency futures contracts or a spot foreign exchange contract should make relatively little difference as pricing rarely varies by a few pips or less during times of such high volume and volatility—or so I had casually observed during the development and implementation of the strategy in mid-2008.

Again, the idea behind the development of this strategy was far more important than the details of the strategy itself. It was developed based on the opinion that some people are simply focusing far too much on fear, uncertainty, and doubt when developing trading strategies. It's all well and good if your goal is to develop a trading system that had been back-tested over 10 years of data and then tested on out-sample testing with another 10 years of market data—but even if you had done so, there is still a very good chance that the system will outright fail to deliver one penny of profits tomorrow and for the next 10 or 20 years. Markets change and evolve. General Electric in 2012 moves nothing like the GE of 2006. Whether you blame the market makers, the HFT algorithms, the regulators, or your neighbor's dog, it doesn't mean anything unless your career goal is to write more of the regurgitated cannon fodder shot out of the financial press every day. As a trader, your job is to make money today and tomorrow and for the next 10 years. Sometimes, a relatively simple idea that just seems to work based on a hunch followed by a little market data from recent weeks pasted into an Excel spreadsheet—as long as it's attached to a decent risk management technique that protects you from excessive losses—is all you really need to extract more income from the markets. Never dismiss these opportunities just because the idea seems too simple, too obvious, or any other criticisms based on fear, uncertainty, and doubt. If you have a hunch that you think might work in the markets, test it on a small sample of data first. If possible, test it on recent data using Excel, which may or may not be feasible depending on the nature of your idea—or in some cases, on a larger sample.

For anyone who had kept track of the volatility indexes in the markets, it was obviously fortunate that I had considered the old assumption that volatility would increase by September and especially October of each year. As the summer of the northeastern United States drew to a close, my plan was to completely stop running the currency volatility strategy that I had run consistently and profitably throughout the summer months. It had been part of the plan all along, knowing that it would be a matter of taking what I could get while the opportunity remained and walking away when it was no longer seasonally likely to remain. Many would probably question why anyone would or could stop running a profitable strategy that pulled in the kind of winning percentage and numbers that this strategy had pulled in for the whole summer, and so did I. Psychologically, it was much easier to follow the plan on the daily basis than it was to follow the part of the original plan to simply stop trading the method cold turkey by September 1 st. To satisfy this instinct, I threw myself a psychological bone and simply began to run the strategy at a relatively smaller trade size rather than stopping altogether.

As a matter of principle, I would prefer to say that I stopped out of pure discipline, but that was not the case. I only completely stopped running the strategy because there had been a plan for months to visit New York City again with a group of our friends. In the process of preparing for this long-planned visit to the city, I had returned to Toronto to meet up with some of the others in the group before returning to Grand Island so that Anna would come with us. At this point, Anna and I had been engaged for a few months already. During my trips back to the financial capital of Canada, I had noticed that when I returned, Anna hadn't been wearing her ring as she usually did all the time. Like any other part of my life at the time, I resisted the temptation to make an issue of it any more than I would let fear, uncertainty, and doubt wreak havoc on my trading. Instead, I brushed off the issue and the entire group, including Anna, headed back to the city where she was born and raised. She and Bridget had shared as much interest in this trip as the Toronto-born members of our group of friends; after all, very few people who were born and raised in any part of New York City or its boroughs would have visited most of the major tourist attractions.

For most of Black Week, which began on Monday, October 6th, 2008, I was visiting a number of New York City's household name tourist attractions with our group of friends. At some point during the week, we had visited the New York Stock Exchange building on Wall Street. The exact date of that visit is a detail that one would assume would have stuck during such a historic period in the markets. Unfortunately, it didn't.

In the ultimate dramatic irony for any trader that I never would have expected to experience in reality, rather than on a silver screen, that long awaited vacation was soon followed by a seemingly gradual phase in which the core parts of my personal life spiraled into a black hole of worst case scenarios and brutally coincidental timings. Anna became increasingly distant as every day passed at the Grand Island apartment and if I even tried to deny to myself that anything was wrong with our relationship by then, her apparently constant efforts to trigger petty and arbitrary arguments between us at times, when it seemed there was really nothing worth any sort of conflict, began to take its toll. Without delving into the details, it soon became clear that she had purposely created conflict in hopes that I would end the relationship first. A few weeks later, Bridget came to visit us at the apartment in Grand Island and stumbled onto logs of Anna's MSN conversations in pursuit of other relationships, carelessly saved in the same folder where photos from our last trip to New York had been kept on the shared computer. The details are not relevant. In all honesty, though, I must note that I was not even the least bit surprised at the discovery. What did make matters worse was that the events surrounding this period at the end of my relationship with Anna also dragged down a number of close friendships with people who had been a part of the majority of my life.

The timing of these incidents, of course, could not be exaggerated for an individual who made a living by participating in the U.S. equity markets. Like many sectors and foreign markets, my personal life had experienced a correlation with the Fall 2008 peak of the market crash that no trader in the world would have ever considered to be likely.

During the turmoil, I came to the point of questioning every single one of the core ambitions I had held as a centerpiece of my life. I began to question how exactly each of them could possibly contribute to achieving the goals that originated from childish and naive mental pictures of what I had wanted out of life in the first place. With the gradual destruction of my closest relationships and all the future goals and plans that went along with them, not only with my fiancée but also with some of the closest friends whom I had grown over the years to trust with my life, things that I had taken for granted as being a part of my personal life only a few months earlier had become little more than a long-term lost bet.

I took vacation time during that period, and neither my savings account nor the firm had a problem with this decision. The problem was that I had to admit to myself that, in reality, it had taken me much longer to truly live up to one of the most clichéd pieces of trader advice: “Cut your losses and move on to the next trade.” Mentally, it took a little more time off to finally get back into the game of life, to take that advice and apply it in my reality. Ultimately, I did consider that I was lucky to have been able to survive that period of chaos in the global markets. I also consider myself lucky that, aside from Anna, I was able to repair a significant part of my personal life in one way or another over the coming months. After the worst of it had passed, Bridget and I were able to develop a much stronger relationship out of the shared experience after we both cut our ties with Anna and returned to Toronto. And I could never deny again that experiences in one's personal life or in the markets can, at times, be instrumental in a person's development as an individual and also as a trader. While there are times when we can all handle the challenges in one better than those in the other, we can't always predict how we will react when a real black swan event occurs. Sometimes, even if our objective beliefs and views seem ready for any form of adversity that might come in the way of our goals, real-life experience is the greatest contributor to our ability to handle future challenges.

It would be tragically climatic to say that CTNY had been taken down by the market's increased volatility of Fall 2008, complete with the mental images of an empty and silent trading floor left in the dust of the credit crisis, but in reality that wasn't the case. Whether it was due to internal exposure hedges, the profits from senior traders who prospered during the peak of the volatility countering the losses of many novice traders, just plain dumb luck, or a combination of all these factors, the fact was that CTNY lived to participate in the markets another day.

Having long rooted for Erin to succeed at CTNY, I later found out that she had been among the traders who initially suffered significant losses at the peak of the October 2008 volatility levels. However, unlike many who faced the largest losses in their careers and folded, she was also among the few who were able to adapt quickly and was then able to more than recover from the losses by outperforming in the months that followed. In short, Erin faced unpredictable conditions but quickly adapted and survived a black swan event.

As in the markets, reality will never hand us a fairy tale ending. Every day, the best we can do is put forward our personal best in our ability to adapt to new challenges and face new forms of adversity. Sometimes, we find the best aspects of the hand we're dealt simply by being able to turn a disadvantage into a new asset. No matter what sort of assumptions we may have developed since childhood, none of us are intrinsically entitled to any success in life or in the markets.

And as with relationships of all kinds, no single loss, or even a streak of losses, will mean the end of the world. Sometimes an unexpected event might naturally weed out the weakest hands in the game, but the survivors are the ones who can adapt and survive to face the challenges of another day.