Bill Lipschutz: The Sultan of Currencies

(continued)

Were there any other trades that were particularly unusual for one reason or another?

One trade that was interesting because it turned into a virtual poker game occurred in 1987. I had put on a huge option spread position: long twenty-three thousand Japanese yen 54 calls and short twenty-three thousand 55 calls. If the calls expired in the money, each side of the spread would represent nearly $800 million-an enormous position at the time. When I put on the position, the calls were well out of the money.

(The position Lipschutz is describing is a bull call spread. In order for the trade to be profitable, the price of the yen must rise above 54 by an amount sufficient to at least offset the cost of the spread. Unlike a straight call position, however, the profit potential is limited to one full point per contract, since the long 54 call position is offset by the sale of an equal size 55 position. Although the sale of the 55 call limits the profit potential, it also substantially reduces the cost of the trade, as the income generated by selling the 55 call partially offsets the cost of buying the 54 call. The maximum profit would be realized at any price above 55, in which case each spread position would generate one full point profit ($625) minus the price difference between the 54 and 55 calls at the time of the position implementation. Given the numbers described by Lipschutz, the maximum profit potential on the entire spread, which again would occur at a price above 55, would approximate $13 million.)

The risk of doing this type of trade is that if the front strike is in the money but the back strike is not (i.e., a price between 54 and 55), you could end up exercising the long 54 call and not getting called away on your short 55 call. While this would imply a profit at expiration, it would also mean mat you would be left net long a near $800 million position, which would have to be carried over the weekend until the Tokyo market opened on Sunday night. In other words, you would be left with a tremendous risk exposure to an adverse price move over the weekend.

Couldn't you hedge the position near expiration?

You could if you were sure about whether the market was going to settle significantly above or below the 55 strike level. But what if the market is trading near the strike price as expiration approaches? In that case, you're not sure whether you're going to be assigned on the contracts or not. You certainly don't want to try to liquidate the entire twenty-three thousand contract spread position in the final hours of trading, since you would, have to pay away a tremendous amount in the bid/offer spread to get out of a trade that size at that point. If you don't hedge the long 54 call position because of the assumption that the market will expire above 55 (an event that would cause the short 55 call to get exercised), but instead the market closes below 55, you can end up carrying a net huge long position over the weekend. If, on the other hand, you hedge your long 54 call position on the assumption that the market is going to close below 55, but instead it closes above 55 and the short 55 call is exercised, then you can end up net short the entire face amount over the weekend. It's the uncertainty about whether the market will close above or below 55 (or, equivalently, whether or not your short 55 call position will be exercised) that makes it impossible to effectively hedge the position.

One particularly interesting element of the trade was that one market maker was on the opposite side of about twenty thousand lots of the spread position. When you deal with positions of that size on an exchange, you generally know who is on the other side.

The expiration day arrives, and as the market is in its final hours of trading, guess what? The price is right near 55. The market-making firm doesn't know whether I have hedged my long 54 call or not, and I don't know whether they have hedged their short 54 call or plan to exercise their long 55 call to offset the position. Neither one of us will know the other's position until Sunday morning, which is when you get notified of any option exercises.

On Sunday evening we get to play the same poker game all over again in the Tokyo market. If they have exercised their long 55 call (making me short that position), they won't know if I'm short yen or not, depending on whether or not I've hedged. If they haven't exercised their call, they won't know if I'm net long yen or neutral, again depending on whether or not I'm hedged. For my part, I also won't know whether they are net long, short, or neutral, since I don't know whether or not they have hedged. Consequently, going into the early New Zealand and Australian market openings, either I'm going to be long nearly $800 million worth of yen and they are going to be short the same position, or they are going to be long that amount and I'm going to be short, or one of us is going to have a net long or short position while the other is hedged, or we could both be hedged. Neither one of us will be able to figure out the other's position with any certainty, and given our size at that time of the day in those trading centers, we're the only game in town.

On Friday afternoon (the expiration day), I heard that the firm on the other side of the trade was buying yen in the cash market. They had tipped their hand. I knew then that they had not already hedged their short 54 call position and had no intention of exercising their long 55 calls.

At 5 P.M., the yen closed within one tick of the 55 strike level. Because of the other firm's actions in the cash market, I thought they probably wouldn't exercise their long 55 calls, but I couldn't be certain.

On Saturday, the phone rang and it was the other firm's trader. "How are you doing?" I asked.

"Very good. How are you doing?" he asked in return. "I don't know, you tell me," I answered. Remember, you don't get your notices until Sunday, and this conversation was taking place on Saturday. "What did you do?" I asked.

He said, "What do you think I did? You'll never guess." "Well, I think you kind of tipped your hand on Friday afternoon," I answered.

"Yeah, that was the stupidest thing," he said. The purchase of yen in the interbank market hadn't been his decision; it was a committee decision at his company. He finally told me, "We're not going to exercise."

Did he just call to let you know that they weren't going to exercise and let you off the hook?

I would have had that information prior to the New Zealand opening anyway. He was probably trying to sniff out my position-that is, whether I had hedged or not. If he could figure out what I had done, there would be a potential play for him in the marketplace. As it turns out, I had not hedged, and I was net long the yen position. If he knew that, he could have gone into New Zealand, which is the first interbank market to open, and pushed the market against me. By telling him that they had tipped their hand by selling the yen on Friday afternoon, I let him believe that I had figured out their position-which I had-and hedged-which I had not. In any event, there was some news over the weekend, and the dollar opened up sharply lower against the yen. I actually ended up substantially increasing my profit on the trade.

How much did you end up making on that trade?

A totally ridiculous amount-something like $20 million. However, the thing that was so great about the trade was not the money but the mental chess game that Friday afternoon-all the back-and-forth bluffing. People were calling my desk all Friday afternoon to ask us what was going on between us and the other firm. There was nothing else going on in the market. These were the biggest positions in the market by a hundredfold that day.

Are there any other trades you can think of that were particularly memorable?

I can tell you about the one time since I first started trading that I was really scared. In fall 1988, there wasn't much going on in the currency markets. The D-mark had been in a very tight trading range. As was very typical in those types of low-volatility periods, our position size tended to grow as we tried to capture smaller and smaller price moves and still produce the same results. As a result, our position size at the time was larger than normal.

We knew that Gorbachev was going to make a speech at the UN, but we didn't know what he was going to say. At the time, I was short about $3 billion against the D-mark.

Three billion! Was that the largest position size you ever traded?

I've been bigger, but that was a very large position. The market had been trading in a narrow 1-2 percent range, and I had expected that sideways price action to continue. Then Gorbachev made a speech about troop reductions, which was interpreted by the market as meaning that the United States could also cut its armed force commitment- a development that would be beneficial for the budget deficit. All of this was considered very bullish for the dollar. The dollar started moving up in New York, and there was no liquidity. Very quickly, it was up 1 percent, and I knew that I was in trouble.

One percent of a $3 billion position is $30 million! Did this loss transpire in just one afternoon?

It transpired in just eight minutes. All I wanted to do was to make it through to the Tokyo opening at 7 P.M. for the liquidity. If you really have to buy $3 billion, you can do it in Tokyo; you can't do it in the afternoon market in New York-you can't even do it on a normal day, let alone on a day when major news is out. My strategy was to try to cap the dollar in New York. Normally, if you sell several hundred million dollars in the afternoon New York market, you can pretty much take the starch out of the market. I sold $300 million, and the market went right through it.

The people on my desk didn't really know the size of our position, with the exception of Robert, who was my number two man. I looked at Robert and said, "That didn't slow the market down too much, did it?" He grimaced and shook his head slowly from side to side. I realized that I couldn't cover these positions. I was really scared. I remember thinking: This is the bullet that finally catches me in the back of the head.

Tom Strauss, the president of the company, sat about fifteen feet away from me. (Gutfreund was not there that day.) I got up and walked over to Strauss and said, "Tommy, we have a problem." He looked at me and calmly said, "What is it?" I answered, "I'm short the dollar and I've misjudged my liquidity in the market, I've tried to hold the market down, but it's not going to work. And I can't buy them back."

He very calmly asked, "Where do we stand?"

"We're down somewhere between seventy and ninety million."

"What do we want to do about this?" he asked. I distinctly remember being struck by the fact that he used the word we, not you.

I said, "If I try to buy some back, I may get a little here and a little there, but it won't amount to very much, and we'll just end up pushing the market further against us. The first liquidity is Tokyo."

"What's the plan?" he asked.

I answered, "When Tokyo opens, I have to see where it's trading. My intention now is to cover half the position at that time, and go from there.

He said, "We've had a good run on this. Do what you need to do." That was the entire conversation. It was over in two minutes.

In discussing this episode several days later, Robert said, "I never saw you look like that." I asked him what he meant. He answered, "You were as white as a sheet." My perception of what was going on around me at the time was, of course, quite distorted because I was so focused on that situation. I was later told that, for the entire afternoon, there was virtually not a word spoken on the desk and that Robert didn't let anybody come near me. I was oblivious to all this at the time.

Continuing our conversation, Robert said, "I don't know how you went over to Strauss."

"Why?" I asked. "What would you have done? It was the only thing I could do; I had to inform Strauss about what was going on."

Robert responded, "Ninety million. You were down $90 million! Do you understand what that means?" I asked, "What would you have done?"

He answered, "I would have put my coat on and walked out of here. I would have figured that was it, it's over, I'm fired."

Now, I don't I know if that's what he really would have done, but it never occurred to me to walk out. The idea that I had possibly just lost my job never entered my mind. This was a firm that bore me and nurtured me; it was just inconceivable that that could happen. The first thing I thought about was the position. The second thing I thought about was making sure that management knew about it. In absolute consistency with the firm's approach, as exemplified by Tom Strauss's response, there wasn't going to be any negativity in our conversation. It was a measured discussion, but if there was going to be any analysis of what went wrong, it would be after the situation was resolved.

What eventually happened to the position?

By the time Tokyo opened, the dollar was moving down, so I held off covering half the position as I had previously planned to do. The dollar kept on collapsing, and I covered the position in Europe. I ended up with an $18 million loss for the day, which at the time seemed like a major victory.

Most people in your situation would have been so relieved to get out that they would have dumped the position on the Tokyo opening. Apparently, you deferred to your market judgment and avoided that emotional temptation.

The reason that I didn't get out on the Tokyo opening was that it was the wrong trading decision. Actually, I'm a much better trader from a bad position than from a good position.

What did you learn from the entire experience?

Mostly I learned a lot about the firm and myself. I have a lot of respect for Salomon's willingness to understand what happens in the markets. If you want to play the game, sometimes somebody is going to get assassinated, sometimes someone is going to make a speech at the UN, and you're going to be on the wrong side of the trade-it's just the way it is. Exogenous events are exogenous events. They really understood that.

You said that you also learned about yourself. What did you learn?

That was the first time it hit home that, in regards to trading, I was really very different from most people around me. Although I was frightened at the time, it wasn't a fear of losing my job or concern about what other people would think of me. It was a fear that I had pushed the envelope too far-to a risk level that was unacceptable. There was never any question in my mind about what steps needed to be taken or how I should go about it. The decision process was not something that was cloudy or murky in my vision. My fear was related to my judgment being so incorrect-not in terms of market direction (you can get that wrong all the time), but in terms of drastically misjudging the liquidity. I had let myself get into a situation in which I had no control. That had never happened to me before.

Any other traumatic trading experiences?

You never asked me about what happened to my own account.

All right, what happened? As I remember, you started out with about $12,000.

That's right, and the peak was about $250,000.

Really? You had built it up that much!

Well, this was over a period of about four to five years.

Still ...

Yes, I had a lot of success. Anyway, I ended up blowing out virtually the entire account in a few days.

What happened?

On September 23, 1982, the Dow went from down 30 points to closing up 20. This was the famous Granville reversal, which was the bottom of the bear market.

Does "Granville reversal" refer to the rally occurring just after Joe Granville (an extraordinarily popular market advisor at the time) had put out a sell recommendation?

Exactly. I was very bearish and heavily long puts. I kept pyramiding all the way down. I was really pressing. I lost most of the money that Monday, and by Wednesday the account was virtually all gone.

You took over four years to turn $12,000 into $250,000 and lost it all in a matter of days. Did you have a moment of self-questioning?

No, I just saw it as one major mistake. I've always had a lot of confidence as a trader. My feeling was that I had developed and practiced the basic trading skills that had landed me at Salomon Brothers and that I had a tremendous amount of fun in the process. I was devastated by the way I had traded, but the money never had a major effect on me.

Did you change anything because of this experience?

I decided that since I was going to work for Salomon Brothers, all my attention should go into doing that very well, not trading my own account. After that point, I never again traded my own account-not because I had lost money but because I didn't want to split my focus, as I saw some other people do over the years. I basically took my pay-check every two weeks and put it in a money market account-a government securities- only money market account because I wanted the extra protection.

How did the sudden demise of your personal account change you as a trader?

I probably became more risk-control oriented. I was never particularly risk averse.

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