Turtle Trading Rules

Chapter 3 The Trader Who Plays the Risk Game (1)
High Risk, High Reward: It takes guts to play this game.

——Before the Turtle Project, I said this to a friend. People often ask such a question: What makes a person a trader instead of an investor?The distinction between the two is often blurred because many people who call themselves investors are actually traders.

Investors buy for the long term, believing that their investment will appreciate in value over a considerable period of time (many years).They will buy physical goods, that is, real things.Warren Buffett is an investor.He bought businesses, not stocks.He was buying what the stock represented: the business itself, including its management team, products and market position.The stock market may not reflect the "correct" value of his business, but he doesn't care.In fact, he made his money off of that.He would buy businesses when the stock market was grossly undervalued and sell businesses when the stock market was grossly overvalued.He made a fortune this way because he was good at it.

Traders don't buy physical things like businesses, nor do they buy grain, gold or silver.They buy stocks, futures contracts and options.They don't care too much about the quality of the management team, oil consumption trends in the frigid Northeast, or global coffee production.Traders are only concerned with price, and essentially they are buying and selling risk.

In his fascinating book Against the Gods: The Remarkable Story of Risk, Peter Bernstein said that markets allow risk to be transferred from one player to another participant.That's actually why people created financial markets, and it's a constant function of financial markets.

In today's modern marketplace, businesses can purchase forward foreign exchange or futures contracts in order to insulate themselves from the risk of exchange rate fluctuations.Companies can also use the contracts to protect against rising prices for raw materials such as oil, copper and aluminum.

Buying and selling futures contracts to offset the operating risks brought about by changes in raw material prices or foreign exchange fluctuations is called hedging.If a company is very sensitive to the price of raw materials such as oil, then proper hedging operations may play a very critical role.For example, the aviation industry is very sensitive to the cost of flight fuel, which is closely tied to the price of oil.When the price of oil rises, airline profits fall unless they raise fares.If fares stay the same, profits fall because higher oil prices drive up costs.

The answer is to hedge in the oil market.Southwest Airlines has been good at this for years, so when the price of oil went from $25 a barrel all the way to $60 a barrel, the company's costs didn't increase much.In fact, its hedging strategy has been so successful that even after years of rising oil prices, it still buys 85% of its oil at $26 a barrel.

It's no accident that Southwest Airlines has been one of the most profitable airlines over the past few years.Southwest executives are well aware that their job is to move passengers from place to place, not to worry about gas prices all day long.Therefore, they use the financial market to avoid the risk of oil price fluctuations.They are very smart.

Companies like Southwest Airlines use futures contracts to guard against business risks, so who sells futures contracts to such companies?Be a trader.

Liquidity Risk and Price Risk
Traders play risk.There are many types of risk, and each risk corresponds to a type of trader.In this book, we group all small risks into two categories: liquidity risk and price risk.

Many (perhaps most) traders are short-term traders, and they operate what is known as liquidity risk.Liquidity risk is the risk of not being able to buy or sell: when you want to buy, no one sells; or when you want to sell, no one buys.When it comes to the concept of financial liquid assets, most people are familiar with the term liquidity.Liquid assets are assets that can be quickly and easily converted into cash.Cash stored in a bank is highly liquid, actively traded company stocks are relatively liquid, and a piece of land is illiquid.

Suppose you want to buy XYZ stock and it was last traded at $28.50 per share.If you look at the quotes of XYZ, you will see two prices: the bid price (bid) and the ask price (ask).Let's say the buy price is $28.50 per share and the sell price is $28.55 per share.This means that if you want to buy a share of XYZ, you have to pay $28.55, but if you want to sell a share, you only get $28.50.The difference between these two prices is called the spread.Traders who deal with this type of liquidity risk are often called scalpers or market makers.Their profit comes from the bid-ask spread.

There is a variant of this type of trading called arbitrage.An arbitrage trade involves the liquidity of two different markets.An arbitrage trader might buy crude oil in London and sell crude oil in New York; or buy a portfolio of stocks and simultaneously sell stock index futures representing a similar portfolio of stocks.

Price risk refers to the risk that prices will rise or fall sharply.A farmer might worry about rising oil prices, which raise the cost of fertilizer and tractor fuel.Farmers also worry that the prices of their products (wheat, cotton, soybeans, etc.) have fallen so low that they are making no money.Airline executives worry about rising fuel costs as well as higher interest rates, which make it more expensive to finance planes.

Hedgers hedge against price risk by transferring risk to traders.Traders who engage in this price risk are called speculators or position traders.Speculators make money on changes in price: buy and sell when prices rise, or sell and buy back to cover when prices fall—a transaction known as short selling.

Hedgers, speculators and hatters
Markets are made up of groups of traders who buy and sell from each other.Some traders are short-term hatters who just want to profit from the difference between the bid and ask price over and over again; others are speculators who try to make money on price changes; purpose enterprise.There are good and bad traders in every category, ranging from seasoned veterans to first-timers.To understand how different types of traders work differently, let's look at an example.

Acme (ACME) wanted to hedge the risk of rising costs for its British laboratory, so it bought 10 British pound futures contracts on the Chicago Mercantile Exchange (CME). ACME is at risk because sterling has been appreciating, and the costs of UK labs are paid for in sterling.If the pound appreciates against the dollar, the laboratory's dollar cost will rise.Buying 10 sterling contracts eliminates this risk and insulates the company from exchange rate fluctuations.Because if the pound appreciates against the dollar, the profit from the futures contract will offset the loss from rising costs. ACME bought the contracts at $1.8452 a pound from Sam, a Chicago floor trader, what we call a hatter.

The actual transaction is executed by MAN Financial Company, a broker of ACME Company. MAN had its own employees on the floor: telephone operators who answered the calls in the rows of seats surrounding the floor, and traders on the pound floor who executed trades for MAN.The runner sent the trade order from the telephone desk to a trader on the floor, and the trader then traded with Sam.If the trading volume is too large, or the market changes too quickly, MAN's floor traders may use hand signals to receive buy and sell signals directly from MAN's telephone desk.

The details of a futures contract are specified by the exchange, all written in a document called a contract specification.These documents specify the quantity and type of goods represented by a contract, and sometimes the quality of a particular commodity.In the past, the quantity of goods for a contract was determined by the load of a wagon: 5000 bushels[4] of grain, 112000 pounds[5] of sugar, 1000 barrels of oil, etc.For this reason, contracts are sometimes called wagons.

Transactions are in contracts: your transaction volume cannot be smaller than one contract.The exchange's contract specifications also stipulate the minimum price change range, which is called a tick or minimum tick in the industry.

(End of this chapter)