Lessons from When Genius Failed: The Rise and Fall of Long-Term Capital Management

Lessons from When Genius Failed: The Rise and Fall of Long-Term Capital Management

As options traders we need to pause and learn the limitations of the Black-Scholes options pricing formula and other mathematical models, and learn to expect the unexpected.

I recently finished working my way through When Genius Failed: The Rise and Fall of Long-Term Capital Management.  The book chronicles the early adoption of mathematical models by Wall Street firms and hedge funds.

Long-Term Capital Management was such a firm that was started by a group of bond traders who had made millions in bond arbitrage at Salomon.  After a scandal in 1991, John Meriwether left the firm and started Long-Term Capital Management.

Meriwether recruited the traders with whom he had worked at Salomon, and also managed to attract both Myron Scholes and Robert Merton, who were responsible for developing the Black-Scholes options pricing formula and recipients of a Nobel Prize in Economics.

The central theme upon which LTCM trades were based was the notion that pricing outcomes are normally distributed.  This was the essentially the same premise upon which the Black-Scholes formula relied.

Relying upon this premise, LTCM traders looked for pricing inefficiencies and entered spread trades that relied upon a convergence of price.  For example, if interest rate spreads were wider than normal LTCM would buy one bond and get short another.  In doing so, they did not care whether the yield rose or fell just so long as the spread between the two converged.

Because the money to be made on typical spreads was limited, the fund also relied on massive leverage to generate profits.  The leverage worked to their advantage, permitting them to take positions many times larger than the fund's actual equity.  So long as the markets behaved as the models predicted, LTCM was assured of profitability.

Indeed, the profitably of the fund was spectacular in its first few years, but the 1997 Asian financial crisis and the 1998 Russian crisis saw spreads widen many times more than the LTCM mathematical models suggested were possible.  Confronted with a mathematical impossibility, the fund had no contingency plan to deal with it. As spreads continued to widen the fund began hemorrhaging capital and ultimately in 1998 was bailed out by a consortium of Wall Street banks.

The two lessons an options trader might take away from this book is 1.) a realization that markets are not normally distributed and are subject to seemingly irrational behavior, and 2.) that mathematical option pricing models have inherent limitations as a result.  These models provide tremendous insight and value, but they do have "blind spots" and it is important for a trader to know where those blind spots lie.

Markets have what we might call "fat tails."  This means that a traditional bell curve is not applicable to markets because the number of multi-sigma events occurring in the market exceeds the number that is mathematically expected.  As such, as traders we must learn to literally expect the unexpected.

If you find the notion of two, three, or four standard deviation moves concerning you are more than welcome to join me and other members in our Trading Room.  Preparing for unexpected market moves and protecting capital are a recurring subject on which we present and engage in discussion upon.  Risk will always be present in the market, but there are techniques that can reduce those risks appreciably.

Christopher Smith
TheOptionClub, LLC

Lowenstein, Roger, When Genius Failed: The Rise and Fall of Long-Term Capital Management

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