Tuesday, May 13, 2008

Livermore and Niederhoffer

While on the topic of book reviews and risk, I recently read "The Education of a Speculator", Victor Niederhoffer's autobiography (up till 1996) and "Reminiscences of a Stock Operator", the story of Jesse Livermore (up till 1923). Both are, in my opinion, fascinating reading for those interested in the history of the financial markets and musings on how to trade and speculate. While trading is mostly about technicals - short-term supply and demand for securities - and investing is mostly about fundamentals in the long-term - speculation is about the combination of the two in the medium term. Both Niederhoffer and Livermore were very independent minded and both very successful for periods of time, punctuated by massive blowups. The problem is both cases was lack of risk control. Livermore traded individual stocks using 10% margin, which was allowed before the 1930s and tended to pyramid his positions up and up and then pile all the profits into another huge notional position. When eventually the markets turned against him he had his biggest position and especially as the markets were relatively illiquid at the best of times in the early 20th century selling quickly was hard and he suffered massive losses. Niederhoffer never used stops, used large positions and describes the familiar situation of praying that the market will vindicate you eventually as you lose more and more. He blew up one year after this book was published after a tremendously successful run. The problem: shorting large amounts of puts. As the article cited in the last sentence mentions, Berkshire Hathaway is also shorting puts. The difference, is that the amount is small relative to the net worth of Berkshire. Unless some catastrophe took Berkshire and the S&P down to less than 20% of their current value they won't be wiped out. The lesson is not to short more puts than you are happy to buy the stocks that you are obligating yourself to buy. Don't be too greedy.

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