All Commentary
Saturday, June 1, 1996

A Speculator Talks About Free Markets

Markets Evolve Spontaneously, Beyond the Control of Any Individual or Institution

Victor Niederhoffer is president of Niederhoffer & Niederhoffer, Inc., a commodities trading advisor. Managed Accounts Reports ranked his global hedge fund number one out of 144 funds in its class during the three years ending June 1995. This article is adapted from his forthcoming book, The Education of a Speculator (Wiley).

French Finance Minister Michel Sapin recalled that during the French Revolution, speculators were beheaded. He spoke approvingly, since he blamed his government’s recent financial troubles on speculators.

He was talking about me, among others, although like most politicians he didn’t seem to know what speculators actually do. Specializing in stocks, bonds, and currencies, I help balance supply and demand by selling when prices are too high and buying when prices are too low. I help users and suppliers of goods discover the right price, given all the relevant factors present, past, and future that are likely to affect it. The price provides a key signal telling market participants how urgently a product is desired, how scarce it is, which resources should be dedicated to its production.

I don’t offer these vital services out of benevolence. I speculate because markets enable me to enjoy the dignity of productive achievement within a venue of respectability, compared with a casino or racetrack.

Many people used to think free markets led to monopolies which could only be curbed with antitrust laws, but the truth is that free markets humble the mightiest among us. History is littered with great names who tried and failed to dominate markets.

Look what happened to Metallgesellschaft (MG), a pillar of corporate Germany. It was a conglomerate which had over 250 metallurgical, mining, trading, and engineering firms. It employed around 65,000 workers. It was the 14th largest firm in Germany, among the 30 prestigious blue-chip stocks on the DAX, Germany’s equivalent of the Dow Jones Industrials.

In 1991, MG’s New York oil-trading operation implemented a strategy developed by theoreticians at the financially astute House of Rothschild. The strategy, which was supposed to make $10 million a month, involved covering long-term commitments for delivering oil with supposedly cheaper short-term futures contracts. The contracts represented about 150 million barrels of crude oil—$2.8 billion worth—purchased primarily on the New York Mercantile Exchange. Nobody seemed particularly worried about the risk that the price MG would pay for short-term futures contracts might rise above the price MG would receive from making long-term deliveries.

Well, MG didn’t trade in a vacuum. Other market participants adapted their trading to MG’s practice of routinely rolling over all those short-term futures contracts, and short-term prices rose above the price of the company’s long-term commitments. It lost money on every delivery. Instead of making $10 million a month as predicted by the theoretical model, MG wound up losing a reported $50 million a month. In 1993, these losses hit $1.3 billion, and 120 banks had to work out a $1.95 billion rescue package. Top executives were fired. The company started selling businesses as fast as it could to raise cash, and thousands of people around the world lost their jobs.

Big Central Banks, Bigger Free Markets

Central banks are the biggest players in world financial markets, and they certainly have an impact while they’re trading, but they can’t trade all the time. As soon as they finish a transaction, underlying market trends tend to continue.

Again and again, central banks lose tremendous sums trying to buck free markets. Look what happened at Bank Negara, the Central Bank of Malaysia. They had a huge trading facility with direct phone lines to at least 30 major currency dealers around the world. Reportedly Negara traders, acting with military precision, called dealers simultaneously and hit each with perhaps a $20 million trade. Negara injected something like $1 billion into the market by the time they were through. News of what they were doing went out over the financial news wires.

Big though Negara was, free markets were bigger. The bank lost $4 billion in 1992, mainly by betting that the British pound would rise. They lost another $5 billion in 1993, first by betting that the Japanese yen would go down (it went up), and then by betting it would go up (it went down).

Markets are efficient. They respond to news incredibly fast. For example, on Wednesday, January 9, 1991, I had a long position in Treasury bond and Standard & Poors 500 futures contracts, a short position in crude oil futures. Each position was up 50 percent on my margin. Secretary of State James Baker had scheduled a meeting with Iraqi foreign minister Tariq Aziz. The meeting had already lasted eight hours. I figured they must be finalizing an agreement. After all, considerable progress had already been made on the terms of Iraq’s withdrawal from Kuwait. Surely neither party would want a showdown.

At 2:30 P.M., Secretary of State Baker called a press conference. “Regrettably,” he began—and that one word set off a stampede of reporters for the telephones. No settlement had been reached. Within two minutes, stocks plummeted 80 points, bonds were down 1 points, and oil was up $3.00 a barrel. That one word from Baker was good for a $3 million swing in my equity.

Ahead of the News

Frequently, markets signal something important is happening well before reporters get the story. For instance, on Thursday, February 10, 1983, I established a short position in gold because it tended to decline about $3.00 per ounce between Fridays and Mondays.

Suddenly, around 1:00 P.M. on Friday, gold jumped $5.00 per ounce. No one could explain what was going on. Then a day and a half later, around 4:00 A.M. Sunday, came news that U.S. Navy fighters had shot down a Libyan jet over the Mediterranean. This caused tremendous tension, always good for higher gold prices.

Apparently, the Pentagon had put out the word that an incident should be provoked to show the Mideast powers who was boss. Knowing that U.S. planes had been flying near Libya for several weeks, Mediterranean traders bought gold, and this led to higher prices, alerting people around the world. The U.S. gold market, in its wisdom, had anticipated the move.

Or take this example from Japan: on October 11, 1993, Columbus Day, financial markets were quiet. Most banks were closed. I was long on the dollar. About noon, the dollar rose from 110.25 yen to 100.45 yen. I sold the dollar at 100.45, and 15 minutes later it fell to 100.15 yen. I bought it back for a 20-pip profit.

What happened? At 11:55 P.M., news came over the wires that an earthquake registering 7.2 on the Richter scale had hit Tokyo. The potential damage to the Japanese economy was enormous, causing a run-up in the dollar. But it turned out that the earthquake had actually struck offshore, with no significant damage to Japan. The dollar went right back down. Then there was reassuring news that the earthquake wouldn’t be followed by tsunami (tidal wave). This time I was golden.

Market action reflects not just facts affecting supply and demand but sheer dumb luck, which is part of life, too. For instance, one summer day in 1992, I had a short bond position that I intended to buy back at the close. But there was a freak accident. Workmen sinking pilings on the floor of the Chicago River caused a crack in the containing wall where the river flowed through the Loop. Billions of gallons of water flooded the surrounding financial district. Probably for the first time in history, the Chicago Board of Trade was closed at 11:00 A.M. rather than at 2:00 P.M. By the time I could get out, the bonds rallied 1 points, and I had a loss.

The Fascination of Markets

On another occasion, I established a long copper position at 76 cents a pound. In those days, the Chicago Mercantile Exchange closed copper futures trading at 1:55 P.M. I thought I had a winner at 1:50 P.M., as the price stood at 76.60. But then an exchange clerk entered the wrong price into their system, 7066, rather than 7660. This erroneous price set off sell stops at 71 cents and below from all the trend followers, whose computers were activated by on-line price feeds. Copper closed at 68 cents. In just two minutes, I lost 200 percent on my margin, all because of a clerical error.

I have been fascinated with markets for more than 30 years. They are global phenomena which evolve spontaneously, beyond the control of any individual or institution. They reflect the choices of all participants, and not even government central bankers have an inside track on which way prices will go for very long. There’s always conflicting information about market trends. And markets are so competitive that they require all the discipline, persistence, and stamina you’ve got.