Benny's Global Macro Trader Blog: February 2011

Thursday, February 24, 2011

Comparing Chinese provinces with countries in the world

This is a very interesting graph from The Economist:

Which countries match the GDP, population and exports of Chinese provinces?

China is now the world’s second-biggest economy, but some of its provinces by themselves would rank fairly high in the global league. Our map shows the nearest equivalent country. For example, Guangdong's GDP (at market exchange rates) is almost as big as Indonesia's; the output of both Jiangsu and Shandong exceeds Switzerland’s. Some provinces may exaggerate their output: the sum of their reported GDPs is 10% higher than the national total. But over time the latter has consistently been revised up, suggesting that any overstatement is modest.

What about other economic yardsticks? Guangdong exports as much as South Korea, Jiangsu as much as Taiwan. Shanghai’s GDP per person is as high as Saudi Arabia’s (at purchasing-power parity), though still well below that in China’s special administrative regions, Hong Kong and Macau. At the other extreme, the poorest province, Guizhou, has an income per head close to that of India. Note that these figures use the same PPP conversion rate for the whole of China, but prices are likely to be lower in poorer provinces than in richer ones, slightly reducing regional inequality.

Tuesday, February 22, 2011

How to: Trade the Crack Spreads

I first heard of trading crack spread when I read a report a few years ago that published a list of the world’s top 30 traders under 30 years old. Many traders were in the field of equities, interest rates or derivatives but one of them caught my attention. His name was Glenn Graham, at age 23, he made his name from trading something called the crack spread and I immediately wanted to learn what it was. Just to mention, at the age of 22, Glenn was already responsible and ran the firm’s entire energy trading operation at Casa Energy.

So, let’s begins with a definition, what is a crack spread? Crack spread is a term used in the oil industry for the differential between the price of crude oil and the petroleum products extracted from it. As many of you are aware, even though oil comes in different density and mix, the term crack spread is used in the world of oil futures trading to describe the potential profit margin that an oil refinery can make by cracking the crude into shorter hydrocarbon chain petroleum products, such as gasoline, kerosene, diesel, jet fuel, etc.

Now, trading the crack spread in the future markets is done with the West Texas Intermediate (WTI) crude on the NYMEX or the Brent Blend crude traded on the London ICE exchanges. Crude oil is graded by their density and these two oil types have an API gravity of around 38-39 degrees, which classify them as intermediate grade, with 0 degrees being the heaviest and 100 degrees the lightest. FYI, the lightest the oil is, the better the quality it is since it's less dense and therefore ready to yield higher value products such as gasoline. Now, for integrated oil companies that controls the entire supply chain from production to distribution of products after refining (ex: XOM, CVX), there is a natural economic hedge in prices with the inputs and outputs. However, for independent oil refiners (ex: VLO, TSO, HOC), they have to consistently hedge their positions with the futures market to protect against price movement of their refined products. That’s why, if you noticed, stock like Valero and Tesoro does not follow oil prices like ExxonMobil does. Don't let this ever fool you to think that a stock is undervalued because all the other oil companies went up and your Valero, the parent company of Ultramar is not moving. Here, I plotted a chart for VLO vs the USO ETF during the oil bubble in 2008, look at the graph and you'll understand what I mean.

So, how does an individual trader go about buying and selling the crack spread? The general crack spread ratios in the market are 3:2:1, 5:3:2 and 2:1:1, with the Gulf Coast 3:2:1 being the most popular, meaning 3 barrels of crude oil = 2 barrels of unleaded gasoline + 1 barrel of distillate fuel oil. On the NYMEX, crack spread futures that are the most traded is the ones with the 3:2:1 ratio. Now let me explain crack spread trading with the simplest terms.

Selling the crack spread: Locking in margin @ 4$

X (crude oil): 6$ Y (gasoline): 5$ Z (fuel oil): 5$

So in the case, if you expect the finished products price to go down relative to the crude oil price going up, you sell the spread to sell the refined products and lock in the profit margin. The other way around, you would buy the crack spread and this is where an investor would enter into a future position to sell short the 3 crude oil futures at a high price while holding a position in the refined gas contracts, than reverse the position with the intension of a positive spread. Obviously, this is the most basic method to explain trading this spread, but to profit from it in reality; it gets much more complicated since there are so many factors that can influence the movement of this spread.

To sum up, here is a graph of the NYMEX crack spread vs. refining margins.

Monday, February 21, 2011

An Interview with Larry Levin

Here is an recent interview with Larry Levin and TraderDaily, there are some good tips and insights in the interview, for those of you don't know him yet, he basically started from nothing, went bust four times and now is a legendary S&P 500 trader averaging 2500 to 3000 contracts on the CME per day.

TraderDaily: In your career, you have successfully climbed the ranks from the bottom to the top of the ladder. Do you think this type of advancement is possible in today’s market, particularly without formal education? What advice would you give to the guys at the bottom trying to follow your lead?
Levin: No, the trading floor was a place where you could start at the bottom and work your way up, or even find an opportunity with a different trading company in the same place (the trading floor). Back then, it was pretty easy to get an entry-level job on the trading floor, and if you were sharp, you had a chance to get noticed. Now, you must try to get in with each individual company, and that’s much more difficult. And without a finance degree, most won’t even talk to you.

TraderDaily: In the mid-1980s, Richard Dennis began his Turtles experiment, where he gave relatively inexperienced personnel a clearly defined trading system and some capital, with impressive results. In today’s markets, are traders born or can they be made?
Levin: Traders are made, not born. Every trader has to go through the same learning process. They all must learn from their mistakes, just like you’d learn any skill. The problem is most people don’t have a Richard Dennis to show them how to avoid the mistakes quickly. Therefore, people will run out of money long before they figure out how to trade.

TraderDaily: You first started marketing your training program, “The Secrets of Floor Traders,” in 1998. How much has commodity trading — and its secrets — moved off the floor in the years since then?
Levin: The edge used to be gained on the trading floor by seeing institutional orders and learning from other experienced traders. Today, the edge is to understand technical analysis and how to trade electronically. There is no edge on the floor anymore.

TraderDaily: Some trading firms like to start with people who have not traded before and, therefore, carry no bias or pre-conceived ideas to the table. Does this kind of approach work today, or are trading firms hiring people with as much experience as possible?
Levin: If the trading strategies are extremely defined, then hiring inexperienced people can work. But when you ask a trader to think and trade in a discretionary method, then experienced traders are necessary.

TraderDaily: In addition to the S&P 500 index trading that’s been going on for years, many institutional players use index ETFs to take long and short positions. Does heavy trading of ETFs distort the markets they are supposed to track?
Levin: I don’t really think so. Even if they do, it doesn’t really matter, as the market will move the way all traders make it move. Unless large positions are not allowed in the ETFs, it’s just something else that traders have to deal with. I don’t think about it much.

TraderDaily: A majority of your trading career took place prior to the widespread electronic trading that moves markets today. What’s your take on this evolution? Has it affected you personally?
Levin: I don’t fight it. I took on electronic trading as close to its onset as possible. It made me a lot of money! Unfortunately, many traders haven’t made the evolution to electronic trading, and they are struggling.

TraderDaily: Do you think that automated and low-latency trading played a role in the May 6 flash crash, or is that just an attempt to find a convenient explanation for something that is difficult to explain?
Levin: I do think HFT trading is a big part of it. But this is the world we live in, and you must have stop losses in place on all positions at all times. Naked positions are the kiss of death. In all honesty, I don’t know exactly what caused the Flash Crash, but it wouldn’t surprise me one bit to see one happen again.

TraderDaily: A lot of prop traders blow out — you did it four times and managed to get back in the business. Was there a common thread behind your four wipe-outs? What did you learn from them?
Levin: The common theme was that I figured out how to get more money each time I blew out. I’m a big fan of learning from your mistakes and evolving into a better trader. The reason most people blow out is that they trade with real money before they know what they are doing. The key is trading with a simulator until you have the proper skills.

TraderDaily: How did you avoid giving away your edge when you came out with “The Secrets of Floor Traders”?
Levin: The edge is different with each person. Each trader needs to find what works personally for them (and it can be different for each person). So you can’t really give it away, you can only help someone find his or her own “personal edge.”

TraderDaily: How helpful are E-mini S&P 500 contracts for traders who are not starting out with a substantial amount of capital?
Levin: They are extremely helpful as they were devised for the small trader in mind. They allow you to trade a contract that is 1/5 the size of the big S&P 500. It was the smartest move the CME group ever made.

TraderDaily: What is the biggest single mistake you see new traders make?
Levin: Not using stop loss orders. It’s how to end your trading career very fast!

Tuesday, February 15, 2011

The Jersey Shore...

Don't let the title fool you, Im not talking about MTV's Jersey Shore...

Today, I decided to write about New Jersey's financial situation and the municipal bond market in the United States. Why? First, I was talking to one of my friends about pension liabilities today and second, because that even though this is such a huge market (2.86$ trillion), we don't hear much of it on the news since most retail investors aren't participants in this niche. So, let me give you an update of the muni bond market today and lets begin with New Jersey as it received its new rating downgrade from S&P a few days ago.

Lets start with some actual facts. Most issuers in the United States muni bond market, meaning the states and local government, are facing possible rating reduction by agencies because of their pension problem. Recent study show that states and government are now showing a 3.6$ trillion gap between their assets and penion liabilities. Last week, even the US Congress began to review whether federal law should allow states to enter into bankruptcy court protection, where as local government can already do under chapter 9.

New Jersey was downgraded to AA- by S&P last week and it's getting a step closer to the bankrupt state of California and Illinois, which are the only two states in the country with a lower credit rating. Standing along side with the other states that are facing billions of budget deficits in the next year ( Arizona, Kentucky, Louisiana, Michigan, etc), we just hope that New Jersey can better managed their budget situation in the year to come. Governor Chris Christie said last month that they won't need a door to the bankruptcy court, well I hope so for them, you know, Jersey is still the second wealthiest US state by income per person. However, this rating cut will definitly hurt them as managers are getting more uncomfortable and reducing net exposure to these states due to their increasing financial risk.

Now, the Terminator, Mr Schwarzenegger, who had the plan to sell 11 state owned building to receive cash flow and then leaseback these properties in order to reduce the budget deficit in California ( which is completly retarded if you ask me! ), Jerry Brown announced a different plan to cancel the sales and to borrow 830$ million from the special fund reserve instead. This is estimated to cost them 18$ million in interest and it should be repaid for 2014. So, the end of the line is, one juice head decide to sell state building like a court house at a low price and than lease them from investors at a high cost to cut its deficit in the short run to make himself look good as a governor, the new guy decides to borrow more money to fund the debt they already own so the next dude can deal with the problem...Seriously, maybe Meg Whitman has a better idea....

Keep following the page, I am busy the next two days but I will have an article up by friday talking about the famous crack spread that oil traders trade...

Thursday, February 10, 2011

What is a B.I.S.T.R.O?

Instead of jumping right into the advanced structured credit stuff, I decided to write up a little post to both paint a picture and to give an explanation of the early days of the world of credit derivatives. I am sure that most of you that are reading this blog are somewhat familiar with credit derivatives, if you are familiar with the world of structured credit, read on! (Cuz if not, you will find this article sounding like chinese...)

Did you know that, in the early 90s, the initial CDOs were all actually imitations of the MBS structure? They were basically all just a bunch of CLOs. Banks took their loans to corporate clients and sold them to a SPV, the SPV then issued debt in the capital markets, then the money raised was used to pay for the loans.

A few years gone by, something changed in 1997 with the invention of the famous BISTRO, short for (Broad Index Secured Trust Offering). It was a deal that was lead by a team under the famous M.Cassano at JP Morgan that allowed the bank to sell about 9.722$ USD Billion of credit risk with only 700$ USD million set aside to protect against the risk of default. These guys were the pioneers of financial engineering. In 1997, the regulators were more than confused with the risk involved. Cassano and his team pooled more than 300 loans at JP Morgan to create this first BISTRO and issued securities based on the income streams from these loans.

This gets a bit confusing, but this is how it works: The BISTRO first sold trenched bonds with attractive yields to investors, the proceeds from the sales was kept in a cash reserve which was used to collateralise the BISTRO, the bankers then wrote credit default swaps against the bond and the other assets on JP Morgan’s own balance sheet. These Synthetic CDOs worked because the banks saved on capital with the use of CDS rather than asset ownership! They also sweetened the returns to the investors and dealers for helping them do the capital shuffle. So, if part of the loans started to default, imagine what would happen… Talk about credit crisis 2008... VaR of 99% confidence level? Its always the last 1% that count...

Wednesday, February 09, 2011

20th Century President Quiz:

Here, lets switch to something fun and go to politics for a little before posting my next article on structured credit ... Lets see how many of these you guys can answer! I personally got 7 of the 10, I guess it must be harder for us finance guys then those of you in political economic and political science...Here is the quiz, no cheating!

1.Teddy Roosevelt suffered from what ailment as a child?

a. polio

b. making long-term foreign alliances

c. asthma

d. attention deficit disorder

2.What was Woodrow Wilson's major slogan in his campaign for re-election in 1916?

a. "Wilson for Victory"

b. "He kept us out of the war"

c. "Fourteen Points of Light"

d. "If we cut and run now, Belgium will become a haven for terrorists!"

3.FDR's political prestige took a large blow in 1937, when he attempted, unsuccessfully, to pass a law that would allow him to do what?

a. serve a fifth term

b. add five extra judges to the Supreme Court

c. create a fifth branch of the Armed Forces to enforce the New Deal at home

d. repeal the right of Habeus Corpus and legalize torture

4.As a young man, Harry S. Truman managed to enlist in the Armed Forces despite what handicap (and how did he do it)?

a. bad eyesight (by secretly memorizing the eye chart)

b. a club foot (by wearing a fake foot over his real one)

c. a weak heart (by drinking a pot of coffee before his physical)

d. asthma (his doctor removed it from his record for him)

5.What was the "Eisenhower Doctrine" of president Dwight D. Eisenhower?

a. to stop communism from spreading through Greece and Turkey

b. to stop communism from spreading through the Middle East

c. to stop communism from spreading through Southeast Asia

d. to stop communism from spreading through Joseph McCarthy's overactive imagination

6.Which of the following did NOT happen during John F. Kennedy's presidency?

a. the failed Bay of Pigs invasion

b. the Cuban Missile crisis

c. the building of the Berlin Wall

d. the landing of the first man on the moon

7.What was the "Nixon Doctrine," put forward by President Nixon in Guam in 1969?

a. that China was to become a trading partner of the United States

b. that all a President's actions are ipso facto legal

c. that the U.S. would stand down as the Vietnamese stood up

d. that he would not return his illegally donated dog, "Checkers"

8.Why did President Gerald R. Ford change his birth name, Leslie Lynch King?

a. because Leslie was also a woman's name and earned him constant disrespect

b. because "Lynch" had too many negative associations for a political career

c. because his father, who was his namesake, was abusive

d. because his mother changed it after remarrying a man of that name

9.One of Jimmy Carter's most important achievements as president, the Camp David Accords, accomplished what?

a. established a lasting peace between Israel and Egypt

b. increased trade with the Soviet Union

c. greatly reduced American energy consumption

d. achieved the release of hostages from Iran

10.What was the change to the national debt under President Ronald Reagan?

a. it was nearly paid off

b. it was cut in half (as a share of GDP)

c. it remained about the same (adjusted for inflation)

d. it approximately doubled (as a share of GDP)

Answer: 1.c 2.b 3.b 4.a 5.b 6.d 7.c 8.d 9.a 10.d

Accounting, Derivatives and Financial Engineering

I had a chat with my collegue the other day and we discussed about how useless auditors are. In my view, they just look over financial statements and get paid, period. When in the last 20 years can you name an accounting firm that actually prevented a financial fraud anyways? So I decided to discuss here some strategies that can easily manipulate the balance sheets with the use of derivatives. Maybe I should work for the regulators instead...

Example 1: Say you are a bank and the 1000$ you lent out is now worth 600$, meaning you have lost 400$. To disguise the loss on your books, you first enter into a trade with the market dealer. He pays you 1000$ for the loan but you have to simultaneously enter into a interest rate swap with the dealer on 2000$ where you pay 5.34% pa for 10 years. The rate is 2.34% more than the market rate of 3%. (2000$*2.34%=46.80$), the extra payment over 10 years equal the 400$ loss plus interest plus the dealer’s profit. So there you go, one way to hide a loss on your books!

And to give a real example of how even government use swaps to hide their transactions, let me tell you a story of what happened in Italy in the year 1996-97. Between 1996-97,

Italy

had cut its budget deficit from 6.7% to 2.7% to meet the EU target. It issued a 200 Billion Yen bond and by 1996, the yen depreciated, giving Italy a large currency profit on its borrowing. Then, Italy enter into a currency swap to lock in its profit in the OTC markets. Under the swap, Italy paid a rate of dollar LIBOR minus 16.77%, given the LIBOR was at 5%, Italy was than paying a massive negative interest rate so it was actually receiving huge payments from the swap. The swap was really a loan where Italy had accepted a bad exchange rate and received cash in return. Then, they use the payment to pay down that budget deficit...Who figured huh?

Example 2: The magic of an option trade! LEPO, short for low exercise price option were options that were around 4 years in maturity with a strike price of 0.01$ that cannot be exercised until expiry. To see how they work, I'll bring in a real life example again. Lend Lease Corp, wanted to sell its 9% holding in Westpac when the stock were trading at 5.40$. So this is how a transaction goes:

With the strike of 0.01$ on the option, the buyer of the option would paid a 3.65$ premium on a stock that is trading a 5.40$. The discount of 1.75$ to the Westpac share price reflected the value of dividend forgone by these option buyers. Now, you might ask, why do that? Because the dividend were tax free due to tax credit, investors on the higher tax bracket who would prefer capital gain took up on the option. So what does this do? Simple, the tax authorities would lose out on the taxes!

Well there you go, one example of avoiding losses on the books and another of avoiding taxes with derivatives... Hey, is EY, PWC, KPMG or Deloitte hiring these days?

Tuesday, February 08, 2011

Aging population, a time bomb for Japan and the United States?

As I spoke about Japan in the Q1 market report, just like the United States of America, Japan is a country with a massive debt load, currently standing at 11$ Trillion. These two countries are the world economic powers and the reason why they have such borrowing power is that one, for the United States, the USD is the world reserve currency and for the latter, Japan is mostly funded internally at a very low rate, where the rates on the 10 year JPY bond remained between 0.5% to 2% over the past decade, much lower than any other country in the developped world. This cheap internal financing makes them much less sensitive to an increase in interest rates resulting from the country’s default risk.

As the Japanese population age, the government may have to rely increasinly on foreign investors (just like the US) to service their financial debt burden. Japan’s debt to GDP ratio is at 225% while Greece’s ratio was 130% for 2010 and was at the blink of default. But even if Japan's debt to GDP is way higher than the Greek's, currently, in Japan, only 5% of the government bonds are held outside the country while comparatively speaking, about 70% of Greek government bonds were held by foreign investors. Now you can see how much internal borrowing can affect the debt load of a country.

As an estimate by the US census Bureau, by 2025, over a third of the Japanese population will be 60 years or older up from 30% today. This is not a short term problem, but as they need to increasingly rely on external financing at a higher rate when the population ages, we can see how this can become a big concern for

Japan

in the upcoming decade.

In the US, approximately 18% of the population is over 60 years old. The United States

’ government is having the same problem with financing their social security programs as the ratio of young versus old decreases. Today, increasing payouts for senior retirees will be funded by fewer young workers as time goes on. Social security will eventually collapse, talk about a Ponzi Scheme! I’ll get into the details of the Social Security mess next time…

Thursday, February 03, 2011

38 steps to becoming a trader

This post is for all you traders out there, in the field of trading, we are know how we beat ourselves up over and over again... After trading actively for abit over 6 years now, I look at this list and realized how true this learning process is and how funny it is when I get people telling me what stock to buy and how easy is to make money LOL... So, which step are you on?

THEY ARE AS FOLLOW:

1. We accumulate information - buying books, going to seminars and researching.
2. We begin to trade with our 'new' knowledge.
3. We consistently 'donate' and then realise we may need more knowledge or information.
4. We accumulate more information.
5. We switch the commodities we are currently following.
6. We go back into the market and trade with our 'updated' knowledge.
7. We get 'beat up' again and begin to lose some of our confidence. Fear starts setting in.
8. We start to listen to 'outside news' and to other traders.
9. We go back into the market and continue to 'donate'.
10. We switch commodities again.
11. We search for more information.
12. We go back into the market and start to see a little progress.
13. We get 'over-confident' and the market humbles us.
14. We start to understand that trading successfully is going to take more time and more knowledge than we anticipated.

MOST PEOPLE WILL GIVE UP AT THIS POINT, AS THEY REALISE WORK IS INVOLVED

15. We get serious and start concentrating on learning a 'real' methodology.
16. We trade our methodology with some success, but realise that something is missing.
17. We begin to understand the need for having rules to apply our methodology.
18. We take a sabbatical from trading to develop and research our trading rules.
19. We start trading again, this time with rules and find some success, but over all we still hesitate when we execute.
20. We add, subtract and modify rules as we see a need to be more proficient with our rules.
21. We feel we are very close to crossing that threshold of successful trading.
22. We start to take responsibility for our trading results as we understand that our success is in us, not the methodology.
23. We continue to trade and become more proficient with our methodology and our rules.
24. As we trade we still have a tendency to violate our rules and our results are still erratic.
25. We know we are close.
26. We go back and research our rules.
27. We build the confidence in our rules and go back into the market and trade.
28. Our trading results are getting better, but we are still hesitating in executing our rules.
29. We now see the importance of following our rules as we see the results of our trades when we don't follow the rules.
30. We begin to see that our lack of success is within us (a lack of discipline in following the rules because of some kind of fear) and we begin to work on knowing ourselves better.
31. We continue to trade and the market teaches us more and more about ourselves.
32. We master our methodology and our trading rules.
33. We begin to consistently make money.
34. We get a little over-confident and the market humbles us.
35. We continue to learn our lessons.
36. We stop thinking and allow our rules to trade for us (trading becomes boring, but successful) and our trading account
continues to grow as we increase our contract size.
37. We are making more money than we ever dreamed possible.
38. We go on with our lives and accomplish many of the goals we had always dreamed of.

Wednesday, February 02, 2011

Very Interesting and quite funny Video: The difference between the United Kingdom, Great Britain and England explained

If you don't know by now the difference between UK, England and Great Britain, you should take a look at this video! Its only 5 mins long and its pretty entertaining...

Link to Video: http://www.wimp.com/differencebetween/

What exactly is the Foreign Exchange Reserve?

I came to realized that most people are confused when they read about China and hear on the news about terms like: Foreign Exchange Reserves, Current Accounts Surplus, Pegging, undervalue, etc. So today, I'll do a little write up to explain what exactly is Foreign Exchange Reserves and how the central banks around the world controls these deposits to influence their currency and economy.

By Definition, Foreign exchange reserves in a strict sense are only the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, SDRs and IMF reserve positions. FX operations will cause an expansion or contraction in the amount of domestic currency in circulation which in the end affect a central bank's monetary policy and inflation. And this is how it works:

Lets start by giving a real example. When we hear that the Chinese are artificially keeping they currency pegged at a certain level, how do they do it? To maintain the same exchange rate level and not allowing it to go higher even if there is increase demand for the currency (when there is a increase demand, RMB value should go up and therefore keeping it at the previous level is why they say the RMB is undervalued), the central bank of China can issue more of the RMB (print money) to purchase foreign currencies, which in this case is the US dollar. This will increase the sum of FX reserves for China (increase of US dollar in their reserve) and the RMB's value will be held down since the supply of the RMB is increasing. This artifically keeps the Chinese goods cheap for US consumers to therefore increase exports and maintain growth/GDP. However, this may provoke domestic inflation for China. In theory, the manipulation of foreign currency exchange rates can provide the stability that a gold standard provides and large reserves allow a gouvernment to better manipulate exchange rates. On the other end, since the amount of foreign reserves available to defend a weak currency (a currency in low demand) is limited, a foreign exchange crisis or devaluation could be the end result if that was the case.

Well hope I explained it well, here is a list of countries by FX reserves: