The Hour Between Dog and Wolf: Risk-taking, Gut Feelings and the Biology of Boom and Bust. John Coates

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СКАЧАТЬ shot of excitement, until one option just feels right. Martin has a hunch, and with growing conviction believes the market will weaken.

      ‘Offer at 100.25.’

      Esmee relays the information to DuPont, and immediately shouts back to Martin, ‘Done! Thanks, Martin; you’re the man.’

      Martin doesn’t notice the stock compliment, just the ‘done’ part. He now finds himself in a risky position. He has sold $750 million-worth of bonds he does not own – selling a security you do not own is called ‘shorting’ – and needs to buy them. The market today may not seem much of a threat, languishing as it is, but this very lack of liquidity poses its own dangers: if the market is not trading actively, then a big trade can have a disproportionate effect on prices, and if he is not stealthy Martin could drive the market up. Besides, news by its very nature is unpredictable, so Martin cannot allow himself to be lulled into a sense of security. The ten-year Treasury bond, which is considered a safe haven in times of financial or political crisis, can increase in price by up to 3 per cent in a day, and if that happened now Martin would lose over $22 million.

      He immediately broadcasts over the ‘squawk box’ – an intercom system linking all the bank’s offices around the world – that he is looking to buy ten-years at 100.24. After a few minutes a night salesman from Hong Kong comes back and says the Bank of China will sell him $150 million at 100.24. Salespeople from around the US and Canada come back with other sales, all different sizes, eventually amounting to $175 million. Martin is tempted to take the little profit he has already made and buy the rest of the bonds he needs, but now his hunch starts to pay off; the market is weakening, and more and more clients want to sell. The market starts to inch down: 100.23–24, 100.22–23, then 100.21–22. At this point he puts in the broker screen a bid of 100.215, a seemingly high bid considering the downward drift of the market. He immediately gets hit, buying $50 million from the first seller, then building up the ticket to $225 million as other sellers come in. Traders at other banks, seeing the size of the trade on the broker screen, realise there has been a large buyer and now reverse course, trying to buy bonds in front of Martin. Prices start to climb, and Martin scrambles to lift offers while he still has a profit, at higher and higher prices, first 100.23, then .24, finally buying the last of the bonds he needs at 100.26, slightly higher than where he sold them. But it is of no concern. He has bought back the bonds he shorted at 100.25 at an average price just under 100.23.

      Martin has covered his bonds within 45 minutes, and made a tidy profit of $500,000. Esmee receives $250,000 in sales credit (her sales credit, a number that determines her year-end bonus, should represent that part of a trade’s profit which can be attributed to the relationship she has built with her client. You can imagine the frequent arguments between sales and trading. Like cats and dogs). The sales manager comes over and thanks Martin for helping build a better relationship with an important client. The client is happy to have bought bonds at lower levels than the current market price of 100.26. Everyone is happy. A few more days like today, and everyone can start hinting to management, even this early in the year, their high expectations come bonus time. Martin strolls to the coffee room feeling invincible, with whispered comments trailing behind him: ‘That guy’s got balls, selling $750 million tens right on the offer side.’

      This scenario describes what happens on a trading floor when things go right. And in general things do not go badly wrong on a Treasury trading desk. There are certainly bad days, even months; but the really fatal events, like a financial crisis, strike at other desks. The reason is that Treasury bonds are considered to be less risky than other assets, such as stocks, corporate bonds or mortgage-backed securities. So when the financial markets are racked by one of their periodic crises, clients rush to sell these risky assets and to buy Treasuries. Trading volume in Treasuries balloons, the bid–offer spread widens, and volatility spikes. In periods like that Martin may price billion-dollar deals several times a day, and instead of making one or two cents, he may make half a point – $5 million at a crack. A Treasury desk usually makes so much money during a crisis it helps buffer the losses made on other trading desks, ones more exposed to credit risk.

      There is a further reason the Treasury desk holds a privileged position on a trading floor, and that is the unrivalled liquidity of Treasury bonds. A bond is said to be liquid if a client can buy and sell large blocks of it without paying a lot in bid–offer spread and broker commissions. In normal conditions, clients can buy a ten-year Treasury at the offer side price of, say, 100.25, and sell it immediately, should they need to, a mere one cent lower. By way of comparison, corporate bonds, ones issued by companies, commonly trade with a bid–offer spread of 10–25 cents, with some trading as wide as $1 or $2. The Treasury market is the most liquid of all bond markets, and is thus perfectly tailored for large flows and fast execution, Treasury bonds being the thoroughbreds of trading instruments.

      Such a market calls forth traders with a complementary set of skills. Traders like Martin must price client trades quickly, and cover their positions nimbly, before the market moves against them. This is especially true when the markets pick up speed, for then Martin has no time to think; if he is to avoid owning bonds in a falling market or being caught short in a rising one, he must price and execute his trades with split-second timing. In this his behaviour resembles not so much that of rational economic man, weighing utilities and calculating probabilities, but a tennis player at the net.

      We are now going to look at Martin’s trade much as an athlete’s coach would, as a physical performance. We saw in the last chapter that our brain evolved to coordinate physical movements, and these, by the very nature of the world we lived in, had to be fast. If our actions had to be fast, so too did our thinking. As a result we came to rely on what are called pre-attentive processing, automatic motor responses and gut feelings. These processes travel a lot faster than conscious rationality, and help us coordinate thought and movement when time is short. We will look at some extraordinary research that demonstrates just how unaware we can be of what is really going on in our brains when we make decisions and take risks.

      In this chapter we stray from the trading floor and visit other worlds where speed of reactions is crucial for survival, as it is in the wild and in war, and crucial for success, as it is in sports and trading. In the next chapter we look at gut feelings. These chapters provide the science we need, the background story, that will help us understand what we are seeing when, in later chapters, we head back onto the trading floor and watch Martin and his colleagues as they are swept up in a fast-moving market.

      THE ENIGMA OF FAST REACTIONS

      We evolved in a world where dangerous objects frequently hurtled at us at high speeds. A lion sprinting at 50 miles an hour from a hundred feet away will sink its teeth into our necks in just over one second, giving us very little time to run, climb a tree, string a bow, or even think about what to do. A spear launched in battle at 65 miles an hour from 30 feet away will pierce our chest in a little over 300 milliseconds (thousandths of a second), about a third of a second. As predator and projectile zero in, and our time to escape runs out, the speed of the reactions needed to survive shortens into a timeframe our conscious mind has difficulty imagining. Over millennia of prehistory, the difference between someone who lived and someone who died often came down to a few thousandths of a second in reaction time. Evolution, like qualifying heats at the Olympics, took place against the sustained ticking of a stopwatch.

      Things are not that different today, in sport, for example, or war, or indeed in the financial markets. In sport we have sharpened the rules and honed the equipment to such an extent that once again, as in the jungle, we have pushed up against our biological speed limits. A cricket ball bowled at 90 miles an hour covers the 22 yards to the batsman’s wicket in about 500 milliseconds; a tennis ball served at 140 miles an hour will catch the service line in under 400 milliseconds; a penalty shot in football will cover the short 36 feet to the goal in about 290 milliseconds; and an ice hockey puck shot halfway in from the blue line will impact the goalie’s mask in less than 200 milliseconds. In each of these cases, the less than half a second travel time of the projectile СКАЧАТЬ