Thread by @ReformedTrader

1/ The Futures (Emily Lambert)

Thread with quotes from the book

"In 1808, the government built Fort Dearborn on a small hill near the shore of a large freshwater late. The soldiers defended the fur trade. Chicago was built, literally, for trading."

amazon.com/Futures-Specul…

2/ "Warm fronts from the south clashed with cold fronts from the north. As the seasons changed, temperatures swung from bitter cold winters to hot, humid summers. That's part of the funny story of this business and one reason why it developed in Chicago instead of, say, Florida."

3/ "The river and canal were sometimes frozen, and merchants couldn't get corn to Chicago, so they stored it in corn cribs. In the spring, the river thawed and sellers converged on Chicago and drove prices down to the point that it wasn't always worth making the trip.

4/ "Farmers, traders liked to say later with a theatrical flourish, would dump their corn in the river.

"Merchants started arranging to sell in advance. On March 13, 1851, a seller promised to deliver corn the following June for 1¢/bushel less than the March price."

5/ "Similar contracts were traded at other places and times. Some traders pointed to the Bible, ancient Greece, medieval Europe, and 17th-century Japan to show they were following an established path. But this trade took root in Chicago the way it hadn't before." (p. 5)

6/ "Futures markets are the real free markets. Speculators serve a vital economic and social function given the right architecture.

"The traditional futures market, because of its written and cultural limits, serves as useful example for how markets ought to work." (inside flap)

7/ "They traded furiously because the demand for grain skyrocketed as northern and southern soldiers fought in the civil war. The Union quartermaster, who was responsible for keeping the troops fed, ordered oats and pork in advance, and speculators dove in." (p. 6)

8/ "By 1865, contracts started to look alike. Instead of specific bags of grain, contracts called for standardized grades to be delivered in standardized amounts on standardized dates. It became easier to trade them like baseball cards.... the modern futures contract." (p. 6)

9/ "Traders were more than gamblers: they bet on risks that [already existed]. The corn crop could fail. Farmers could be snowed in and unable to deliver.

"So traders provided insurance: by locking in prices in advance, they took risks that other people didn't want." (p. 7)

10/ Bhardwaj, Janardanan, and Geert Rouwenhorst look at futures contracts back to 1871.

Consistent with Lambert, they find that contracts that may not have functioned well as insurance (extreme returns or easily substituted) were less likely to survive.

https://twitter.com/ReformedTrader/status/1197401269821792256

11/ "The more, the better. Whenever a farmer or merchant wanted to trade, someone was usually there to make a deal. As traders, they quoted competitive prices and created smaller gaps between buying and selling prices, shrinking what could be large swings in price." (p. 7)

12/ "In a sense, everyone in Chicago was speculating. Hopeful businessmen constructed warehouses, railroads, homes, and shops. Some built stockyards on swampland. When cholera broke out, they raised the city streets and reversed the flow of the river." (p. 7)

13/ "Some made money at the expense of farmers and merchants. They fixed prices. They had railroads deliver grain to them regardless of where it was supposed to go. Elevator owners spread rumors that grain was going bad so they could buy it. They bribed grain inspectors." (p. 9)

14/ "Hutchinson and Leiter headed up a long line of people who tried to corner their way to riches and glory. The local papers gleefully reported on the many who failed.

"Finally, the secretary of agriculture demanded that Board of Trade members oust the clique of

15/ " 'gamblers and scalpers' in control of the exchange. And members in the 1920s had no choice but to adopt something they had previously resisted: a self-enforcement system called central clearing that became a foundational element of futures trading." (p. 13)

16/ "The clearinghouse became an intermediary that guaranteed both sides of every trade.

"Because the clearing firm was on the hook, it watched the trader. If he looked like a wild gambler, the clearing firm limited how much he could trade." (p. 14)

17/ "It was important to learn to avoid the psychological traps that caught traders, like being too proud to admit a mistake. It was best to take a loss and move on. That was surprisingly hard to do.

"A new trader had to learn not to talk about how much he had made or lost.

18/ "To listen to what people said, nobody ever made a dime. There was a legitimate reason to keep quiet. A trader needed a poker face. When the bell rang, a he had no friends. If a man was in financial trouble and showed fear in his eyes, he was like a wounded antelope." (p. 20)

19/ "Egg prices could change while eggs sat in storage. Eggs were seasonal: there were a lot of fresh eggs in the spring, the equivalent of harvest time, and there was a shortage in the winter. It was also difficult to predict how many eggs housewives would buy in any given week.

20/ "Egg men on the street used futures like short-term insurance. A dealer sold a contract as a hedge if he thought prices might fall. That way, if the price of eggs dropped, he bought back the contract for a profit that canceled out what he had lost on the eggs." (p. 29)

21/ "At the Board of Trade, it had become more difficult over the years for traders to corner a market. There was simply too much grain. It was still possible, though difficult, to squeeze the market by holding product off the market and buying futures to drive the price up.

22/ "The traders most likely to pull it off were large grain firms. They had the best idea of supply, the money to buy a lot of grain, and the connections to disguise their purchases. A deep-pocketed trader who could buy grain and store it for years had a huge advantage.

23/ "The Merc had smaller markets and perishable products. It was cheaper to try to corner. It was also easier to keep it secret. Because the products couldn't be stored, the trader didn't have to worry about people suddenly dumping inventory on the market." (p. 37)

24/ More recently, Jamie Mai had an interesting idea for trading heavily contangoed futures: short oil on the futures market and hedge the trade by storing physical oil on a tanker.

https://twitter.com/ReformedTrader/status/1206057238911021057

25/ "Kosuga and Siegel double-crossed the onion growers. They joined the sellers, knowing the price would go down, and prepared to deliver onions that they had said they would hold off the market. They helped drive prices down to ten cents a contract and made millions." (p. 42)

26/ "The price got so low that onions were worth less than the bags that held them. Growers angrily plowed onions back into the fields. Cars on tracks at the rail yard were full of worthless onions, and their unlucky owners had to pay rent to keep them there." (p. 42)

27/ "In 1958, PResident Eisenhower signed the Onion Futures Act.

"The Merc tried to get the onion ban reversed.... Many onion growers now hated the traders. Without growers, and people who wanted to hedge, they didn't have a viable market. The traders dropped their court battle.

28/ "The Merc needed something else to trade to justify keeping the floor open. The governers of the Merc, inventive men, started thinking, and that's when the law of unintended consequences kicked in. In an attempt to contain the futures trade, Congress unleashed it." (p. 44)

29/ "They needed a product with prices that fluctuate, which would attract people in the business who wanted to hedge away risk as well as traders who wanted to speculate. To fit the mold of the typical commodity, it needed to be seasonal, storable, and gradeable." (p. 46)

30/ Pork bellies: "The reason a futures contract could work was that the packer had risk. If prices went down, he could get stuck with a bunch of frozen pork bellies that had lost value.

"This seasonal problem created a trading opportunity." (p. 47)

31/ "Some might have thought that cattle ranchers would use futures conservatively, as insurance. Instead, they became some of the riskiest speculators, doubling down on the bet they were already making with their livelihood (putting on 'the Texas hedge')." (p. 66)

32/ "Sometimes people swapped money at a rate that different from the official one using forward contracts, speculating that central bankers would be forced to adjust the fixed exchange rate to something more realistic, which they often did. In the years after WWII, the market

33/ "deviated more and more from official rates. It got harder for bankers to keep them fixed.

"It was getting tougher for businesspeople to budget because they didn't know how far the dollar would go in the near future.

"In 1971, Nixon tore up the Bretton Woods system." (p.79)

34/ "The traders in the pit seemed disconnected from the business, and in fact, they were. For their business to work, they needed to link the markets.

"The pit was like a candy store. All bankers needed to do was use forward contracts to buy British pounds from customers...

35/ "then turn around and sell an equivalent amount of futures on British pounds for more money in the pit.

"But the bankers lacked the risk-taking soul of traders using their own money. The bankers traded only a tiny amount of futures (if they traded at all)." (p. 84)

36/ "Although the bankers weren't going to take advantage of price differences by arbing, a trader might do it—if only the banks would let them trade. Banks hadn't let Milton Friedman trade with them, and they weren't about to let these yokels trade either.

37/ "Chicago banks were willing to allow certain qualified futures traders to arbitrage between the pit and the bankers' private markets.

"They could make a few thousand dollars a day, practically risk-free. Eventually, the bankers would instruct their own men to trade." (p. 85)

38/ "Before they headed home, Lind went shopping for a suit. He studied the bill for $1,725 like a college student who had just taken Econ 101. Curious about the exchange rate he had paid, he told his assistant to find out what the Italian lira had traded for in the pit that day.

39/ "He figured that American Express had bilked him out of $25.

"The experience made him confident—even more so than before—that currency futures would work. The traders in the pit offered better deals than the banks themselves were willing to give." (p. 86)

40/ 1973: "In 'The Pricing of Options and Corporate Liabilities,' Black and Scholes solved a problem that had plagued mathematicians and economists for three and a half centuries.

"Traders had to make sense of formulas and equations that looked like alien scribbles." (p. 103)

41/ "Traders started walking around with 'sheets'—pieces of paper filled with numbers that had been calculated using what was to be called the Black-Scholes model.

"The trade who could quickly do the calculations in his head had an advantage and probably got the trade." (p. 103)

42/ "The options traders and futures traders didn't mingle much. In general, futures traders saw the options crowd as stuck-up, while options traders saw futures traders as dopey." (p. 103)

43/ "Customers stopped calling put and call dealers in New York. They didn't need the dealers to spend several days finding someone to trade with them and to take a generous fee for doing that. They could just call Chicago, where there were speculators standing by." (p. 105)

44/ "Stockbrokers saw options as a new product to sell to make themselves money. Some promised exaggerated returns or indicated that strategies were more conservative than they were. An option could be used conservatively, but it could also be one of the riskiest trades possible.

45/ "Like a car or a knife, an option could be a tool or a weapon. Brokers didn't always explain the difference or disclose the risks. In 1974, a broker in change of an account held by a widow whittled her $400,000 down by half. He made $40,000 in commissions for himself.

46/ "The men on the Amex floor didn't seem to understand options like the ones in Chicago did. Many saw options as being just like stocks, something that gained or lost value.

"The traders in Chicago seemed to always offer better prices than the ones in New York did." (p. 106)

47/ "Sandor wrote a futures contract for gold—as did his rivals at other exchanges—to be traded the moment Nixon lifted a four-decade ban of owning it in the form of coins, jewelry, and dental crowns. When he did, individuals could begin to own—and trade—gold bullion." (p. 112)

48/ "Real estate was a pretty boring business. People bought homes and lived in them for decades. Interest rates had risen slowly and predictably. The real estate market was financed primarily by thrifts, also called savings and loans.

49/ "Bankers were in the 3-6-3 business: borrow at 3%, loan at 6%, and be on the golf course by 3:00. Most kept loans on their books: thrifts were careful whom they lent to.

"Sandor watched the market change. In the boom, thrifts couldn't keep up with the loans people wanted.

50/ "Rates went up and disrupted 3-6-3. Thrifts were stuck borrowing at 3%: federal law restricted how much they could pay depositors, who took their money and left. When thrifts had no money to loan, the housing boom turned into a bust, and the economy tipped toward recession.

51/ "Congress created Freddie Mac, which bought conventional loans from thrifts so they could use the proceeds to make more loans. Sellers had to keep 10% of every loan, so they still had an incentive to loan prudently.

"Bomar's goal was to take those loans in batches of,

52/ "say, $100 million, package them up, and sell them to investors as bonds through Wall Street's dealers.

"But while he waited to sell the loans, Freddie was exposed to interest rate risk. Bomar wrote an article expressing a wish for a futures contract as a hedge." (p. 114)

53/ "Sandor wrote a futures contract on Ginnie Mae bonds (a proxy for mortgages). The contract's value rose and fell with interest rates.

"Back then, if a person wanted to buy or sell a Ginnie Mae, he called a dealer who would quote a price. Cahnman stopped by the Chicago office

54/ "of the bond dealer Lehman Brothers. The office had fancy furniture and a silver coffee service.

"Cahnman realized they were in the same business and believed he could rival the mortgage-dealing professionals. He had no office space to maintain or fancy furniture to buy.

55/ "He became an aggressive buyer and seller in the pit. When someone was bidding, he bid more. When someone was selling, he sold for less. Brokers started looking to him when they had orders to fill." (p. 122)

56/ "Bomar decided that the contract didn't help him. The loans that his agency bought weren't guaranteed like the ones to low-income borrowers. His loans changed value at different rates.

"But Ginnie Mae was just a stepping-stone to the pit that would change the Board." (p.123)

57/ "The culture was changing, and younger people were coming in. One was Richard Dennis. Barely out of high school, he turned a few hundred dollars into a few thousand, then a few million.

58/ "He studied charts to find trends, representing a new breed, the technical trader. With that approach, he made more money than most of the people on the floor. Some said he'd be a three-month wonder, like many who had blown in and out, but he kept making money." (p. 126)

59/ We have a great deal of recent trend-following research, but Richard Dennis was actively using similar strategies in the 1970's.

Time Series Momentum

https://twitter.com/ReformedTrader/status/1189676012990124032

(Trend following for stocks)

https://twitter.com/ReformedTrader/status/1134949730247557121

Trends Everywhere

https://twitter.com/ReformedTrader/status/1133940159127310336

60/ "Grain traders were so important that their weather mattered. When it rained on La Salle Street, it made them a little moody, and it also made some of them think about how it would affect crops and whether there would be more corn (and therefore lower prices).

61/ "The price was affected by the weather in Chicago, whether or not it was raining where the crops grew. So the price on La Salle Street affected the price of grains - and of food - all over the world." (p. 127)

62/ "A buyer who held on to the futures contract would get bonds, so Salomon had competition. Customers started looking at the price in Chicago and comparing it to the one they got when they called Salomon.

"Salomon traders, led by Meriwether, saw a way to make some easy money.

63/ "They bought cheap bond futures and sold Treasury bonds (and vice versa), making money on the price differences between the two markets." (p. 132)

64/ "Yet trading in bonds remained sporadic and erratic.

"Then came 'Tall Paul.' Volcker called an unusual weekend press conference and announced some moves intended to slow inflation (partly by raising interest rates). Overnight, the bond business went berserk.

65/ "The banks that had been trading futures suddenly looked very smart. IBM had just announced plans to borrow $1 billion. Several banks and large dealers on Wall Street had committed to buying IBM's bonds in order to resell them. When interest rates went up, they were stuck

66/ "with the bonds, and some took huge losses. But a few, including Salomon, where Meriwether's team was, were spared b/c they had hedged using futures.

"It became more acceptable to trade futures. Banks set up desks on the floor. Bonds brought Wall Street to Chicago." (p. 133)

67/ "The NYSE made plans to open a futures exchange and bring financial futures to NY. But they were missing an ingredient: all the Chicago traders.

"The new exchange didn't have hundreds of people willing to risk their own money and trade against major institutions." (p. 134)

68/ "Farmers, millers, bakers, merchants, and exporters traded futures to hedge.

"The same could apply to stocks. Millions of investors owned stocks and worried about prices falling. Pension fund managers worried about prices rising before they had a chance to buy." (p. 140)

69/ "What separated gambling from futures was the existence of risk. Gambling was contrived. With futures, the important point was that the risk existed, not that the wheat did. Practically speaking, only a small percentage of contracts resulted in delivery anyway." (p. 144)

70/ "To make a futures market work, they needed hedges and speculators. There weren't enough traders to take the other side at a good price, especially after the stock market hit a downturn. Men on the floor in Kansas City ran out of money." (p. 145)

71/ "Congress closed the tax loophole that gold traders had enjoyed and, in compromise, gave futures somewhat favorable tax treatment. When customers couldn't lower their tax bills by trading gold spreads, volume dropped, so some gold traders stepped into the index pit." (p. 146)

72/ "With the S&P pit, which grew fast, futures traders broke through the wall separating them from Wall Street. Some made more money than Wall Street executives.

"The era of the egg men was officially over, and the new era of the modern speculator was racing forward." (p. 148)

73/ "The ones who made it were often the street-smart kids with a sense of the odds who respected and feared markets like they feared the neighborhood bully. If he was lucky, either he'd quickly lose money or an older trader would bawl him out for making a risky trade." (p. 166)

74/ October 19, 1987: "Traders stood outside of the pit under orders not to trade from clearing firms that were too scared to guarantee their trades. Some watched one man in the pit lose his membership and home in two minutes.

"The names of clearing firms were blacked out, but

75/ "the directors saw what the firms owed and wondered which ones would collapse by the end of the day. If the firms went down, they wondered if the exchange would survive. And if the exchange went down, they wondered what it would do to the stock market and to the country.

76/ "The clearinghouse was at the center of the crisis. It was there to keep order, but it was stressed. It usually collected money from losers and distributed to winners at the end of each day. With huge amounts of money changing hands, it started collecting some money earlier

77/ "in the day. That caused some confusion because some banks weren't sure how much they owed. Some balked at sending over the massive sums required.

"The clearinghouse had a 7:30 AM deadline. If it didn't receive funds by that point, the exchange couldn't open.

78/ "If Morgan Stanley didn't send money over, the headline in the paper the next morning would read that Morgan Stanley had defaulted. The executive said that he understood, and Sandner waited nervously to see if the money would arrive. The system worked, but barely." (p. 168)

79/ "In 1989, the CFTC tacitly admitted that swaps looked like futures when it said that many swaps possessed 'elements of futures or options contracts,' but it let the swaps dealers off the hook. It said that swaps were not appropriately regulated as futures.

80/ "From that point on, swaps demonstrated what futures markets might have looked like had they not been pounded into shape in frontier times.

"A futures trader was in a public marketplace where everyone saw his trade. In the clearinghouse, a scorekeeper knew who the biggest

81/ "traders were, how much they might lose on a day-to-day basis, and how that could affect the market.

"Swaps didn't need a public marketplace or a clearing firm or a clearinghouse, things that were in place to prevent manipulation and to direct speculative impulses." (p. 174)

82/ "More swaps trading meant more futures trading. After a Wall Street dealer at a place like Salomon Brothers engaged in a $50-million swap, he often turned around and made a similarly big trade in Chicago to get rid of the risk." (p. 175)

83/ "No one thought that the money would stop. When luck ran out and they couldn't keep up their lavish lifetstyle, it could be traumatic. Jimmy Kaulentis had friends who committed suicide.

"Electronic trading threatened this way of life, particularly for floor brokers." (p.181)

84/ "Most people were awed by the excitement and madness. But the Swiss bankers looked at the floors and saw something else: inefficiency. They saw thousands of people running, yelling, trading, and doing jobs that computers could do better." (p. 184)

85/ 1997: "The German exchange introduced some incentive programs that made it cheaper to trade on the computer.

"A few months later, traders on the floor could tell something was changing. Soon the pit was empty, an open wound on the trading floor. The computer won." (p. 187)

86/ 2004: "The Swiss-German exchange, Eurex, was now the biggest futures exchange in the world. Its all-electronic model had proven to be a winner. People could trade from anywhere in the world, not having to deal with a dirty, smelly, sometimes violent trading pit." (p. 192)

87/ "At the country's largest financial institutions, people perfected credit default swaps, which were used to insure mortgage-backed products. The swaps were used to speculate. Like the original futures, swaps concentrated the surrounding frenzy into a financial instrument,

88/ "and people traded those with the light supervision that regulators had decided was appropriate for swaps traders.

"In the 1970s, the chief executive of Freddie Mac had fretted that pools of mortgages could lose value. Three decades later, in the frenzied market, they did.

89/ "Teaser mortgage rates expired. Some homeowners couldn't pay their higher mortgage bills.

"Some banks that had made loans collapsed with the housing market. Some companies that had used swaps to provide insurance on mortgages collapsed or nearly did.

90/ "The financial system itself came close to collapse. Taxpayers stepped in, rescued institutions, and paid off swaps to keep the financial markets functioning.

"The year looked like a referendum on free markets and on capitalism itself. But there was a better test case:

91/ "the futures markets, which were still understood or appreciated by only a few.

"They left blueprints showing how a group of people constructed markets that, on balance, worked well." (p. 201)

92/ 2011: "Traders' computers send more orders, faster than ever. They run high-frequency algorithms that try to beat others to the trade. It's quiet. This data center is the new floor, and one or more of these computer cages house the new pits.

93/ "Andrews came to Chicago to trade, but now he can do his job from anywhere. It has become cheaper and easier to trade.

"He is happiest close to his ranch and cattle business. For him, the business is still about animals and the people who trade them. It always was." (p. 206)