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Minyan Mailbag: Seeing the Signs

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I can't predict, only point out that risk is increasing...

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Prof. Succo,

Thank you for taking time out of your busy schedule to answer my questions. Although I agree that timing is impossible to predict, I still really value you making readers aware of if "A occurs, B will follow" situations as you did with your "if the Dow drops 200 pts" warning. These heads-ups help me time my purchases and sales in the very near-term (hours, minutes) so in this regard, timing is possible.

Your responses have elicited more questions from me. It was impossible to predict ahead of time that a crash would occur in 1987 but were there warning signs in the weeks prior that led you to believe things would get much worse near-term before they got better? If so, then in my mind, maybe timing near-term direction is possible. Given your area of expertise, were you able to predict vols spiking much higher in late Sept/early Oct of 1987?

I've often wondered, how did your friend and colleague Simon know a crash was imminent to buy $12,500 in puts six months out? Was it gut feel? Was he timing the market? Maybe neither because the risk/reward was attractive, he applied an appropriate amount of capital or defined risk he was willing to lose and planned to reload if they expired worthless.

Another question that's been gnawing at me is how did Simon know that he was in the middle of a trade of a lifetime? How did he know to let his trade ride for maximum profit? With a position in gold, I believe it's in the realm of possibility that I may be in a similar situation sometime in the future and am hoping you could teach us Minyans how to fish for maximum profits when the time comes. I've reread your piece on Simon several times and feel the type of data points available to Simon during the 1987 decline not only may not be available to me, the retail investor, but are also too touchy feely for me to depend on. If maximizing profit on a trade is more art than science, then I may need to depend on the MV professors to help me "time" the sale of my gold as I don't have an artistic bone in my body.

I hope this finds you well.

Minyan Dennis

MD,

1987 was a confluence of events. Simon was sitting in the right seat at the right time. First, he sat at the desk of Morgan Stanley, then the dominant derivatives dealer. Portfolio insurance was a huge product where many different funds in very large size were employing the strategy. Simon was very smart, he understood that portfolio insurance, which I have described in detail, was a flawed product and had thrown the supply/demand balance of convexity in the market way off kilter. In short, it caused a hugely abnormal amount of gamma to be introduced into the market. Simon saw the implications while most "quants" did not: the potential was there for a forest fire; all that was needed was a match. Simon also covered some very smart accounts that were tuned into markets technically: they were issuing warnings of an "extremely over-crowded market." In other words, their indicators were showing almost all investors bullish and already over owning stocks.

The match was slightly rising interest rates. As the match was lit, he started buying his puts.

I don't believe anyone can predict the future, where stock prices are going. Simon was no different, but he was smart enough to see the confluence of events and how rare they were. The bet was a good one.

Since then every correction, starting with this one, has been met by government intervention: massive pumping of liquidity. Markets are much more controlled than they were then and investors have become conditioned to that. This management in the short run has smoothed out stock prices, but bottled up market forces.

I don't believe central banks will ultimately be able to control those forces, only delay them. For their policies are making imbalances worse and worse. But I can't predict, only point out that risk is increasing.

-Succo
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