I have just added my own comments to extend this - Note that the original black is Hawker's, the blue is Bubba7's and the red font is my notes/extensions... I hope all this deepens the insight on the subject a little. Compliments, ~The Scientist
This well known article by Taleb has a lot to say abt scapling. But what is a dynamic hedger and could someone explain what "the markets follow the path that hurts the highest number of dynamic hedgers" means? from the article--- The World According to Nassim Taleb, 1996. http://www.gsm.uci.edu/~jorion/oc/ntaleb.htm "NT: I left Wall St. for the first time in 1991. I was obsessed with price formation. I couldn't understand from the screen how prices were determined. It took me six months to be able to read prices in the pit. Locals basically read information from the order flow and squeeze the weak party. There's always a pack five or six dominating locals who abruptly change the prices, who bid a lot higher than the previous offer and have the guts to do it and the rest of them follow. " "NT: Financial economics has been extremely successful at melding the math with economic insight. This is providing traders with better understanding of derivatives pricing. My motto is that the markets follow the path that hurts the highest number of dynamic hedgers. It was exciting to read a mathematical proof of it by Grossman and Zhou in the latest Journal of Finance."
oops, meant the September bond futures...was just looking at the June contract...Essentially, I had a hard time with Taleb's earlier book, which was abstract and extremely math intensive. After reading "Fooled by Randomness" however, it became clear what his message was. When you read a few of his follow up articles, such as the article in the New Yorker, (Jan, 2002), he is basically the anti-Niederhoffer, or the guy who makes the bets on disaster, the "black swan", whereas others are most likely adjusting their hedges in lockstep with current market dynamics. I think it is a similar mentality to Soros, but there are definitely differences.
I'll answer my own question here. These two articles explain dynamic hedging and why they can get into trouble in the markets. A dynamic hedger can be like a trader who sticks to a losing position too long. They get run out at the worst price. The phrase "the markets follow the path that hurts the highest number of dynamic hedgers" is a corollary to the market concept that the bull rises with the fewest number of longs. (That is, the bull will rise when the longs have been run out of their positions, driving the market to its lowest point. Odd sounding that a bull can rise only after all the longs have been burned. Odd sounding, but it is dictated by market logic. A market cannot reward many people and remain a game worth playing. The market will twist and turn until it arrives at a point where a few number of people receive the majority of the rewards.) http://home.netcom.com/~ntaleb/rubinste.htm http://www.bwater.com/pdf/DYNAMICHEDGING.pdf
Great article, thanks. Quote: "I couldn't understand from the screen how prices were determined. It took me six months to be able to read prices in the pit. [...] I learned about market dynamics in my second sixth months than from years on a desk. I learned that traders' income is not the bid-offer spread, but the micro-squeezes that take place. Markets move from squeezes to squeezes. Traders make money on stop losses and other free options. It made me interested with information economics." http://www.elitetrader.com/vb/showthread.php?s=&postid=248281&#post248281
" It took me six months to be able to read prices in the pit. [...] I learned about market dynamics in my second sixth months than from years on a desk." For those who ask how long does it take, it took Taleb a year to learn to read order flow in the pit and he was already a money manager.
I was a scalper trading up to 2000 contracts a day in the CBOT bond pit for close to a decade. I'd like clear up a few mis conceptions about the pit. Locals do not have a handle on players or personalities or chart points but merely trade against customer orders. In this day and age it's rare for a local to even know what firm he just traded against let alone to know whether that order was an index arb, a stop, a fund, or even another local who used a floor broker to get out. Maybe in Pork Belly's circa 1975 but not in the current high volume world of financial futures and indices. Generally one's clerk gets the "name" of the counter party when the trade is being "checked" several minutes after the trade occurred. If I knew every time I traded a 100 lot that there was another 4000 coming I'd be retired on an island, not trading ES from home like many of you guys. The advantage locals have, and it's big, is that open outcry is not time prioritized. That means that a local may join a bid or offer "leaning" on paper at that price and have as good or even better chance of participating at that price while orders remain unable. That may seem unfair but it's a major reason futures pits have such liquidity. Often when there is 500 offered on paper, a floor broker will get a 1000 lot buy order, go to locals for the first 500, and then lift the paper offers for the balance. Of course as a local you're pissed when that happens but it's part of the process. By the same token the cry "Trade with a local" is often heard. as a reminder to filling brokers that it's locals who are there facilitating a lot of crap trades. The other major advantage of members trading there own account is low commissions. Just imagine if all of you were trading for a buck instead of 5$ how much improved your P/L would look! The truth is locals make ridiculously little money per contract traded. They "scratch" between 60-70% of their trades and on the balance they trade just like you guys...meaning their good trades are scalps and the bad trades are day trades, LOL. They seldom "hunt" for stops as they don't often really know where they are and even if they did all's it takes is for one arb to step in and say "this has gone to far" and offer the market right down before the locals have had a chance to unload their longs into the stops. Back in the Bonds hey day in the 80's many guys were having 1-6 million dollar years. At least half of them are now broke! The large mythical "shooters" that one hears about are not the ultimate winners. The no-name 5 lotter who was content to make a grand per day over a 16 year period is the guy who is now living large. And believe it or not, 75% of the guys on this board have more intelligence, technical savvy, and trading skill than he, but none of the pricing advantages that will allow that success to occur.