Green politics, philosophy, history, paganism and a lot of self righteous grandstanding.

Tuesday, 6 January 2015

Gaming the Markets

Here's a question for you. Why is the oil price crashing? Is it:

a) The USA using the oil weapon on Putin for invading the Ukraine?

b) Saudi Arabia trying to take out the US unconventional oil industry?

c) The first sign of another, massive, stock market crash?

d) All of the above.

There are lots of reasons to think we might be heading for a crash. The big banks, bailed out but unreformed, are still printing imaginary money, the city traders, we can be sure, are still massaging the figures to boost their bonuses, and the the Chinese economy is so overheated it's a surprise you can't see it from space.

All we are waiting for is the trigger, which could be the US sub-prime auto bubble, Greece telling the EU it won't swallow its austerity, bad news from the pension funds or who knows?

But the trigger is not the same as the cause. The reason for the crash will be the underlying problems of our global economy, a system that is very good at channelling wealth upwards, and which has doubled the number of billionaires since 2008, but doesn't appear to be able to do much else.

Gaming the Markets

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However the last place to notice that it's all gone tits up will, rather bizarrely, be the futures market. Here the men, and a handful of women, who are paid eye watering sums of money to predict the market will no doubt continue to invest our money on the never-never even as their world comes crashing down around them.

Why this is is explained very neatly by Nate Silver in his book The Signal and the Noise. Silver uses a very simple example of Game Theory.

Basically as a City Trader you can either buy or sell, and the stock price will either go up or go down. Guess right and your company makes a packet, guess wrong and it doesn't. Guess very wrong and the entire economy collapses.

It's important to get this right, right? So it's equally important to make sure your staff are rewarded for doing the right thing, and punished for doing the wrong. Is that how it works in real life? You don't need me to tell you the answer, do you.

Here are the four possible outcome:

Dealer buys, stocks rise

This is what it's all about. You make money for your bank and they give you a whopping bonus, which you spend on a yard of cocaine and new Porsche.

Lets call this a +100% win, although even today that's pretty stingy.

Dealer sells, stocks rise

Oh dear. You blew it. Collect your P45 and get a real job.

Lets call this a -100% loss.

Dealer buys, stocks fall

This is what happened in 2008. A big disaster. But what about the (not so) poor broker? Well, clearly no bonus, but then as everyone was doing the same thing you'd be unlucky to get the blame personally. Around one in ten traders lost their jobs when their companies went bust, but hardly anyone was actually fired for getting the predictions wrong.

That makes this a -10% loss.

Dealer sells, stocks fall

There were indeed a handful of Cassandras who did this. But what happened to them? Well, they didn't get a bonus as there was no money to pay them. A few went on to fame and lifetime of lecturing fellow Bankers. Academic positions were certainly on offer, but these don't pay as well as the City.

How do you score this? It's very difficult. At most you could call this a +10% win but I think that's being generous. I mean, if you value the respect of your peers more than filthy lucre why go into share dealing in the first place?

The scores on the doors

So where does that leave our City Trader, watching the price of Brent Crude tumbling and wondering what to do?

Well if he sells its  -100% against +10% whereas if he buys it's +100% against -10%. A bit of a no brainer really.

So the moral of the story is if you trust the smart men in suits to look after your money, get ready to lose your shirt. Again.

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