Trading strategies

I had fallen victim of Amazon's one-click Kindle purchasing one time too many, and, without thinking, bought this book, which, to my dismay, is another piece of chartist claptrap backing up its techniques with claims of years of impressive results -- I discovered this on a plane flight, and quickly diverted myself with a nap, but this experience turned my thoughts to that best of gambling (which is really the same as trading) systems: the martingale. To refresh the reader's memory, this system (already popular in 18th century France) allows one to win against any casino game, no matter how big the house edge. As an example, we will use Roulette, in its primitive red-black form: the gambler comes into the casino, and bets a dollar on red. If he wins, he walks away. If he loses, he bets two dollars. If he now wins, he has won two dollars after losing one, so walks away with a dollar net gain. If he loses, he now bets four dollars. It is easy to see that this sequence of double-downs allows our gambler to walk away with a dollar, with probability one. Somewhat unfortunately, this system works particularly well if you have unlimited bankroll, in which case winning a dollar might be viewed as rather small pickings.

The first (and most important) improvement to this strategy is to start a hedge fund. Let's assume, for the sake of argument, that the starting capital is $1000. Our intrepid money manager (based in Atlantic City, for convenience -- lets call him A) walks into Taj Mahal every trading day, and practices the martingale. Since his Sharpe ratio is infinite (every day he makes his dollar, like clockwork), his investors are happy. In the 250 trading days of the year, he makes \$250, which is a 25\% return, of which he collects a 20\% performance allocation of \$50. In addition, he makes \$20 in management fees, so in a little under four years our hero is around \$250 richer. A good thing, too, since this is roughly when A loses \$1000, to the chagrin of his investors.

The next, and also important step, in this process is leverage: Money manager B, having observed A, is horrified that the investors had lost money, while A has made out rather well. So, B borrows money on margin, so he now has \$2000 to play with, so he scales up his bets two times higher than A. At the end of four years, not only does he have \$500, but when the day of reckoning comes, a large chunk of the damage he suffers is allocated to the lender, so both B and B's investors are happy. Not so the bank's shareholders.

As a final(?) improvement, our manager C has not \$2000, but \$20000000000. All of the activity in the previous paragraph takes place, but now the bank's shareholders (and especially its bondholders) proclaim the bank too big to fail, and the bill goes to the taxpayers, of whom there are quite a few, and it takes only a few dollars of the savings of each of them to subsidize C, his investors, the bankers, and the vitally important luxury yacht industry, it seems that everyone is now happy.

Progress is a wonderful thing!

What is interesting is that the parable described above not only describes much of recent "investment" activity, but also encapsulates pretty much the entire content of The Black Swan, at greatly reduced investment of time, money, and pseudo-intellectual rambling.