Ho John Lee's Weblog

…start with a large one.

This weekend’s news that JP Morgan will take over Bear Stearns for around $2/share is astonishing. Last Friday BSC closed at around 30. A week ago it was around 60. A year ago it was around $150/share. So in a year the shares are down by 99%, and even the bargain shoppers who got in on Friday are down by something like 85%, based on today’s close.

A cautionary tale gets added to market lore. This is going to make a good movie at some point…

In one of the banking world’s most unsettling recent disclosures, France’s Société Générale SA said Mr. Kerviel had cost the bank €4.9 billion, equal to $7.2 billion, by making huge unauthorized trades that he hid for months by hacking into computers. The combined trading positions he built up over recent months, say people close to the situation, totaled some €50 billion, or $73 billion.

Mr. Kerviel is no trading legend who let a transaction get out of hand. He was a low-level trader in the bank’s “Delta One” desk in western Paris, earning about €100,000 ($145,000) a year. His job was to make bets on how large European stock indexes would move, according to bank officials. His expertise was trading baskets of stocks such as the Euro Stoxx 50.

At $7.2 billion, this loss is larger than than the estimated 2006 GDP of 65 of the 183 countries tracked by the World Bank. It’s just about the entire output of Cambodia ($7.193 billion), and greater than the combined output of Seychelles, Liberia, Grenada, Gambia, Saint Kitts and Nevis, Saint Vincent and the Grenadines, Samoa, Comoros, Vanuatu, East Timor, Solomon Islands, Guinea-Bissau, Dominica, Micronesia, Tonga, Palau, Marshall Islands, São Tomé and Príncipe, and Kiribati ($6.846 billion).

I’ve noticed that the news coverage keep reporting “fraud”, which is apparently true (he made up fictitious trades with outside partners of the bank), but it mostly sounds like internal risk controls failed in more than one place.

Of course, if it had gone the other way and turned a profit, we never would have heard about it.

Looks like no one was impressed by Bernanke’s non-intervention on Thursday and the Bush/Paulson send-everyone-800-bucks stimulus package. US markets are closed for Martin Luther King Day, but the rest of the world is open, and down hard. DJ futures are showing something like -520 for tomorrow’s open, around 11586. The NYSE circuit breaker rules don’t kick in until a 10% move (1350 points), which would be somewhere around 10740. (The thresholds get reset every quarter.)

Don’t think we’ll see that tomorrow, but the way things have been going recently, it’s not out of the question. I wouldn’t be surprised to see a last-ditch central bank intervention tomorrow morning before the open, either. I think they missed their chance on Thursday, but I also don’t think the Fed has the luxury of waiting until the official FOMC meeting January 29 for their next move.

I take a week or so away from the markets and look at what happens…

The preface to Oscar’s e-mail this morning summarizes the current sentiment pretty well.

“Caution: This Next Trade is Not for Widows or Orphans”

Bear in mind that he’s a short term futures trader, so if you’re a buy-and-hold investor, none of this matters to you. You might enjoy his daily video commentary though.

Both CNBC and TheStreet.com have separately reported problems with their respective stock trading contests.

The CNBC contest site apparently had a coding flaw that allowed traders to open an order entry window before market close, then wait until after hours to actually enter the order, which would be executed the closing price.

The more interesting comment from CNBC is this:

In addition, there have been allegations that one or more contestants may have engaged in illegal market manipulation to affect actual prices of stocks represented in their contest portfolios.

With a million dollars at stake, this seemed like a plausible scenario even before the contest started. It’s unclear to me whether “illegal market manipulation” here actually means “illegal under contest rules” or “illegal under SEC regulations”, but it seems quite feasible.

Along similar lines at TheStreet.com, which offered $100,000 in their contest:

The final results of the game indicate that players employed trading strategies to achieve returns that could not be duplicated in the real world, thereby depriving other contestants of an equal chance to win.

I don’t know why these large contests don’t just partner with a retail brokerage that already has a paper trading (“demo”) mode instead of building their own. Wouldn’t solve the market manipulation problem though.

See also:

• BusinessWeek – CNBC’s Easy Money
• Insufficient volatility to win
• Not bad for real money, but not enough for paper trading

It appears I didn’t win the CNBC stock contest, ending up at +30%. The leading portfolios were something like $4-5MM, so there is a huge spread in that top 2% bracket.

I’m currently in the top 4% at 14746 in the CNBC contest. Oddly, they don’t publish the portfolio values on their website, but did show the current portfolio values and standings on TV last Friday. The top positions are clustered around $2M, or a total return of around 100%. It would be interesting to know what the distribution of 1-week returns looked like. That’s probably the best opportunity for placing at this point.

In either case, I haven’t hit any 25% to 50% movers, which looks like a prequisite for placing in the standings so far.

It’s hard to find high volatility stocks that are likely to move up in this market. I made a little progress on the CNBC stock contest, but this is going to be a lot lower tomorrow when they update the results (seeing how the markets had another abysmal day). It would be a lot more interesting if you could take short positions. Everyone would probably be in NEW and LEND.

As an aside, the rules for the trading contest apparently don’t prohibit multiple accounts owned by the same person. Consequently, someone named “Nancy Beaumont” has entered hundreds of portfolios. By the rules, they can only win once, but having multiple high-volatility portfolios in the running significantly improves your chance of ending up with one or two successful outliers, sort of like buying multiple lottery tickets, but with much better odds. At the moment they’re occupying 8 of the top 20 rankings.

CNBC is running a stock trading contest starting today, with a prize of one million dollars for the best performance by May 25th. Signing up is free. Each participant gets a notional $1,000,000 to trade. There are a few non-obvious rules:

• All trades are priced at end-of-day – no intraday trades, and no GTC limit orders.
• No ETFs – this means no indexes, countries, sectors, or commodities, and no inverse trades
• No mutual funds – again, no indexes, country, sector, commodity, or inverse vehicles
• No options, futures, or other derivatives
• Minimum market cap of $500 million as of the starting date – this is probably to keep people from winning by manipulating a thinly traded microcap stock.

In order to win this type of contest, you pretty much have to treat it like a free lottery ticket and make your selections accordingly. There is no risk-adjusted return to consider, and no downside to taking extreme losses. So on a short timeframe, and in a long-only US stock portfolio, you’re looking for something highly speculative that’s going to move a lot.

Before I read the rules, I was thinking that with a million real dollars at stake, someone would game the system by thrashing a microcap issue back and forth, but the $500MM market cap requirement makes it harder. Not out of the question, but probably not worthwhile for anyone in a position to control the stock price.

Since we can’t trade the easily manipulated microcap stocks, I’d look for low float, heavily shorted small cap stocks that have some positive opportunity for event or news driven movement. Some general areas to look:

• Biotech development companies that have regulatory approval or conferences coming up
• Despised companies that are potential buyout candidates
• Disaster / event driven companies, such as avian flu, anti-terrorism, or whatever you can think of
• Fad driven trades. Last year it was ethanol and energy drinks. It might be ethanol and alt-energy again this year

These are all exactly the opposite of good investment or trading approaches, but the contest has a binary outcome – either you win or you don’t. By taking on extreme levels of portfolio risk, you’re trying to increase the variance of portfolio returns during the contest period, in hope of coming up with the highest outlier by the end.

A contrarian approach might be to stay in cash or very conservative stocks, and hope that everyone else makes speculative bets that crash and burn.

Hmm. I just looked at the rules again, and they also have $10,000 prizes for each week’s best 1-week return. This actually increases the incentive for finding a more-or-less binary, news-driven trade each week (such as earnings, court ruling, regulatory approvals). If it works out, your portfolio goes up. If it goes down, it doesn’t affect your 1-week return for the following week.

I was going to run a scan for this over the weekend, but perhaps I should try to dig something up for this week in case something works out.

Needless to say, this isn’t how one should invest or trade with real money.