- 1999: Volume 8, No. 2 The Mind of a Trader: Trading with Other People's Money

Many traders dream of going it alone and managing money. So what are the pitfalls that a private trader working for himself should be aware of when competing against the institutions?

Bill Lipschutz is an institutional investor who went it alone and set up his own company. Lipschutz was Global Head of Currency Trading at Salomon Brothers at the end of the 1980s. If ever there was a right time and a right place for a trader, that was it-then and there.

Over the eight years he was there, Bill Lipschitz earned for his employer an average of $250,000 profit each and every trading day. Here is a man who knows his trading.

It Not All the Same Money: Source and Effect

Bill left Salomon in 1990 and currently has a company called, Hathersage Capital Management, focusing on FX Trading.

It is often not realized that the source of trading funds can affect one's trading style and performance. As Bill Lipschutz explains, this fact is something even the most experienced traders do not appreciate until they experience it.

"I was unaware that there were these differences. Seven years ago, I had a naive view that you get the money from here, or from Salomon Brothers' proprietary capital, whether it is 10 high net worth individuals or a fund of funds, I felt it was all the same; let me see how much I can extract from the market.

"The whole money-management game is a difficult game. It has not only to do with how well you perform, but what kinds of results people are looking for in their portfolios. Absolute performance is a real misleading thing. I can say to you, 'we were up 600 percent' over five years in our most aggressive program, and you might say, 'wow, 600 percent.' But that does not necessarily mean that much in and of itself, without knowing how well other currency-only managers performed. For example, say a guy is managing $200 million, and $120 million of it is a fund that he runs with a very specific mandate. If he made 600 percent over four years in that particular fund, he may have people pulling money out, because they are nervous, because that really was not the kind of variance they were looking for. So, it is very complicated."

How the Lender Constrains

As Bill Lipschutz explains, one way the source of funding can affect your trading style is through the motivation of the lender and the terms on which the funds were granted. We all, as traders, seek more capital with which to trade. Whatever the source of money, you must be aware that since it can affect your trading style, it may also affect your trading performance. The worse time to have a deterioration in your trading performance is when the money is not your own.

"But, now when you have to charge clients, the client says to you, 'I know you are a speculative guy, or you can be a speculative guy, I am willing to lose 20 percent.' I have sat with clients, and we try to talk with our clients and really understand what they want. If a guy looks me in the eye and says, 'I can be down 20 percent, no problem.' I know he really means 5 percent, because if you call him in three days and say, 'you know what, you're down 18 percent, I just wan'na know how you feel, so we can discuss what to do from here,' he's going to forget he ever said he was comfortable with a 20 percent loss."

"Regardless of what they say, because they are not traders, they don't understand, they certainly do intellectually, I am not trying to take anything from them, but they don't understand it emotionally, necessarily what they are getting into. When you are charged with other peoples money you have to help them and not let them get into something they are not emotionally ready for yet.

"Sometimes being wrong, even if there is a five percent chance of that happening, is a whole lot worse than being right, even if there is a 95 percent chance of that. It's the old, 'gee if I make 25 percent for these guys, they'll be really happy, and they'll think I am a great trader and I'll earn big fees.' 'But you know what, if I lose 5 percent for these guys they're going to pull that money out and I am going to be close to being out of business.' But that is not the probability of the trade succeeding or failing. So you have to lay this on top of the probability of the trade succeeding or failing. It is very complicated. It's a whole set of simultaneous constraints that you have to solve at once."

Therefore, trading with other people's money becomes far more complicated than with one's own. You have to consider both the likely outcome of the trade and the likely reaction of the investor to a positive and a negative trading outcome. The decisions you can make are restricted by the likely responses of your client. That in turn could impinge upon your trading performance.

A Checklist

So, before taking on new funds, ask yourself the following questions:

• What does the lender say he expects?
• What does he really expect?
• Have I traded successfully in the past in the manner required by the lender's expectations?
• Can I deliver what the lender really expects?
• What are the consequences for me if I fail to deliver?
• How much control does the lender want?
• How frequently is the lender going to inquire about the performance?
• What type of personality does the lender have? Is he likely to pester and aggravate?
• Can some ground rules be set?

Alpesh B Patel is a barrister-at-law. He has extensive experience in both the U.K. and U.S. derivatives markets. He is the author of The Mind of a Trader: Lessons in Trading Strategy from the World's Leading Traders and Trading Online: A Step-by-Step Guide to CyberProfits (both published by Financial Times Pitman Publishing). He also runs trading seminars. For more information, visit www.ftmanagement.com/tradingonline