Two is One and One is None

In the introduction of Trader Construction Kit, I discuss how some of the best, most practical lessons about decision making under stress come from other high-intensity professions like gambling, professional athletics, and the military. Even in a world where trading-related educational materials have become readily available there is still tremendous benefit from seeking out and integrating lessons from other disciplines.

One maxim that has stuck with me through the years came from reading about the Navy SEAL teams, who are taught in training that “Two is one, one is none” to hammer home the importance of redundancy, particularly with respect to mission-critical gear, tools, and infrastructure. This is a surprisingly relevant concept for professional traders, even though they are more likely to be metaphorically rather than physically underwater. For example:

·      I was once asked to price a structured transaction that involved delivering electricity to an industrial end user with only one existing path of transmission to their facility and a critical need for supply. Any problem with that single line or the path leading to it and there was literally no way to fulfill my obligations to the client, exposing my firm to potentially enormous non-performance penalties.

·      I once tried to establish a relationship with a financial firm that required, as a condition of taking us on as a counterparty, that all the firm’s trades be routed through their desk for execution, and they hold all of our positions. Seems like a good deal…for them.

·      I once had a colleague who put on a massively lucrative position at a physical commodity delivery point where there was only one other counterparty that would reliably transact. My colleague wasn’t worried, as the counterparty always made them good markets. Until they didn’t.

The financial markets are predatory environments, and aggressive counterparties will not hesitate to take maximum advantage of a trader who has allowed themselves to become trapped in a position. A trader’s primary defense is flexibility. Having more than one counterparty, more than one broker, and more than one product to trade significantly levels the balance of power in the negotiation over price.

When contemplating any speculative exposure, when evaluating any structured transaction, when analyzing any hedge to a risk, the trader must develop both a preferred implementation strategy and tiered list of alternatives that they can instantly pivot to, if needed. Some traders artificially limit their strategic alternatives by only considering certain types of strategies, products, or tenors. Cast as wide a net as possible when considering ways to express your view, then use a rigorous evaluation process to refine the list.

A trader must also take into consideration the current conditions and both the anticipated future conditions implied by their fundamental forecast and more extreme cases that could degrade the operational environment far beyond the normal levels of price and liquidity. An explosion of volatility often drives small and medium-sized players out of the market, leaving only larger more aggressive counterparties and a smaller set of liquid instruments to choose from.

A pragmatic assessment of the players present in the market and the current and future transactional landscape is critical for traders, particularly those specializing in illiquid or volatile markets and products.

Remember, in a crisis, two is one and one is none.