Short Book Review: Black Edge (inside story of SAC Capital) by Sheelah Kolhatkar đź’¸
Last month I flew to California with five books. The first one I finished was Black Edge.
The story starts with a engaging summary of Steve “Stevie” Cohen’s rise from Brooklyn kid to the most successful day trader on Wall Street. I’d recommend the book just for that part of the story. It’s hard to understand today’s hedge funds without remembering how the market used to work, and where the “edge” originally came from.
In short, with today’s tools and understanding, it would be pretty easy to beat the stock market of the 1980’s. As I’m sure it would be easy to compete in any 1980’s competitions with what we know today. The sharp sport bettors must have made a fortune.
As the market evolved, becoming much bigger but also a bit tougher, Cohen maintained his edge, by hiring smart people. At first he looked for young men like himself, but Cohen was always open to new ideas. These days Cohen’s fund (a family office that can not take outside investors until 2018) invests heavily into quantitative analysis.
The book properly focuses on the ever evolving quest for edge, hence the title. According to former senior SAC analyst Jason Karp (I’m paraphrasing):
There’s white edge, with anyone can get from reading public filings; there’s grey edge, which isn’t freely available, and the person getting or giving that information should check with compliance first. Then there’s black edge.
According to another Wall Street friend (not associated with SAC or the book), there’s two ways to get edge in the stock markets:
- Have data or information that others don’t have.
- Analyze the data or information faster than others, and apply it to trades faster and more correctly.
Actually he claims there’s a third edge, which is to predict what other players will do in the stock market — treating their bets as a poker game of sorts. Not just predicting the giant pension funds with positions that will move the market, but anticipating at which point the short sellers will get out of a stock.
It’s no secret that many hedge funds sold Chipotle stock short, after an E. coli health scare came out in November 2015. There were three ways to make money betting on Chipotle stock, as the story developed:
- Find out before others that the company had a health incident.
- Sell the stock more quickly than others based on that information.
- Find out (or correctly predict) that a giant holder of Chipotle would dump the stock, or conversely that the stock has dipped enough, and smart buyers will start buying it up at the current price.
None of these trades are inherently about what Chipotle is worth in the long run, or even its Price/Earnings ratio for the year to come. There’s games beyond the game, as Stringer might say.
The day before I left Brooklyn for California, I watched FourSquare’s CEO Jeff Glueck proudly boast that his company predicted Chipotle’s year-to-year sales in Q4 down by 29.1% — the real drop was 30.0%. The social check-in company now makes $500M a year selling aggregated, anonymized foot traffic data to interested customers, presumably hedge funds.
Ms. Kolhatkar does a great job showing the reader hat in this world information — and therefore edge — is king. She tells the story from the lens of Cohen’s former employees [a few clearly contributed to the book], the regulators, and many of the smaller fish “in the game” to borrow again from The Wire.
Her book is a great compliment to Billions, and possibly the best book on finance that I’ve read in some time. Certainly the most engaging. Two thirds of the way through, the author’s resentment for Wall Street does start to seep in. I give her credit for keeping it out in the earlier sections. It must be hard to spend so much time with these money men and not resent at least some of them, at least some of the time. Even if you accept that they will always be here, and some of them do a great deal of good with their winnings. Billions is great on that.
I should probably close. I have no interest in spoiling the book — and I recommend it highly. Please go out and buy it.
For those who want a little bit more, I will make one more point.
It’s much cheaper to bet long on a stock than to sell it short.
Since Congress banned the “naked short” [betting on a price fall without owning the stock], a hedge fund has to borrow a stock [buy it from a mutual fund that owns the stock] before it can sell the stock now and benefit from the price going down to buy it back later. The stock then has to be bought back from the market, and returned to the mutual fund. Sometimes a prime broker will do this on a hedge fund’s behalf… for a fee.
More importantly, a stock can go up more than it can go down (since the floor on any stock is $0, and in practice, usually higher than that). In short, it’s expensive to bet on a stock price falling. Therefore if you are 60–40 sure that a stock will go down in the next quarter, you may just exclude it from your portfolio to enhance your β, rather than sell the stock short. Whereas you’d gladly buy the stock if it was 60–40 to increase soon, according to your analysis.
FourSquare’s Glueck took pride in his company predicting Chipotle’s falling sales so precisely. They aren’t just selling their hedge fund clients information, but rather selling them information with confidence values.
If you *know* that a company’s sales will be down by 29.1% plus/minus 2.0%, you can make a strong directional bet, including on the short side. There are other uncertainties in your model, but the same-store sales you will know with high confidence, while your competitors at the betting table only know that the next quarter won’t be good for this burrito chain.
It’s perfectly legal and ethical to buy FourSquare’s data, and apparently to mine anonymized credit card receipts from Visa for the same purpose . If you got that information from Chipotle’s head office in Chicago, that would not be ok. But what if a guy told someone you know and you got it third hand? 🤔
Would you still play a game that had some advantage players, as long as it was a positive sum game? Is it the regulators or the randomness and the overflow of information in the markets that make the game beatable by those without all of the grey and black edge?
Black Edge doesn’t get into any of those issues. But it does tell an excellent story. Two thumbs up, with conviction. Mark this one a nine.
