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How studying Goldman Sachs can help you become a better trader

Kathleen Brooks
LAST week, Goldman Sachs announced profits of more than $13.3bn, even as some of its competitors continue to struggle. So what is the bank doing so right? We look at five ways you can adapt your hedging, research and risk styles to a Goldman style and hopefully boost your revenues.

1. Do your research
Goldman’s teams of economists and researchers are just as important to its performance as its traders. It was Goldman that paved the way into investing in emerging markets when its chief economist Jim O’Neil wrote in 2001 that Brazil, Russia, India and China would be the world’s largest economies in 50 years. It was O’Neil who came up with the acronym BRICs. Only if you do your research can you be ahead of the curve.

Now, apparently, the bank is backing US power plants and renewable energy projects. This could be a good lead indicator for where commodities trading will be in five years time.

Even if you are a short-term spread better, you should spend time doing your research. Step away from the charts and take a strategic view on the future direction of the global economy. You can only understand the small picture if you see the big one.

2. Hedge
Goldman Sachs’ hedging strategy helped it during the financial crisis. Back in 2007 at the peak of the mortgage boom, Goldman could see past the irrational exuberance gripping the market and shorted mortgage-backed securities. That was just at the right time. Soon after that, the sub-prime house of cards started to collapse, bringing down Lehman Brothers and Bear Stearns.
Goldman also purchased insurance against losses on various high risk assets it owned with AIG. It then bought risk against AIG failing. Goldman came under attack when it received $13bn from the US government, which had to bail out the beleagured insurer. However, Goldman’s risk management system was faultless and protected the bank from everything bar global financial collapse.

Spread betters would do well to think like Goldman and ensure they are hedged, just in case a large position moves against them. It could also prevent you getting wiped out by volatile markets.

3. Be Dynamic
Goldman’s dynamism is the key to its success. Rather than having rigid structures it is flexible and moves to where the market opportunities are most abundant. For example, in 2007 Goldman made record breaking profits. Its asset management business had net revenues of more than $4.4bn and it could charge high fees to its clients. In 2009, incentive fees were lower and revenues in this business fell by half a billion dollars.

Likewise, in fixed income, currencies and commodities trading, Goldman grabbed the opportunity when the markets started to bounce back strongly from their lows in March 2009. And the bank reaped the rewards. In 2007 fixed income, currency and commodities trading generated $16bn in net revenues. In 2009 it generated more than $23bn.

Don’t get married to your positions – instead, be opportunistic and jump on the back of a trend that looks like it will gather momentum. But, in true Goldman style, remember that timing is everything.

4. Be Careful
Keeping your risk and accounts under control is just as important for individual spread betters. Goldman’s Tier One capital ratio, which is the core measure of a bank’s financial stability and measures a bank’s core equity capital to its total assets, was 15 per cent at the end of December, and in 2008 it was 15.6 per cent. Ratios in the double figures are a good sign of financial health and Goldman’s are among the highest in the industry – Citigroup’s was 11.7 per cent in the fourth quarter of 2009 and Bank of America-Merrill Lynch’s 10.4 per cent.
Spread betters should ensure they have enough of a cushion in their portfolio in case one trade racks up unexpected losses. One of the first rules of trading is that you should never bet more than you can afford to lose and that requires not overstretching yourself. It is generally recommended that you only use 2 per cent of your portfolio on any one trade. Keep track of how your positions are performing and be prepared to get out quickly if the market turns against you.

5. Be Brave
Never be afraid to put your money where your mouth is. Even in a market when many people were sitting on their money, Goldman was trading like never before in 2009. Take these statistics as proof: in the third quarter of 2009, Goldman Sachs’ trading revenue as a percentage of gross revenue was 59 per cent. The number for JP Morgan was 14 per cent for Bank of America, 3 per cent, and Citigroup -2 per cent.

It’s not just about bravery, though. Insiders say that at Goldman, older traders generate ideas, which they then pass to the younger ones who actually execute the strategies.

University of Cambridge research backs up this strategy, showing that the more experience traders have, the more money they make. So the other lesson is that you should keep on plugging away. You’re sure to improve with age.

2009 In Numbers | Goldman Sachs

Income:
Net Revenues of $45.17bn
Net earnings of $13.39bn
Fixed income currency and commodity trading net revenues: $23.32bn
Equities revenues: $9.98bn
Asset management net revenues: $3.97bn
22.5 per cent return on equity

Costs:
Operating expenses: $25.34bn.
It incurred $6.44bn in corporate taxes

Dividend and Bonus pool:
It will pay a dividend of $0.35 per common share on 30 March 2010
Goldman’s bonus pool was reduced by $4bn to $16.19bn, a 20 per cent reduction from 2007 (but up on 2008).