I'm just a degenerate gambler and don't understand what this is all about!
I'll try to explain in the form of a parable.
In a universe far away there is a planet known as Oyth that is very similar to ours but with some differences. One of the countries on that planet, known as the United States of Gringoland, holds a very important and popular horserace every four years, known as the Freakness. The Freakness lasts for 3 years (horses there have much more endurance there than on this planet) and the horse that wins the Freakness is awarded a magical equine nirvana collar which gives the horse that wears it a highly pleasurable sensation. Only one such collar exists in all Gringoland. It is also believed that the horse wearing the collar often psychically transfers a small portion of his feelings of nirvana to the owner of the horse and even to those who cheer the horse on during the race.
In the latest Freakness which is in progress at this moment, four horses are participating in the race. Their names are Hillary (who happens to be the first filly ever to participate in the Freakness), Barack, John, and Mr. Al. The names of the owners of the horses are Mr. Centrist, Mr. Liberal, Mr. Leftist, and Mr. Environmentalist. Right now Hillary has a strong lead, followed by Barack, and neck and neck for last place are John and Mr. Al.
At the racetrack there were four very interesting people present. We'll call them Mr. Deloony, Mr. Slaughtermeyer, Mr. John Q. Public, and Mr. Hammer. Many friends of Mr. Slaughtermeyer and Mr. Public were present at the racecourse too. Mr. Slaughtermeyer, who favored Hillary, and Mr. Public, who believed that one of the other horses would win, were overheard by Mr. Deloony telling each other how they wanted to bet against each other on the race, but that the laws of Gringoland prohibited such betting. Mr. Deloony, a prominent businessman who happened to be a citizen of the country of Eyeland whose border is only a few hundred feet away from the racetrack and where gambling is legal, came up with an idea. He told Mr. Slaughtermeyer and Mr. Public, "Hey, come across the border into Eyeland where gambling is legal and you can make the bet between yourselves there. I'll hold on to the money and pay the winner after the race. I'll charge a 5 percent commission for my services." Mr. Slaughtermeyer and Mr. Public were happy to agree to pay the 5 percent commission for the opportunity to make their bet.
Soon the news spread like wildfire that it was possible to go to Mr. Deloony across the border in Eyeland and place bets using his services. Mr. Deloony was so swamped with bettors wishing to bet against each other that he decided to start a betting exchange in Eyeland that operated on the internet and at which transactions could be made directly from the racetrack using mobile devices. He named his exchange Sintrade. Because Sintrade operated on the same general principle as a commodity futures exchange, people could even reverse their bets at whatever the market price dictated if they changed their opinion about the outcome of the race. For a while Mr. Deloony worried that the authorities in Gringoland would crack down on his operation because of the illegality of gambling in Gringoland. Because Mr. Deloony did not book any wagers himself but only allowed others to bet against each other, he was able to convince the authorites in Gringoland that he was operating a "prediction market" and not a gambling operation. As a result his operation became very successful. It is very similar to the Intrade exchange (www.intrade.com
) operated in the country of Ireland on this planet.
Astute businessman that he fancied himself to be, Mr. Deloony came up with an idea to increase his profits. He noticed that during the beginning of the race, not too much fluctuation in the market prices of the bets for and against specific horses was taking place. So he decided to accept bets on margin. In other words, instead of requiring bettors to deposit the full amount of their potential loss, he required them to deposit only a small fraction of that amount, 50 cents for every contract worth 10 greenbacks, which is the currency of Gringoland. However, commission would be charged on the entire amount of the bet and not just the amount deposited for margin. Because people could wager higher amounts with margin, Mr. Deloony saw his commission profits likewise become higher.
Mr. Deloony implied that he would eventually raise his margin rate by requiring additional deposits to cover the full amount of the potential loss of the bet prior to the end of the race, but at first did not specify exactly at what point in the race such additional deposits would be required. Eventually, after about two thirds of the race had been completed and less than one month prior to the first rate change, Mr. Deloony made known the schedule of margin rate changes. In the month of August in their year 20007, bettors were notified that the amount of margin would triple to 1.50 per contract. At the same time, they were informed that margin would increase yet again to 2.50 per contract in September. In October the margin requirement would increase drastically to 100% of potential loss which depending on the market price of the contract could mean close to a total of 10.00 needed per contract. If a bettor could not come up with the additional margin, Sintrade reserved the right to itself liquidate that bettor's holdings to the point where margin was sufficient.
Mr. Slaughtermeyer was convinced that betting on Hillary to win the race was an extremely good bet prior to the summer of 20007 and accumulated a substantial long position in that contract by that time. He purchased his contracts in the mid-forties and by summer the contract was trading in the high sixties. Convinced that short selling the Barack contract was also a good bet, he also accumulated a substantial short position in that contract while it was trading in the thirties and twenties. This contract also eventually experienced a significant price move in his favor.
On Oyth, horses can talk. Because Mr. Al said that he wasn't really interested in exerting himself too much in order to win the race (he had a traumatic experience at the finish line at a previous running of the Freakness) and because he built his own equine nirvana collar for himself which he said he found to be very satisfactory, Mr. Slaughtermeyer accumulated an especially large short position against Mr. Al.
After the margin rate changes were publicised, Mr. Slaughtermeyer realized that he would need to start liquidating some of his positions in anticipation of the massive jump in margin requirements that would happen in October, because he wasn't sure that he would have access to sufficient funds available for the October margin increase if he kept all of his positions open. It's especially important to keep in mind that as his Barack position was gradually liquidated, he saw his margin requirements gradually decrease, so therefore he continued liquidating the contracts although he would have preferred to hold on to them in anticipation of Barack's loss.
Mr. Slaughtermeyer decided to hang on to as much of his short Mr. Al position as he could which he considered to be virtually a sure thing. When the September margin increase kicked in, Mr. Slaughtermeyer's available balance turned negative. Because funds which he sent to Sintrade did not arrive in time to completely eliminate the negative balance, Mr. Slaughtermeyer's account had a negative balance for most of September. However, whenever he liquidated Obama contracts he saw his negative balance reduced toward the positive direction, so he continued to liquidate his position to the point where he had only a small position in that contract at the beginning of October.
After the drastic October margin requirement increase, the negative available balance became much more substantial. Mr. Slaughtermeyer tried to continue to liquidate his remaining short Obama position but to his great astonishment he found that he was no longer able to buy Obama contracts, but was able at that point to short sell them! Prior to the October margin change he was able to only buy but not short sell them, even though he had a negative available balance both in Septimber and October.
Mr. Slaughtermeyer eventually came to the conclusion that he was able to short sell the Barack contracts in October because by doing so he actually reduced the maximum loss and risk in his account because it would be impossible for both Barack and Mr. Al to win the Freakness, and that the short Barack and Mr. Al positions mutually hedge the risk against each other. Mr. Slaughtermeyer concluded that he was able to buy Barack contracts in September but not short them because of a flaw in the margin software which did not take into account the risk reducing effect of having mutually supporting short positions. This conclusion was reinforced when Mr. Slaughtermeyer received an email from Sintrade stating that the margin calculation program used by Sintrade takes into account the risk reducing effect of mutually hedged short positions only when margin requirements are set at 100% worst case loss. Prior to worst case loss, the margin software did not take into account the risk reducing effect of having mutually hedged positions, but instead treated hedging as if it actually added to risk! But Sintrade denied that there is anything wrong, improper, or deceptive about having this kind of margin calculation!
Mr. Slaughtermeyer is very disappointed in the existence of this problem at Sintrade. Had he known that he would actually increase his risk and margin requirements in October by liquidating his short position in Barack, he would not have done so. He also believes that he should have been able to short additional contracts of Barack in order to hedge against his Mr. Al position while the lesser margin requirements were in place, which would have happened at a price of around 30 and therefore would have resulted in a substantial profit for him when the price of Barack contracts tumbled. If he had kept the short positions in Barack that he did liquidate at a relatively unfavorable price under the false impression that it was reducing his risk, his account would show more of a profit from that too.
Sintrade's position is that it is not liable for any losses that Mr. Slaughtermeyer experienced as a result of the way its margin software operates, and that if Mr. Slaughtermeyer does not deposit additional margin to his account to eliminate the negative balance by the end of today, it will close his account and liquidate positions sufficient to eliminate the negative available balance. Mr. Slaughtermeyer proposed that the matter be brought to an independent betting arbitration organization, but that proposal was rejected by Sintrade.
(to be continued)