I'm not certain that Paulson could have afforded the losses if the market kept booming, so you're likely right about the six months earlier or later.

However in principle, this is exactly how Nassim Taleb (the Black Swan author) made his money during the 1987 wall street crash (iirc). At the time, people were selling options that hedged against large falls in price very cheaply. Taleb bought loads of them and profited hugely as a result of the crash.

Paulson's scheme was a little more complicated, but the formula was essentially the same - underpriced hedging instruments + crash = massive profit.

This quote from the article sums it up perfectly: Mr. Paulson became convinced investors were far underestimating the risk in the mortgage market. In betting on it to crumble, "I've never been involved in a trade that had such unlimited upside with a very limited downside," he says.

If the article is correct, and Paulson was actually short on ABX and mortgage-backed securities, the downside of his strategy was unlimited. Taleb's strategy (option trading) had a bounded loss.

It's unclear how balanced Paulson's fund was/is, but the article makes it sounds like he was playing with fire.

Yeah that was half his scheme, which is unbounded as you say.

The other half of the strategy, which the quote was about, was related to purchasing credit-default swaps, which are derivatives like options. The losses on CDS contracts are bounded.

But you're right... without knowing the balance between CDS contracts and short selling, it's hard to gauge how exposed he was.

He was talking about the downside loss strategically - not in the pedantic sense you are using.

> he was playing with fire.

You only make $15 billion with a shit-ton of leverage.

That's a good point. He broke one of the cardinal rules of trading:

Housing remained strong, and the fund lost money. A concerned friend called, asking Mr. Paulson if he was going to cut his losses. No, "I'm adding" to the bet, he responded...

By comparison, as Ed Seykota put it in the book Market Wizards, "The elements of good trading are cutting losses, cutting losses, and cutting losses."

I don't think he was 'trading'. Trading in that sense means, approximately, buying because smart people bought, and then selling to stupid people. A 'trader' of the sort Seykota (who was interviewed in, but did not write, Market Wizards -- you're thinking of Schwager) would wait for the ABX to fall, then short, then probably cover once it started to rise again.

Paulson was making a judgment that the market was wrong to price subprimes so high. Do you really think his thought process was "The market is wrong that they're worth X, when they should be at .4X. But if they move to 1.1X, they must be right!" He's thinking like a value guy in a macro trade, not like a 'trader'.

I know who the author of Market Wizards is. The comment I quoted is Seykota's. The distinction is rather significant since one of the two is among the greatest traders of all time while the other is not.

Most successful traders emphasize that adding to a position that is showing you a loss, because you believe you are right and the market is wrong, is a losing strategy in the long run. That suggests that Paulson won with a losing strategy, which suggests that timr has a point.

Perhaps you are correct that there is something other than "trading" in which people routinely add to losing positions and end up making money when the market changes to confirm their judgments. It would certainly be something other than winning trading.

I misunderstood you. My apologies. I was under the impression from other interviews in the book that Schwager followed the same strategy.

The thing is, trading can't be the only successful way to make money, or even more successful than other traders on average -- because trading implies buying more as the market confirms your views, and if that's profitable, it implies that traders will own all the world's assets, and every asset will either rise infinitely or collapse to zero.

If it helps, you could think of him as an arbitrageur betting that the mortgage market would converge with reality. That thesis relies on believing that the market misprices assets, so it seems that further mispricing would confirm it rather than belie it.

Warren Buffett would beg to differ with this strategy.

If you trade on value, you shouldn't really care what the market is doing. If risk is mispriced, buy more, even if the price is going down and you are losing money in the short term.

That presupposes you're right. But there's no way to know this for sure in advance, besides which nobody's right all the time. To do as you advocate guarantees that your losses, when they do come, will be maximal.

Whereas your trading strategy presupposes that someone else is right, but that they persistently under-react.

I find it more intellectually appealing to make my money taking a stand than to make it by saying "Me too, me too!"

Cutting a loss is synonymous with "selling low".

I must not have understood you... let me try again. You object to Seykota on the grounds that cutting a loss entails taking a loss. That's objectionable because losses are objectionable. Did I get it?

Of course, a big loss is more objectionable than a small one.

Sure. But you can never know before which way the prices go.

Not if you're short.

Sigh. "Buying high" then.

Rules of thumb can be applied without thinking to control both chance of failure and chance of a crazy success.

Yes, but that's the point.

These types of risks are always brilliant when you win, and stupid when you lose. Articles like this one teach you little, other than the value of good luck, and great timing.

(also, for the record: I agree wholeheartedly with the spirit of his investments; I'm a housing bear too. But I'm also realistic enough to know that he got lucky, using a decidedly risky investment strategy. With hundreds of millions of dollars short in an admittedly irrational market, one bad month of excessively irrational market behavior could have wiped him out.)