If you aren’t familiar with Trading Places it’s an 80s movie with Dan Akroyd and Eddie Murphy. In it, Akroyd plays a rich boy investor for a prestigious company. Murphy is a homeless con-man. The owners of the company conspire to sabotage Akroyd’s life in an experiment, essentially putting Murphy in his place. Eventually of course Akroyd and Murphy learned that they were simply pawns in a bet, and decide to get back at the owners of the company.

It is perhaps one of the best movies in the world of investments, mostly because it’s one of the few that manages to be funny. Though the story is fiction, there is still much to be learned from its events. I’ve grabbed two, the first of which does not ruin the ending, however the second one does. Feel free to ignore the second one if you don’t already know how it ends.

Scene 1:

Allow me to set the scene. Eddie Murphy now works for the investment company and he thinks he has some thoughts as the owners decide to purchase pork belly futures, a commodity item.

As you just saw Murphy seems to understand the irrationality of investors perfectly. Much of this comes from his knowledge of the human psyche. Whereas most investors allow emotion to control their investment decisions, Murphy is able to capitalize on those emotions and make “the Dukes” a lot of money. In the world of hedge funds the ability to control your emotions and make smart decisions are rare and valuable skills

I would be remiss of course if I didn’t point out an underlying flaw with the scene. Though Murphy is accurately able to predict the behavior of other pork traders, he would not be able to predict the actual price in which it would be good to start buying them again. Perhaps with a dozen charts and a team of analysts he could predict a technical breaking point, but without that this was at best a gut feeling. Don’t let it take away from the scene though, this is classic behavioral finance.

Scene 2:

Remember watching this clip will ruin the ending of the movie. Though I’ll admit I first heard of the movie by watching this one scene and it did not spoil the goodness of the film.

Now allow me to set the scene once again. Akroyd and Griffin have teamed up to take down the Dukes. The Dukes have conspired to steal a crop report from the Department of Agriculture. The report has crop estimates of oranges for the coming year. Like a release of GDP or learning of company earning before they are released, having this information could make you rich over night with a few simple trades the day the report is released.

Ackroyd and Griffin replaced the stolen report with a false one. The false report says that the crop will be low, meaning that orange juice futures will be in high demand, thusly increasing the price for them. The actual report states that the crop will not be low.

This clip gives a good explanation for how commodity trading works. Let me explain what happened. When trading began the Dukes had a trader immediately start buying because the report would come out soon. They would buy the futures low, and then sell them after the price spikes with the report release.

The price started increased about 40% in a few minutes. At this time Akroyd and Griffin announced that they were selling future contracts. In order to sell you do not need to own any juice, only have the ability to deliver them on the date of the contract. Desperate traders got confused and the price started going down. As the actual report is released everyone learns they’ve overbought the futures, the Dukes now own tons of futures that they can’t sell. After the price falls below $50 our heroes start purchasing contracts which will allow them to make delivery on the contracts they’ve sold. Essentially, they are going to deliver orange juice to someone for $140 when all they paid for it was $29. Because they did this many times over, in a matter of minutes they are millionaires.

The Dukes on the other hand are stuck with their overpriced contracts. That alone doesn’t ruin you, however they made a classic investing error, buying on margin. This means they used borrowed money to purchase the futures. When you use borrowed money to buy a security and the price falls below a certain point, your broker then initiates a margin call. This means the broker wants you to have more cash on hand to back up all the money you borrowed. If you don’t you’re in trouble.

The lesson here is that there is no sure thing. The Dukes thought they knew exactly what would happen and placed bets accordingly. Using borrowed money they did not diversify their investments to protect in case of a downward swing in the market. What you should do is always invest in diversified assets and never use borrowed money on any investment.

Again this scene is not perfect. It is impossible for the price to swing as far up or down as it did in a given trading day. Trading would be stopped because the exchange would know something is terribly wrong in the market. However the big swing in prices does better illustrate the point. It is perhaps possible that the price would swing from $100 up to $110 and down to $90 in a given day. This would be a huge market swing in and of itself.

The real reason I wanted to show these clips was not to teach you something, it’s because the movie is really good and I want you to watch it. Attached below are the scenes leading up to the clip above and the immediately following it.

By The Weakonomist

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categories: investing