A tale of Infamy

There tend to be two types of people who seek out jobs on Wall Street. The first are those with wealthy parents who were sent to the right prep schools and Ivy League colleges and who, from their first day on the trading floor, seem destined to be there. They move through life with a sense of ease about themselves, knowing that they will soon have their own apartments on Park Avenue and summer houses in the Hamptons, a mindset that comes from posh schooling and childhood tennis lessons and an understanding of when it is appropriate for a man to wear seersucker and when it isn’t.

The second type call to mind terms like street smart and scrappy. They might have watched their fathers struggle to support the family, toiling in sales or insurance or running a small business, working hard for relatively little, which would have had a profound effect on them. They might have been picked on as children or rejected by girls in high school. They make it because they have a burning resentment and something to prove, or because they have the ambition to be filthy rich, or both. They have little to fall back on but their determination and their willingness to do whatever it takes, including outhustling the complacent rich kids. Sometimes the drive these people have is so intense, it’s almost like rage.

Steven Cohen came from the second group.

As he reported for work one morning in January 1978, Cohen looked like any other 21-year-old starting his first job. He could hear the roar of the trading floor, where dozens of young men were chattering away on the phone, trying to coax money from the people on the other end of the line. The room was alive with energy. It was as if a great oak tree were shaking in the middle of an autumn forest and leaves of money were raining down. To Cohen it felt like home, and he ran right in.

Gruntal & Co. was a small brokerage firm located around the corner from the New York Stock Exchange in the gloomy canyons of lower Manhattan. Established in 1880, Gruntal had survived the assassination of President McKinley, the crash of 1929, oil price spikes, and recessions, largely by buying up other tiny, primarily Jewish firms while also staying small enough that no one paid it much attention. From offices across the country, Gruntal brokers tried to sell stock investments to dentists and plumbers and retirees. When Cohen arrived, the firm was just starting to move more aggressively into an area called proprietary trading, trying to make profits by investing the firm’s own money.

For an eager Jewish kid from Long Island like Cohen, Wall Street didn’t extend an open invitation. Even though he was freshly out of Wharton, Cohen still had to push his way in. Gruntal wasn’t well-respected, but he didn’t care about prestige. He cared about money, and he intended to make lots of it.

It so happened that a childhood friend of Cohen’s Ronald Aizer, had recently taken a job running the options department at Gruntal, and he was looking for help.

Aizer was 10 years older than Cohen, had an aptitude for math, and had autonomy to invest the firm’s capital however he wanted. On Cohen’s first day, Aizer pointed at a chair and told his new hire to sit there while he figured out what, exactly, he was going to do with him. Cohen sank down in front of a Quotron screen and became absorbed in the rhythm of the numbers ticking by.

The stock market distills a basic economic principle, one that Aizer had figured out how to exploit: The more risk you take with an investment, the greater the potential reward. If there’s a chance that a single piece of news could send a stock plunging, investors expect greater possible profit for exposing themselves to those potential losses. A sure, predictable thing, like a municipal bond, meanwhile, typically returns very little. There’s no reward without risk — it is one of the central tenets of investing. Aizer, however, found an intriguing loophole in this mechanism, where the two elements had fallen out of sync. It involved stock options.  

The market for options at the time was far less crowded than regular stock trading — and in many ways, more attractive. Options are contracts that allow a person to either buy or sell shares of stock at a fixed price, before a specific date in the future. A “put” represents the right to sell shares of stock price drops, allowing him or her to sell the underlying shares at the agreed-upon higher price. “Calls” are the opposite, granting the holder the right to buy a particular stock at a specific price on or before the expiration date, so the owner of the call will benefit if the stock rises, as the option contract allows him or her to buy it for less than it would cost on the open market, yielding an instantaneous profit. Investors sometimes use options as a way to hedge a stock position they already have.

At Gruntal, Aizer had implemented a strategy called “option arbitrage.” There was a precise mathematical relationship dictating how the price of the option should change relative to the price of the underlying stock. Theoretically, in a perfect market, the price of a put option, the price of a call option, and the price at which the stock was trading would be in alignment. Because options were new and communication between markets was sometimes slow, this equation occasionally fell out of line, creating a mismatch between the different prices. By buying and selling the options on one exchange and the stock on another, for example, a clever trader could pocket the difference.

In theory, the technique involved almost no risk. There was no borrowed money and relatively little capital required, and most positions were closed out by the end of the day, which meant that you didn’t develop ulcers worrying about something that might send the market down overnight. The strategy would be rendered obsolete as technology improved, but in the early 1980s it was like plucking fistfuls of cash off of vines — and the traders at Gruntal enjoyed bountiful harvests. All day long, Aizer and his traders compared the prices of stocks to their valuations in the options market, rushing to make a trade whenever they detected an inconsistency.