Lessons From A Trading Great: Linda Bradford Raschke

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I realize that I’m only human, and that I’ll always make mistakes. I just try to make them less frequently, recognize them faster, and correct them immediately!

We can thank Linda Bradford Raschke for that important bit of trading wisdom.  

Only the very best can battle the markets over the long-haul and still come out on top. Linda Bradford Raschke is one of these traders. She’s been at the game for over three decades and still manages to clean up. You probably know the name. She was featured in Schwager’s The New Market Wizards book (hers was the best chapter in your author’s opinion).

If you haven’t already I highly recommend you go and check out her latest book Trading Sardines. It’s a fantastic read, full of humor and valuable trading wisdom from a decorated veteran of the game.

Linda’s traded from all sides of the business; as a market maker in the open outcry pits, as an individual trader for her own account, as well as a fund manager for institutional investors. She’s literally done it all.

In this piece, we’re going to explore Linda’s methods, habits, and practices. We’ll breakdown how she approaches markets and the tools she’s used to make a consistent killing over the years. Let’s jump in!

Linda’s Trading Program

Linda segments her trading between four different strategies (she calls them profit centers). Each profit center has a different approach to the market so that she can diversify her revenue streams. Not all of them bring home the bacon each year, but she counts on at least one of them to make her nut for the year.

LBR Profit Center 1 — S&P Day Trading

S&P day trading is Linda’s bread and butter. 95% of this trading is in the E-mini S&P 500 futures contract as opposed to the other stock index futures like the Rut, DOW and NASDAQ. This was her original program and still to this day, her most consistent producer.

She stresses that successful day trading in the S&Ps requires contextual awareness. Do the odds favor a low to high day or a high to low day? Is it likely a trend day or a consolidation day? Getting this context right makes the trading day much easier.

Linda likes to fade the noisy fluctuations of the S&Ps as the market awaits a big economic report or FOMC release. On light volume days she likes to fade the tests of the intraday range.

But her biggest money maker is on high volume high vol trend days. Once Linda has the market by the tail she presses hard and rides her position into the close. There’s more on her big bet philosophy in the ensuing sections. Her “secret sauce” (like many of the other wizards) is knowing when to size up and “go for the jugular.”

LBR Profit Center 2 — Swing Trading

Her second profit center involves swing trading on the major futures contracts with a 1-3 day holding period. Losers get cut quickly.

For these swing trades, Linda generates entry signals based on 2-period ROCs and other momentum readings. Even with all the fancy computer equipment available, Linda still chooses to manually write down the indicator reading and closing prices for the 24+ futures markets that she tracks. Writing the data down every day helps keep her in tune with the market in a way that just following things on a screen can’t.

LBR Profit Center 3 — Daily and Weekly Classical Charting Trades

The third trading strategy generates profits using classical charting patterns with Peter Brandt style execution. Like Peter, her entry signals are discretionary but she does her best to quantify her process and patterns via ATRs, pivot points, and swing highs and lows.

To manage these trades she likes to use a trailing stop to see how much the market will give. If momentum begins to move against her, she will override the trailing stop and exit the market at the close.

She finds that her best trades come from daily swings turning up or down (false breakouts) rather than the breakouts of chart formations.

Over the course of her career, Linda has noticed that a particular market will give roughly 14-20 reasonable swings per year. Her goal is to just capture one great swing a month. If she does this then she’ll usually have a great year — provided she pulls back her aggressiveness when the market enters a period of low volume churn.

LBR Profit Center 4 — The Everything Else Bucket (Special Situations)

Linda dips into this bucket during severe market dislocations. One of her favorite trades is to fade sentiment extremes with an option structure that allows her to take the other side of consensus fear/greed while keeping her risk capped. For bullish bets she prefers the long call spread, and for bearish bets she deploys the long put spread. This keeps her risk tightly defined in the incredibly volatile market conditions that accompany extremes in sentiment.

She’ll also take seasonality trades under this bucket. Seasonality trades are generated from patterns in the commodity markets. Check out this website for more info on commodity seasonality.

The defining characteristic of this bucket is that the opportunities are rare. And because of that they are not easily modeled.

Rare opportunities usually mean fatter edges because they can’t as easily be arbitraged away by a professional quant firm that uses immense computing power to search for patterns in reams of market data.

That’s the skinny on Linda’s trading setups. But setups are only a small part of what makes a trader of Linda’s caliber. In Trading Sardines she explains how successful trading requires much more than finding a good chart pattern. It’s about having a sound process, robust research methods, solid position sizing, good market reads and a healthy lifestyle away from the trading screen.

A Strong Trading Process

In trading, a good process leads to good profits.

Linda refers to her trading as a business. She uses terms like profit centers and costs. That’s a great way to frame it because one must approach trading with the same seriousness and discipline as one would running a business.

Successful businesses keep meticulous records so they know what’s working and what isn’t. Based on this feedback the leader will adjust fire and calibrate the process appropriately.

Linda does the same for her trading.

She monitors each of her four profit centers on a quarterly basis. Her performance will come from different programs each quarter depending on market conditions. If she finds that one profit center is consistently underperforming she’ll tweak her approach until it starts producing again.

One indicator she likes to look at is trade frequency. If trade frequency for one of her programs comes in way higher or way lower than normal she knows there’s likely an execution error going on. This usually means she’s overtrading, not getting rid of losers quickly enough, or trading while sleep deprived.

We follow a similar protocol here at Macro Ops. Each quarter we review our results and segment them by market and trade strategy type. We discard what’s not working and keep what does.

Another thing all successful businesses have in place is a crisis management plan. Linda has hers for trading. If an execution error occurs she immediately corrects course, no questions asked.

Linda talks about a time where she came into the open incredibly bullish on the S&P E-minis. But instead of going long she accidentally put on a large short. Instead of monkeying around and trying to find the perfect exit to limit her losses, she immediately cut the trade and went long.

“Correct mistakes immediately” has saved Linda millions of dollars over her trading career.

On Models and System Building

Linda has her four core profit centers that work for her — but that doesn’t mean she stops refining her old edges and at the same time searching for new ones.

She is constantly scrutinizing and scouring around for new and improved approaches — the markets force you to continuously adapt or die.

Linda’s not a 100% mechanical trader but she tries to systematize as much as possible to take some mental burden off of herself so she can focus on the tape. Here’s her explaining this in Trading Sardines.

I was never a systems trader though I try to stay systematic. It is hard for me to give up the control I get with tape reading. I don’t want to give up control, period. I would like to believe my experience gives me an edge. But some people will only be able to make money following a system.

She also mentions that if you do use a system it has to be your system. This is in line with what we preach here at Macro Ops. You can’t succeed long-term blindly following somebody else’s approach. Here’s Linda again (emphasis mine).

The problem is, it’s hard to muster the necessary confidence in a system unless you develop it yourself. Systems, even ones that make 100 trades a month, can go through brutal drawdown periods. And if the system isn’t your baby, you’ll abandon it with a loss instead of adhering to it long enough to recover a drawdown.

To vet system ideas Linda is a fan of manual backtesting.

My best work came from testing by hand. I could see where a signal worked and why. I could also look at the conditions where signals failed. When testing with a computer, too much data gets lumped together. This often cancels things out and it is easy to miss the subtle nuances that lead to learning. I’ve learned more by notating signals on charts, studying when signals don’t work, looking for secondary or confirming signs, and recording seas of data by hand. There is no way I could have created my numerous nuanced tactics by backtesting and doing computer runs.

This is exactly how our resident systems trader at Macro Ops, Chris D. does his research.

He’s all about manual backtests so he can develop a feel for the signal and the underlying market. You also see ways to subtly improve things that a computer can’t catch.

Even though Linda is a discretionary trader she likes to build her trade ideas from the base of a model. Here’s why:

Most professional traders know things intuitively from experience. However, we are all subject to different cognitive biases. Models help us keep an open mind and guard against biases. They differ from mechanical systems but are an integral part of the trading process.

It’s possible to trade within the confines of a model or a framework but still allow enough flexibility so your trading is not 100% systematic. Using a model or framework to define trade ideas coupled with manual execution gives you the best of both worlds. The model keeps you from overtrading and the manual execution allows you to make adjustments depending on market conditions.

In Trading Sardines, Linda gives us some advice on how to start the modeling process. For her, it starts by asking some simple questions.

A modeling process starts out by asking simple questions. For example, what happens if you enter on a breakout of the first 15-minute bar after the opening? What is the distribution of how many ticks you can get in the next 15-minute bar? What happens if you enter on a breakout of the 15-minute bar going into the last hour and exit at MOC (market on close)? Is there a distribution pattern showing the most common time for highs and lows? The permutations are endless.

Once you discover the answers to these questions through backtesting and market research you can start to develop a real trading edge that will act as the foundation for your own profit center. Linda makes her models world-class by incorporating new information into each of her trades. This is a form of Bayesian inference — another concept we hound on again and again here at Macro Ops. Here’s Linda (emphasis mine):

Another essential step is to layer on top of our multiple model tree a form of Bayesian process. Start with the prior models and probabilities and then continuously update them as new information unfolds. One data point at a time. To go one step further, we can even weigh these new pieces of information. And as the volume of information increases exponentially, you see how easy it is to fall down a rabbit hole.

In regards to model building Linda offers up some wisdom on how to design exit criteria. She’s a fan of time-based exits.

Much of my modeling uses time-based exits. Exits on the close or the next day’s close, Exit after one hour. Exit when Europe closes. Time-based exits are not dependent on the range or volatility condition, and they are robust.

Instead of exiting based on a predetermined price target, time exits allow you to realize the full strength of the signal. Here’s more on her exit philosophy from her interview in New Market Wizards.

I’m also a firm believer in predicting price direction, but not magnitude. I don’t set price targets. I get out when the market action tells me it’s time to get out, rather than based on any consideration of how far the price has gone. You have to be willing to take what the market gives you. If it doesn’t give you very much, you can’t hesitate to get out with a small profit.

On Position Sizing and the Big Bet

At Macro Ops we’re huge proponents of the Big Bet and there’s a reason for that. All of the trading greats talk about how “going for the jugular” when the stars align with your approach to the markets.

Linda says the same thing in different words (emphasis mine).

When traders think about money management, they think about stops and trade management. But a big part of the equation is knowing when to go all in, increase the leverage and press your trading to the hilt. Load the boat. These opportunities have an increase in volume and volatility. There is no point in actively trading in a dull market. Let the market tip its hand and come to life first. And then if you are fortunate to be in the groove and know you’ve got a tiger by the tail, milk it for all it is worth. This is where the real money is made.

It’s possible to simply “get by” in trading by having an okay edge and proper risk control. But if you want to achieve market wizard status you have to know when to up size and bet big.

Linda’s first ever 7-figure day in the market came from utilizing the big bet strategy on the S&P E-mini contract (emphasis mine).

There is no more glorious feeling in the world than capturing a huge trend day. My first seven-digit day came from a short position in the S&Ps. The market was overbought, the sentiment readings showed too much bullishness, the 2-period rate of change was poised to flip down and my models lined up like a rare planetary alignment.

I had come into the day with a short side bias. When the market started selling off the opening, I added in a big way and held until the close.

I want to stress her planetary alignment comment here. Because this moment is similar to what Druck talks about when he says to go for the “whole hog” or when Warren Buffett mentions “swinging hard at the fat pitch.”

All market opportunities are not created equal which is why position size must vary depending on the expected value of the trade: EV = (Probability of Winning) x (Amount Won if Correct) – (Probability of Losing) x (Amount Lost If Wrong)

When trading a diverse set of markets like Linda it’s paramount to standardize the dollar risk of each contract so each trade risks a similar dollar amount. By not standardizing the risk between markets, the most volatile market will dominate the p&l.

Linda uses the average dollar daily range for each contract she trades in order to get all of her positions sized correctly.

Each quarter, we calculated the average daily dollar range per market. If gold had a 20-dollar average daily range over the previous 30 days, this translated into a $2,000 average daily dollar range. If the S&P e-minis had a 14-point average daily range, this is a $700 average daily dollar range. Gold sizing might be 4 contracts per million. If we had $100 million of AUM, it mean that 1 unit of gold equaled 400 contracts. In the S&P e-minis, 1 unit might be 10 contracts per million or 1000 contracts.

This is otherwise known as volatility-weighted position sizing. This ensures a trader risks similar amounts on each trade. Lower volatility instruments will need more contracts and higher volatility instruments mean fewer contracts. By sizing this way, fluctuations in highly volatile markets will equal the fluctuations in quieter markets.

In markets, there’s a time to play aggressive offense (and place the big bet), and then there’s a time to play aggressive defense. When positions move against you, Linda suggests to taking off size until you can think clearly again.

Whenever you have your back up against the wall, you have to get smaller. Reduce your size to the level where you can start trading again, because in these types of situations when there is uncertainty or unprecedented volatility, there is lots of money to be made. But you can’t do it if you are frozen or stressed, so figure out the level where you can function and trade freely again.

Taking size off when things go south will preserve mental capital and allow you to get ready to pile on again when general conditions favor your bias.

On Market Dynamics

It’s not the actual news that’s important — it’s the market’s reaction to that news that is most important to a trader.

Linda talks about this concept and gives guidance on how to best trade news driven moves.

If positive economic news is released and the market sells off on that news, this could also be perceived as an aberration. It is a divergence from what would normally be expected. But this, too, is the market’s way of imparting powerful information. In this case, it may be that there are no buyers left, or that the news has been long discounted.

Trade in the direction of the aberration. The market is never too high to buy or too low to sell.

Trading mastery requires a thorough understanding of the boom/bust process that plays out over and over again in public markets. Linda has studied the underlying dynamics of the boom/bust process to give her the confidence to trade bubbles when they are about to pop (emphasis mine).

There was a study done on price behavior when the field of behavioral finance was just coming on the scene. It simulated trading with groups of individuals who were not traders. The price of the market would always rise first. It kept inching higher until everyone had bid and there was nobody left to buy. At that point, it broke sharply with no support underneath.

To this day, this is one of the main reasons markets sell off—there is nobody left to buy.

That’s why at Macro Ops we are such huge fans of sentiment indicators. Sentiment indicators tell us when there is “no one left to buy.” Periods of extreme optimism set the stage for gut-wrenching selloffs. Linda exploits this same edge in her profit center 4 through the use of call spreads or put spreads.

On The Trifecta Approach: Combining Fundamentals and Technicals

The best traders in the game pull data and information from numerous sources to construct a trading thesis. Linda uses the “Marcus Trifecta” approach in her trading by first finding fundamental market imbalances and then entering the market via technical analysis cues.

She made tons of money trading the yen using this multi-faceted approach. Here’s an excerpt from Trading Sardines which describes the trade in more detail (emphasis mine).

The “carry trade” was a popular strategy from 2002-2007. Investors borrowed money in yen where interest rates were low and invested it in higher-yielding currencies. It was a crowded trade, meaning too many people were in this same position. What was going to happen when people needed to unwind?

I trade by technicals since I have not yet had much luck using fundamentals. But I am aware when there is a market imbalance implying a crowded trade. The yen was a ripe situation. It has left a bear trap or false downside breakout on the weekly charts. I tried twice to put on a position, both times unsuccessful. The third time I knew I got it right. It was our signal to load up. I don’t mind trying a few times if there is a basis for a position but the timing is off. The real key is to make it pay and use maximum leverage when the trade starts working. I told Judd to keep buying yen, and the ensuing rally made our year. The yen went straight up for the next five years as global interest rates came crashing down.

On Trading Lifestyle

Grinding an initial capital stake into millions of dollars takes time. Fortunes aren’t made overnight in the trading business. The big money is made by finishing the marathon, not the sprint.

Linda makes this clear and lays out many lifestyle strategies that maximize your chances of making a  real fortune from trading the markets.

She used the following three things over her long career to keep her mind and body fresh and ready to battle the markets day in and day out.

  • Gratitude practice
  • Physical fitness
  • Time off

The markets are volatile beasts which mean they will send your emotional brain into a whirlwind. In order to combat the push/pull of these emotions, Linda uses a gratitude practice to keep her grounded when things go wrong.

Gratitude is a key ingredient of success. It means that even when bad things are happening, you always have something to focus on. Just like pilots have a gauge to make sure they can still tell which way is up, gratitude keeps me from ever feeling upside down. When you are trading the markets, you have to have a separate source of happiness —- to know that there are still wonderful things all around, most of which do not require money. It is easier to take risks when you remove your personal happiness and well-being from the equation.

Gratitude leads to optimism, and a positive attitude is 90% of the game.

Linda was extremely active in the gym and even competed as a bodybuilder! The discipline required for her to compete in bodybuilding carried over into her trading program.

Trading and physical training have a lot in common. Every successful training routine requires the following:

  • A sound methodology
  • Consistent execution of that methodology through the use of daily rituals
  • Records of progress
  • Positive thinking and optimism

These are the exact same things needed to succeed in the trading grind! So if you aren’t already, get in the gym!

Finally, Linda recommends taking time away from the trading screens to refresh and recharge. A hobby helps to relieve stress. For her, this was horseback riding.

LBR has the whole package of a legendary trader — a burning desire to win, emotional fortitude to withstand the ups and downs of a trading career and the ability to “go for the jugular” when the market required it.

I want to end this piece with her advice on how to find success as a new trader (emphasis mine).

Understand that learning the markets can take years. Immerse yourself in the world of trading and give up everything else. Get as close to other successful traders as you can. Consider working for one for free. Start by finding a niche and specializing. Pick one market or pattern and leam it inside out before expanding your focus.

Finally, remember that a trader is someone who does his own work, has his own game plan, and makes his own decisions. Only by acting and thinking independently can a trader hope to know when a trade isn’t working out. If you ever find yourself tempted to seek out someone else’s opinion on a trade, that’s usually a sure sign that you should get out of your position.

Well said Linda… Now time to get to work!

If you liked this article, you will love Lessons From The Trading Greats Volume 1 which has more insight from the world’s best traders. Click here for a free copy!

The Difference Between Great Traders and Good Traders: The Art of Totis Porcis

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The following is an excerpt from Barton Bigg’s book, Hedgehogging, where he relates a conversation with “Tim”, a successful macro investor (emphasis mine).

Tim works out of a quiet, spacious office filled with antique furniture, exquisite oriental rugs, and porcelain in a leafy suburb of London with only a secretary. My guess is he runs more than $1 billion, probably half of which is his. On his beautiful Chippendale desk sits a small plaque, which says totis porcis—the whole hog. There is also a small porcelain pig, which reads, “It takes Courage to be a Pig.” I think Stan Druckenmiller, who coined the phrase, gave him the pig.

To get really big long-term returns, you have to be a pig and ride your winners… When he lacks conviction, he reduces his leverage and takes off his bets. He describes this as “staying close to shore… When I asked him how he got his investment ideas, at first he was at a loss. Then, after thinking about it, he said that the trick was to accumulate over time a knowledge base. Then, out of the blue, some event or new piece of information triggers a thought process, and suddenly you have discovered an investment opportunity. You can’t force it. You have to be patient and wait for the light to go on. If it doesn’t go on, “Stay close to shore.”

What separates the great traders from those who are just good?

The answer is knowing when to size up and eat the whole hog.

Let me explain.

To become a good trader you have to master risk management. Managing risk is the foundation of successful speculation. It’s the core of ensuring your long-term survival.

After risk, there’s trade and portfolio management. These are not wholly separate from managing risk. But they have the added complexity of things like thinking about when to take profits on a trade or how the drivers of your book correlate across positions etc…

Risk and trade management are absolute critical skills to becoming a good trader. All good traders are masters in these two areas.

But the thing that makes great traders head and shoulders above the rest, is the skill in knowing when to go for the jugular. In sizing up and aggressively going for Totis Porcis, the full hog.

Great traders know how to exploit fat tail events — the large mispricings that only come around once in a blue moon. They swing for the fences when fat pitches come across their plate.

Examples of this are Livermore making a fortune shorting the 29’ crash. PTJ doing the same in the 87’ rout and the Nikkei fallout in 1990. Druck and Soros when they took down the Bank of England in 92’. Buffett, who’s a master of exploiting fat tails, did it when he put nearly half his capital into AXP when it was selling for dirt cheap prices.

This is something we at MO call FET which is just short for Fat-tail Exploitation Theory.

Markets and investor returns follow a power law. Similar to Pareto’s law, returns adhere to an extreme distribution of 90/10. This means, that amongst great traders and investors, 90% of their profits on average come from only 10% or less of their trades.

Let’s look at the following from Ken Grant (who’s worked with traders such as Cohen, PTJ et al.) in his book Trading Risk (emphasis mine):

Some years ago in my observation of P/L patterns, I noticed the following interesting trend: For virtually every account I encountered, the overwhelming majority of profitability was concentrated in a handful of trades. Once this pattern became clear to me, I decided to test the hypothesis across a large sample of portfolio managers for whom transactions-level data was available. Specifically, I took each transaction in every account and ranked them in descending order by profitability. I then went to the top of the list of trades and started adding the profits for each transaction until the total was equal to the overall profitability of the account.

What I found reinforced this hypothesis in surprisingly unambiguous terms. For nearly every account in our sample, the top 10% of all transactions ranked by profitability accounted for 100% or more of the P/L for the account. In many cases, the 100% threshold was crossed at 5% or lower. Moreover, this pattern repeated itself consistently across trading styles, asset classes, instrument classes, and market conditions. This is an important concept that has far reaching implications for portfolio management, many of which I will attempt to address here.

To begin with, if we accept the notion that the entire profitability of your account will be captured in, say, the top 10% of your trades, then it follows by definition that the other 90% are a break-even proposition. Think about this for a moment: Literally 9 out of every 10 of your trades are likely to aggregate to produce profits of exactly zero.

This power law for investment returns is ironclad. Like Grant notes, it’s consistent “across trading styles, asset classes, instrument classes, and market conditions.”

And here’s where we get to the crux of the matter. Good traders don’t know how to harness this power law. While great traders do. They exploit it, using it to their full advantage.

Here’s Druckenmiller on the subject (emphasis mine):

The first thing I heard when I got in the business, from my mentor, was bulls make money, bears make money, and pigs get slaughtered.

I’m here to tell you I was a pig.

And I strongly believe the only way to make long-term returns in our business that are superior is by being a pig. I think diversification and all the stuff they’re teaching at business school today is probably the most misguided concept everywhere. And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it. And that’s kind of the way my philosophy evolved, which was if you see – only maybe one or two times a year do you see something that really, really excites you… The mistake I’d say 98% of money managers and individuals make is they feel like they got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket very carefully.

But how can one be a pig while still being a good manager of risk. It kind of seems like a paradoxical statement doesn’t it?

Here’s how.

Your average trader picks trades that have symmetrical potential outcomes. This means that the market pricing is on average, correct. It’s efficient. And the distribution of returns for these trades will fall randomly within the cone of future possibilities.

On average, these trades don’t produce alpha.

Using trade and risk management, a good trader can take this symmetric futures cone and produce positive returns by reducing the downside of return outcomes through trade structure and stop losses. But their upside is limited to the average distribution of outcomes.

But great traders and investors are different. They are skilled at identifying highly asymmetric outcomes.

These trades have the potential to massively reprice in their favor. The distribution of future outcomes for these trades looks more like this.

And not only are they skilled at identifying these skewed setups but when all the stars align they go for the whole hog and exploit the market’s error. They know that these rare asymmetric opportunities don’t come around often.

Great traders have this ability not because they are any better at predicting the future. Prediction is a fool’s errand.

It’s because they have built up a store of knowledge and context and pattern recognition skills. This allows them to more effectively assess the range of possibilities for an outcome set and identify one’s that are highly skewed to the upside.

They have the experience base that allows them to aggressively size up while at the sametime properly manage their risk. Simply put, they’ve earned the right to have conviction. And the vast majority of good traders haven’t earned this right. So they’re better off sticking with consistent and manageable bet sizing.

Tim from Hedgehogging stated it perfectly in saying that “the trick was to accumulate over time a knowledge base. Then, out of the blue, some event or new piece of information triggers a thought process, and suddenly you have discovered an investment opportunity.”

The evolutionary process of a trader should be to focus on mastering risk management. Then trade management — riding winners to their full potential. All the while building up a library of experience and useful context that will give them tools to identify asymmetric opportunities down the road. And once they’ve earned the right to have conviction, they can go for Totis Porcis.

Until then, “stay close to shore”.

Some final words from Druckenmiller.

The way to build superior long-term returns is through preservation of capital and home runs…When you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig.

 

 

A Comprehensive Reading List For Global Macro Traders & Investors

A Comprehensive Reading List For Global Macro Traders & Investors

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The successful macro investor must be some magical mixture of an acute analyst, an investment scholar, a listener, a historian, a river boat gambler, and be a voraciousreader. Reading is crucial.

~ Barton Biggs

After being asked countless times about the best books to read when it comes to markets and trading, I finally decided to create a comprehensive list.

I’ve read hundreds of books on trading, markets, economics, history and psychology over the years. And even now I still try to read a new one every two weeks. Reading is not only vital to developing yourself as a trader, but also as a person who’s able to get what they want out of life. Read more

How Short-Term and Long-Term Debt Cycles Work

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Conventional economic “wisdom” fails to understand the role of credit/debt in our market based system. Mainstream economics completely neglects to understand not only credits affect on demand, but also how this credit demand fluctuates in both short and long-term cycles. Read more

Stanley Druckenmiller

Lessons From A Trading Great: Stanley Druckenmiller

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The “greatest money making machine in history”, a man with “Jim Roger’s analytical ability, George Soros’ trading ability, and the stomach of a riverboat gambler” is how fund manager Scott Bessent describes Stanley Druckenmiller. That’s high praise, but if you look at Druckenmiller’s track record, you’ll find it’s well deserved. Read more

Understanding George Soros’ Theory of Reflexivity in Markets

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My conceptual framework enabled me both to anticipate the crisis and to deal with it when it finally struck. It has also enabled me to explain and predict events better than most others. This has changed my own evaluation and that of many others. My philosophy is no longer a personal matter; it deserves to be taken seriously as a possible contribution to our understanding of reality. ~ George Soros (via FT) Read more

Karen Blows Up

Karen “The Supertrader” Goes Rogue

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Famed Tastytrade icon Karen “The Supertrader” has gone rogue. On May 31, 2016 the SEC filed a complaint against Karen and her investment advisory Hope Advisors LLC.

For those who don’t know, Karen achieved widespread recognition through the Tastytrade financial network. Tastytrade focuses on option selling and Karen in particular sells strangles on stock indices, which she does in size. So large, that Tastytrade had her on air multiple times for promotional purposes with headlines like “Made $41 Million Profit in 3 Years Option Trading.”

By early 2016 Karen was trading over 200 million dollars for herself and clients. These funds were split between HDB Investments and Hope Investments (HI).

Karen was using a “0 and 20” fee structure for both HDB and HI. This meant she took a 0% management fee on total assets, plus a 20% incentive fee on all profits.

Normally in the hedge fund world, the 20% incentive fee is only taken on new profits. Profits must exceed the high water mark of the fund before fees are taken.

So say you’re a fund manager with a NAV (net asset value) starting at $100,000. In month one, your NAV increases to $120,000. At this point you would be entitled to a share of that 20k in profits through your incentive fees.

Now imagine in month two you have a drawdown and the account falls to $105,000. You don’t earn any fees for the losses.

Then in month three you have a gain that brings the NAV up to $118,000. Even though you made a $13,000 gain here, you would still not be entitled to any incentive fees. And that’s because you didn’t exceed the high water mark of $120,000. You would need to make new profits above the $120,000 to earn your fees.

This is the standard practice in money management for how incentive fees are calculated.

But this is not what Karen did. Instead of basing her incentive fees off her NAV’s high water mark, Karen based them off realized profits.

This was handy because she could defer trading losses by never realizing them and still take an incentive fee every month, despite her NAV not exceeding the high water mark.

In HDB’s operating agreement there was nothing to indicate that she was allowed to take fees on realized profits without hitting a high water mark.

But for HI, there’s actually language in the agreement that fees were based off realized profits despite unrealized trading losses. But it’s also explicit in saying that losses would only be deferred for a maximum of 90 days, not rolled indefinitely.

agrement_for_karen_fund

The SEC is now on Karen’s case because of her shady fee structures. They claim she’s perpetually rolled losses through “scheme trades” since November of 2014. By taking an incentive fee each month despite her failure to make new NAV highs, she violated both her agreements and defrauded her investors.

It’s interesting how she did it. Between October and December of 2014, Karen took some heavy losses selling her options. But to keep the incentive fees coming in, she organized a sophisticated options roll at the end of each month. This allowed her to still “realize gains” of 1% every month to take fees from, while pushing unrealized losses out to the next month. Month after month the losses continued to snowball while she continued to collect her fees.

Each month began with a huge realized loss. (The SEC reports that these losses now exceed $50 million dollars.) She offset these accrued losses by selling a ton of in-the-money call options on the S&P 500 E-mini futures due to expire at the end of the month. This injected fresh cash into the fund. Just enough so that she could report a small realized gain to investors. That way she could take fees that month too…

But of course there’s no free lunch in trading. You don’t get gains out of nowhere. When these call options expired, yes she had her cash injection (from the option premium), but she was also left with a futures position (due to assignment) that carried a huge unrealized loss.

Here’s where the loss rolling came in. She needed that futures position to stay open until the next month because if she closed it beforehand, that would realize a loss and cancel out the profits from the calls she sold. That means no incentive fees.

So to cover this futures position, she would simultaneously purchase in-the-money call options expiring the following month on the same day she sold those original in-the-money call options. These calls allowed her to offset any gains or losses the futures incurred at the end of the month until the beginning of the next month.

When the second tranche of options expired at the beginning of the next month, her fund finally realized the huge loss again.

The cycle then repeated.   

And on top of all this funny business, the redemption practices of the HI Fund were screwy. Basically, investors could withdraw money from the fund without having to take a hit from these perpetually rolled unrealized losses. So people that got out early would get a windfall, while those slow to act would be left holding an empty bag.

The SEC also claims that Karen did not inform new investors that their investment immediately lost value when entering the fund due to the built up unrealized losses.

This all smells like a classic Ponzi scheme…Pay the old investors with money from the new ones.

But rather than shout from the mountain tops about how Karen is a fraud or how selling options is stupid. I will give her the benefit of the doubt. We’ll let the court systems sort it out after hearing the other side.

Instead let’s focus on the lessons investors and traders can learn from this situation.

Lesson 1:

Don’t fuck up your fund’s disclosure docs. Don’t write in policies that are destined to get scrutinized by the SEC/CFTC. If you want to trade other people’s money, do it correctly.

Lesson 2:

Leverage kills. Now it’s unfair to throw out a blanket statement like “never use leverage.” Leverage can be a wonderful tool if used correctly. We use it all the time. But it must be used safely and responsibly.

A lot of investors abuse leverage because it can create short-term fame and fortune. You can over-lever and put up amazing numbers, attracting a lot of investors. But without fail, an over-levered trading operation will always go under. High leverage is a double-edged sword. It comes with massive upside and massive downside. Over-levering will blow up your fund.

Now when I first read through the SEC complaint, I was confused why Karen would need to run this scheme in the first place. After all… she is a strangle seller/volatility seller in equity indices. Thinking back to the beginning of 2014 I couldn’t remember any market events that would cause a vol seller to hit an unrecoverable drawdown. Volatility sellers should have done very well since the beginning of 2014.

To test this assumption, I ran a very basic backtest of strangle selling in the Thinkorswim platform.

I went back to Jan 2014 and mechanically sold a 10 delta strangle with 60 days to expiration. For position sizing I assumed a $1,000,000 account and sold 1 SPX option per $100,000 of capital.

Here were the results:

strangle_selling_SPX_backtest

You can see in the profit and loss table that there was not a single expiration cycle that ended in a loss.

SPX_strangles_sell_backtest with enlarged equity curve

The blue line above shows the strategy’s equity curve versus the SPX. You can see there were some violent drawdowns during the sell off in October 2014 (where Karen allegedly got burnt) and then again in the summer of 2015. But the losses were quickly recovered as volatility contracted and markets continued to range.

By the end of the simulation the net profits were around $170,000. That’s a 17% gain on a million dollar account. On a notional basis the position sizing I used was 2x the cash value of the account. But even with this leverage, the worst drawdown (August 2015 flash crash) was only around 9.5%. That would not end your fund.

Now Karen doesn’t mechanically sell strangles in this fashion, but this example is used to illustrate that even blindly selling strangles with a respectful position size actually worked very well since early 2014.

So how did Karen get caught in a situation where she was left with huge unrealized losses?

The only answer is by using too much leverage. When you get over-levered, whipsaws like the one in 2014 can force you to adjust and tinker your strategy to your detriment. Give the market enough time, and it will exterminate all over-levered players. Especially those using leverage on short gamma strategies like option selling.

The point here is not to dismiss all volatility and option selling strategies as useless and blow up prone. The short volatility trade on equity indices is one of the best trades out there. It does very well long-term.

The key takeaway is that you must get position sizing right if you want to last in this game. Without a deep understanding of how to size positions and how to manage trades once they’re on, you’ll surely die out.

If you want to make sure you’re sizing and managing your options strategy correctly, then check out our options special report by clicking here

 

The Art Of Learning by Josh Waitzkin Book Review

The Art of Learning By Josh Waitzkin – Book Review

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“Evolution, Morpheus, evolution” – Agent Smith, The Matrix

I’m a performance nut.

Whether it’s trading, endurance racing, rock climbing, ju jitsu, or anything else. It doesn’t matter. If I’m doing it, then I’m obsessing over performance — and going to extreme lengths to improve and be better than the next.

This is why trading and investing appeals to me. I like challenges. And there are few games more challenging than the markets. 

A big part of what we do at Macro Ops is study other top performers.  Read more