,

Trading During 9/11 Attacks And Why I Became A Systems Trader

The S&P 500 was down. Really down. Down hard. Then I heard the news on CNBC behind me.

“Another plane just crashed into the World Trade Center.”

I was short the S&P 500 E-mini futures. My system had me short. I had no idea what was causing the S&P to fall so much up to this point, and it had been falling since the May highs of $1320. I had been aggressively short selling since $1209 on August 8th, 2001.

The market had been selling off since March of 2000, the dot com bubble had burst, and we were generally in a bear market, trending lower and lower. By the summer of 2001, we had already sold off about 30% from the highs, officially entering bear market territory; but the buzz from the roaring tech bubble bull market was still a star in everyone’s eye. We all wanted that big dip buying momentum to return.

Spoiler: it didn’t.

When the news hit CNBC on September 11, 2001, I was already profitable well over 100 points on my short position. Each point in the E-mini S&P 500 is worth $50 per contract (multiply that by how many contracts you have), so I was well positioned at this point, with massive profits.

When I woke up that morning I had no idea what was happening. I checked my screen’s as I did back then when I first woke up (see my post from last week about my “new” morning routine); futures were down again, my trade was working, and I was ecstatic. This was the first time I had built such a massive position and it had played out. I thought about taking some profits, but held true to course as my system kept telling me to stay in.

I had a plan, but I wasn’t really sure exactly how to navigate these waters. This was unprecedented. I was in disbelief watching what was happening on TV, watching my screen as the market went “limit down,” and watching as the entire world stopped trading.

(Note: Limit Down means that the exchanges stop trading for a period of time to let things cool off a bit before trading can commence again. This event was so big that the market continued with this closure for another four days – the longest duration in modern history.)

As anyone around during that time remembers, prior to 9/11 the market had been selling off, and was selling off hard. I kept getting more and more indicators to add to my short position, so I kept adding. I had the maximum position allowed for me at that time.

There I was: massive profits thanks to a huge short position that my technical analysis had “predicted.”

I did everything according to my trading plan. I had proper position sizing. I increased my position as new levels were breached. Everything was “by the book,” minus the World Trade Center collapsing on live TV right before my eyes.

Other planes were still in the sky., The Pentagon got hit. This was unprecedented fear and chaos.

While trading was halted, there was nothing I could do but watch, and worry.

Where would they attack next?

Were there more planes out there ready to attack?

Would my location (Los Angeles) be hit?

Was it safe to leave? Should I go get food? Was anyone working today?

All I could do was watch live news coverage and listen to people speculate as to what might happen next.

The next four days, while the markets were closed, we all just watched and waited for more information.

Traders talk to each other day in and day out about the market, market analysis, market news, and what they think will happen. We speculated when trading would resume, how far the market would plummet before it was opened again, and if the government would intervene and support the market by buying everything until it stopped selling (aka the rumored “Plunge Protection Team”).

No one knew anything.

We started building out plans for the “what if” scenarios.

What if…when trading opens they only allow single contract trades, so I can’t cover my position quickly?

What if…the market is down 1,000 points on the open? Do I cover?

What if…the market is up 1,000 points on the open and I can’t cover in time?

What if…the market is open, but no one is trading, and I can’t cover my position?

What if…they don’t open the market until 2002?

On Sept 17th, they did re-open the market. The New York Stock Exchange was so kind as to inform the public when they would open, so other markets followed suit, and things resumed some sort of normalcy.

The S&P 500 opened 50 points lower on the morning of the 17th, and traded within a 40 point range.

It was insanity, complete chaos. Volume was huge, the world was ending, then the world was saved. This cycle seemed to be on repeat for days on end.

Believe it or not, I did not cover my short position.

Having the time to think through everything during those days off, I realized that I needed to stick to my trading plan and prove my thesis.

Why? If there was no signal to cover my short position, and my trade was sized correctly, then it follows that I wouldn’t suffer enough to take me out of the game.

This outlier event, 9/11, the most dramatic event to ever happen in the United States, was actually covered in my trading plan. Not by name, but certainly the rules were broad and effective enough to keep me in winning trades.

Eventually I did cover, and for a massive profit. But, I left plenty on the table, like nearly every good trade.

I learned a lot about myself in the days that the market was closed, reflecting on what happened.

I learned that the market can give you insight before something happens. There is speculation that 9/11 was heavily shorted by certain parties that participated in the planning and execution of the attacks. I can assure you I wasn’t one of those parties, however, my trading plan identified and planned for the events that followed the terror attacks.

I learned that taking time to breath, think, and relax is usually a better tactic than immediately reacting. I started to invest a little more in my meditation practice.

I learned to imagine and consider more outcomes and new threats.  The crazier the better! Approaching the future in a reality that was entirely different and unexpected than the present resulted in my ability to create new strategies to handle the unexpected.

Trading is a job;  emotions about the current state of affairs is not. I have learned that while I can be angry, sad or any other emotion about something that is happening, not letting that interfere with decision making is a muscle that needs to be exercised often. In the markets, math generally wins over emotion.

Most importantly, what I took out of this outlier incident is what led me to become a systems trader. I now trade mechanically and algorithmically instead of subjectively and discretionarily.

In the event you find yourself in another “outlier incident,” I highly recommend to do the same.  

Focus on finding a slight edge in the market, then exploiting that edge with the most powerful tools at our disposal (position sizing and exits) in order to make meaningful and very consistent returns over time.  

Remove your emotions from trading.  Let your system do the work for you, and trust that it will do what it takes.

 

 

,

Making Better Decisions

Hey everybody.

Chris D here.

Last September, I gave a webinar to Macro Ops Collective members about my health habits and wellness practices. It’s an important topic because sloppy life practices away from the trading screens affect trading results way more than most people realize. Most of the questions and feedback I received from that video were about building trading systems and all the health and wellness that I focus on.

In this article I hope to provide you with health and wellness ideas that will up your trading game as well as your overall well being. After all, we don’t live solely to invest. We have family, friends, hobbies, and other projects in our lives that benefit from a focus on health.

My intention here is to share what has worked for me, for you to pick and choose what would benefit you the most, and then share with our team your tips and tricks.

Focus On Yourself First

Most think that it’s selfish to focus on your well being ahead of others you care about (ie, spouse, children). But, if you continuously sacrifice yourself for others and disregard your own mental and physical health, then what happens when that catches up to you and you’re sick, injured, or burnt out?

Something I learned in the military is a great metaphor for this. When I was younger, I was a United States Marine. An infantryman no less. The Marine Corps takes great pride in being a very self sufficient group, all the way down to the individual level. We are taught to take exceptional care of our weapons, our gear, ourselves and then it expands upward to our team, our squad, platoon, company, battalion, regiment and so on.

The Marine Corps traditionally arrive by sea. With that, we need to take care of our own. I was lucky enough to go through Combat Water Safety Swimmer (CWSS) training (basically lifeguard training on steroids) as part of my training.

During this training, we operate according to the standards and intensity expected of us in combat. All CWSS is carried out in boots, trousers, two shirts, body armor, helmet and rifle along with accompanying ammunition and gear that the normal Marine would wear during an amphibious landing.

A major objective of this training is learning how to rescue a drowning swimmer. This is done in full gear, with the victim in full gear too, while getting hit by ice cold waves. The task is made more difficult since the drowning swimmer is in full on survival mode. They’re fearing for their life and trying to grab onto anything, especially the rescuer.

In order to be a capable rescuer, you need to be a good swimmer, which gives you confidence in the water and provides confidence to the troubled swimmer you are rescuing. This is the most important (and dangerous) part about a rescue; the troubled swimmer isn’t  thinking logically, they are in fight or flight mode and very often you do end up in a fight. But our job is not to fight in the water our job is to rescue. We need to bring our rescuee back to reality, we need to calm them down, we need to give them a little confidence. This can take numerous attempts before you can get the swimmer to calm down enough to be rescued, as crazy as that might sound, and requires that you, as the rescuer remain calm, as well.

Applying this concept to real life: like that troubled swimmer, you won’t be able to help your family and friends when they need you the most if you aren’t taking care of yourself.

In order to take care of others (your spouse, family, friends, community and so on),  you need to be at your best or other people’s troubles will be like that drowning swimmer. If you’re weak, tired, and/or distracted, you put both yourself and those you are helping at risk of being pulled under.

To further emphasize this point, being a good trader/investor doesn’t just happen on a whim, after reading Twitter for months and subscribing to some newsletter. I argue it takes developing a process, focus, discipline, and many other things as well, but you must take care of yourself first.

Excellent decision making is hard. Good decision making is easier. But poor decision making is the easiest of all.

This is why I believe that in order to become successful, and maintain that success as an investor, the majority of the work needs to be done on yourself before you can makegood, and then excellent, decisions with your money and your life.

Treat Yourself Like A Professional Athlete

I’ve been trading and investing for a living for nearly 20 years now. There have been some very hard lessons learned along the way but it wasn’t until I realized that the real success in the markets comes from first working on myself.

As a former semi-professional athlete and someone who still trains quite a bit, I liken my mindset to that of a professional competitor. As an investor, our minds and bodies are the tools we use to get the job done.

(Check out how LeBron James approaches taking care of himself with training, diet and a major focus on recovery. I have a very similar approach, albeit not 7 figures!)

Let’s start with the subject of sleep.

Sleep

It wasn’t until 2018 that I realized how important sleep was to my health and focus, and the opportunity I had to jump-start my performance by just sleeping better.

Back to LeBron James…On the Tim Ferriss podcast, LeBron talks about getting 10 hours of sleep per night, and how he usually nap during the day as well.

This is an athlete playing a physically challenging sport, non-stop for six months at a time, and unlike many other professional basketball players, his season goes to the very last second of the very last game, as he is always in the championship. LeBron is still in his prime and he attributes a large amount of that to sleep.

For me, I always wore my 4AM wake up as a badge of honor, thriving on low amounts of sleep, and spending hours upon hours reading (usually about 8 hours before I really got going on the other things in my life).  While this definitely gave me a huge advantage and I benefited greatly from that discipline, and consumption of information, increasing my hours of sleep has significantly improved my ability to focus and to get into a desired mindset more quickly  and far more frequently than when I was operating on less sleep.

Here’s an interesting study and something I used to start my journey down the sleep “rabbit hole.”

“Brief periods of sleep loss have long-lasting consequences such as impaired memory consolidation.“

In the past I would go to sleep whenever I felt tired and wake up at 4AM regularly. I realized that focusing on the time I woke up was the key to getting more sleep. I force myself to stay in bed longer now, generally 5AM or6AM. I occasionally even find myself sleeping until 11AM – something old Chris would have never been able to do. Once I was able to overcome my 4AM wake up habit, making sure I received eight hours of sleep per night became easy. Now, I regularly get eight to ten hours of sleep every night.

Subjective results? Since then I’ve lost a bit of stubborn weight around the midsection, blew through some physical plateau’s and have built and improved my trading systems at a much faster and, more importantly, efficient tempo than ever before. I feel better, and I’m certain I make better decisions, so I continue.

Meditation

As soon as I wake up, immediately before looking at my phone, any screens, emails, texts, Instagram, charts, news or anything else, that might cause any thoughts, I go straight to meditation.

There is a surprising amount of noise in our minds as we sleep. The activity of dreaming, then switching directly to external feedback, or someone else’s agenda (news, social etc…), means that there is no time to switch context from what our subconscious mind was doing while we were sleeping, to the immediate barrage of stimuli.

Meditating immediately after waking can help organize those crazy subliminal suggestions and enables us to better get our sh*t in order before taking on the day.

I’ve been meditating for about 30 years now, pretty much everyday.

I was lucky enough to be taught it through sports when I was young and have taken that with me throughout my life. It wasn’t until this year that I discovered how much more effective and useful meditation is when you do it first thing in the morning.

Your mind will also thank you again for doing a second session in the afternoon, which I do as well, though not everyday. This can be in the form of a dedicated meditation session or cardio routine. When I’m in a city, I like to go for long walks; when I am in nature,  I like to hike, run trails or jog on the beach. The repetitive nature of hiking/jogging/walking helps me get into a meditative state.

While this s is subjective, meditating slows the world down for me. I make better decisions and am not bothered by things I can’t control when I am in a regular meditation practice. I am able to release worry and stress over these things.

Get Challenged By Nature

Challenging the elements further toughens the mind. I spend most winters in the snowy mountains so I get opportunities to be a part of some of the most extreme things that nature can offer. The strength I get from conquering the cold really sets the stage for my day.

During the winter after my morning meditation I throw my zero drop trail running boots on, a pair of shorts, and take a little morning jog…shirtless. There is something amazing about running in fresh powder snow with no sunlight and overcoming that voice saying that there is a nice warm shower back at home waiting for you, and continuing on.

This is about strengthening my mind, right along with meditation, this gives me the power to not be a victim of things that I can’t control. The cold is relentless but I can choose to not let it bother me.

Cold showers work too if you don’t have mountain access. In urban areas I like to spend about 5 minutes under cold water in the morning after I finish my meditation practice.

Coffee

This is the first thing, outside of water, that is going into my body. I want to ensure that I reap all the benefits that coffee offers, without any of the negative aspects. This means only the highest quality, organic coffee that I can get my hands on. I like Kion Coffee.

Coffee has some amazing benefits, but the wrong type of coffee can have some less than desirable effects. Poor storage, pesticides, mold, and many other factors come into play when dealing with low quality coffee. More importantly, not so good coffee makes me feel not so great…

I hand grind with this travel grinder and run it through my travel french press. Over the years I’ve traveled with different coffee accoutrement and I’ve found this to be my preferred setup.

That is the beginning of my morning routine, and how I start my day before I look at any charts, trades, emails, texts or anything else. When I do fire up the screens and get to work, I put a lot of effort into focusing at a high intensity.

Eliminate Distractions and Achieve Flow State

When I sit down at the computer to work, all notifications are completely removed: no ringers, no pop-ups, all sounds are turned off/muted. My phone goes on Do Not Disturb mode so I will not receive any phone calls unless it’s a family emergency.

Interruptions from Instagram, Twitter, texts, and calls can crush your productivity. The reason is context switching. Anytime you respond to a message, call, or notification you have to refocus your attention. This refocusing costs brain power and precious time. Don’t believe me? Here’s some research that shows how “expensive” context switching is on productivity.

To be in a headspace to make excellent decisions, I focus on doing one task at a time and doing it well. My goal is flow.

A great defense against the distractions from the outside world is a nice set of noise cancelling headphones. I currently use these Bose and Beats and I just pre-ordered these babies – which are supposed to rival the Bose for sound quality.

To get into the flow state, I shove some Binaural Beats into my ear holes based on the chosen mindset I’m intending to achieve. Binaural beats need to be listened to with headphones to have the desired effect, where each ear is played a different musical wavelength and the difference between the two in your brain is the wavelength you are attempting to stimulate. Non-lyrical repetitive music is even easier than going down the Binaural Beat path. Try classical baroque era music; I’ve found it to be useful. Looking for something different? There’s a reason that Trance music is called Trance music. Give it all a shot!

3, 2, 1, Go…

After all of my boxes are checked, (good night’s rest, meditation, cold exposure, high quality coffee, silenced notifications, binaural beats) it’s time to check charts, update trades, and double check my risk for the day.

The first 30 minutes of trading will tell me if I have a new setup or not. If so, I put everything together, entry, exits, position size, and then send off that information to my broker.

That’s the skinny on my morning routine. It has evolved a lot in just one year, and I expect it to continuously evolve as I discover and adopt new best practices, but so far this ritual has me dialed in, focused, and ready to make the best quality trading decisions day in and day out.

The Rest of The Day

There’s a lot more that goes into my daily routine after these morning rituals, but I will save my diet, exercise routine, trading systems, geeky technology thoughts, travel methods, and much more on the soon to be released Macro Ops Podcast!  

I’m happy to chat further about this in the Comm Center Slack where I spend most of my time or Tweeting @chrisdmacro or Insta @chrisdmacro Or hit me up at chris@macro-ops.com.

 

,

The Psychology Behind Managing A 20 Bagger…

What do you do with a massively profitable trade that has grown to become a large percentage of your total portfolio value?

This question has been circulating in the Macro Ops Collective chat room the last few weeks because one of our deep out of the money (DOTM) calls took off in a big way. Back in the summer we bought call options on AMD struck at 28 for $0.40. Those calls traded as high as $8.50 in the month of September — a 2000% gain.

Managing large winners like this is difficult… really difficult. The reason being is that there’s no universally correct answer.

Managing losing trades is pretty straight forward. You define the risk before you enter and once the asset hits your stop, you exit. Easy peasy.

Winners are a whole other animal. Now you’re faced with the question of: Do I let my winner keep running and risk giving some or all of my profits back or do I take profits now foregoing more upside but putting cash in hand? This is literally one of the toughest questions in trading and something we at MO are constantly stewing on.

A winning DOTM option magnifies this conflict because of how volatile they become once they go in the money. A DOTM option can easily lose 30-50% of its value in a day if the stock pulls back after an extended run.

Another difficulty with a profitable DOTM option is that as it becomes more in the money, the reward-to-risk payout structure shifts from a highly convex one to being more linear.

When a stock crosses the strike of a DOTM call the options have usually already appreciated by 10x-20x. At this point, the forward reward-to-risk drastically changes. Instead of risking 1 unit to make 10 or 20, you’re now risking 10-20 units of unrealized profit for a potential gain of another 10-20. So instead of a 10:1 reward-to-risk in your favor, it becomes a 1:1 proposition.

After mulling this over for awhile with the other members of the Macro Ops Collective we think the profit taking decision comes down to these two things.

  1. The size of the unrealized profit relative to your net worth
  2. Your portfolio performance optimization strategy

You may think a DOTM call option will go on to appreciate from a 20 to a 40 bagger. But, what’s really important is whether you have the psychological makeup that will allow you to actually hold through the inevitable volatility and realize that second tranche of gains.

Your ability to hold through the volatility without tapping out is dependent on the size of the position relative to your net worth. This is also why managing large winners is so difficult. Since everyone has their own unique risk tolerances, there’s no “one size fits all” advice.

Picture these two scenarios:

Scenario 1: Bob puts $10,000 in a DOTM call that turns into $200,000. He has a net worth of $500,000.

Scenario 2: Jane puts $10,000 in a DOTM call that turns into $200,000. She has a net worth of $5 million…

Which of these two traders will have an easier time pressing and holding their winner?

Obviously, Jane will, because Bob’s going to feel it right in the gut if he gives back half those gains (20% of his net worth) to the market. It will bother Jane too, but will be much less mentally trying.

The larger the position is relative to your net worth the more mentally taxing it is to hold onto.

It’s painful to watch large paper gains swing up and down by double digit amounts on a weekly basis — which is exactly what can happen if you hold onto a DOTM call option that has 20x’d but still has many months until expiration.

Only a small fraction of traders have the stomach for holding onto large winners like these that have become a large percentage of their total portfolio values. Operator Darrin pointed this out during our conversations in the Comm Center. He correctly states that this ability is partially hereditary.

I’ve been lucky to know some real traders w/ what I’d call “Market Wizard DNA”. One, just made an additional 2mm dollars on LULU overnight (post earnings). I only bring this up because I think this insight can offer clarity for new traders/investors…

This trader was in a drawdown for 6-months that was > -30%. He held conviction in this trade (long gamma, long dated) for almost a year. It was his largest holding. He analyzed the fundies, the vol term structure etc…

At the point in which the trade started to yield some strong profits, he held on. We are talking .03 delta —>.50 delta kind of profits. Yet, he continued to hold on. The moral of the story is that 95% of humans do not have the ability to actually execute at this level.

I meet so many smart quantitative analysts and traders, yet I know that almost none of them have the behavioral edge necessary to reap the benefits of triple digits even four digit returns—and that’s perfectly ok!

I say all of this to remind retail traders that it’s ok to be average. It’s ok if a 20% return on 100k is the best you can do. The financial media have done everyone a disservice. They omit the part of the Big Short where they held losing options for YEARS before getting rich.

I can only speak for my own experience, but the biggest difference between the market wizards and everyone else is probably DNA. They have an ability to take risks on large sums of money that the average person could never imagine. That’s a major edge…probably the biggest edge available.

Having the wherewithal to endure large account swings is not for most of us which is why the correct answer for the majority of traders is to take profits when faced with massive unrealized gains.

Now let’s talk about portfolio performance optimization. This comes into play if the winner is small enough so that it’s not an emotional burden. For example, if a trader put 25 basis points (bps) into a DOTM option that goes on to 20x, that is still only a 5% account appreciation. At this position size the trader can think with his prefrontal cortex instead of his dumb lizard brain (limbic system).

Different traders need to optimize for different things. Some people just want to straight up maximize returns. Others need to prioritize consistent performance, especially those who are managing other people’s money or looking to raise funds.

Traders and investors who need their account balance to help pay for things outside of the market are also operating in a shorter timeframe and generally would rather have consistency and smoothness of returns rather than higher but much more volatile ones.

Taking profits sooner on large winners will pull performance forward in time, reduce account volatility and create a smoother equity curve. But it also sacrifices long-term return potential in the process…

Traders with true long-term capital and the psychological fortitude to ride out massive profit volatility should hold and press large winning trades because that will compound capital at the highest rate in the long run.

The biggest mistake we see with traders who decide to hold their winners is that they are optimizing for the long run even though they aren’t managing true long-term capital. Most people underestimate what it takes to apply a disciplined process day in and day out for a decade. And a decade is the bare minimum we would consider long-term.

If you want to see how we ended up managing our 20x winner on AMD you’re in luck because Tyler will be talking about it in our free DOTM webinar this Thursday, October 4th at 9PM EST.

Click this link to sign up for the Macro Ops DOTM special event!

Tyler will be presenting all the specifics of our DOTM option strategy and how we used it to produce a 2000% gainer on AMD. He’ll also be discussing our year-to-date performance for the DOTM plays, the winners and the losers. You don’t want to miss this.

If you have any interest in our DOTM option strategy that has produced 2000% returns, sign up now at the link below!

Click this link to sign up for the Macro Ops DOTM special event!

 

 

,

How To Implement Cheap Black Swan Protection

The following is a guest post from Kim Klaiman, full time options trader and founder of steadyoptions.com.

Introduction

The earnings season provides a lot of opportunities for active options traders. Some traders like to play earnings with directional bets, buying straight calls or puts. This is a very tough strategy. You have too many factors playing against you. Even if you are correct about direction, you need to overcome the Implied Volatility (IV) collapse that usually comes after earnings are announced.

Others play it with non directional strategies like straddles or calendars, but hold the trades through earnings. Those strategies can definitely work, but they could also be very volatile due to unpredictability of earnings.

Personally, I prefer to play earnings non-directionally. One of my favorite strategies is buying a straddle a few days before earnings and closing the position before the announcement to reduce the risk.

How straddles make or lose money

A straddle is a vega positive, gamma positive and theta negative trade. What does it mean?

  1. The theta is your enemy: all other factors equal, the trade will be losing value due to time decay.
  2. The vega is your friend: increase in IV (Implied Volatility) will help the trade.
  3. The gamma is your friend as well: stock movement in any direction will help the trade.

The straddle makes money as follows: The stock has to move (no matter which direction) and/or the IV (Implied Volatility) has to increase.

A straddle works based on the premise that both call and put options have unlimited profit potential but limited loss.

While one leg of the straddle losses up to its limit, the other leg continues to gain as long as the underlying stock rises or falls, resulting in an overall profit. When the stock moves, one of the options will gain value faster than the other option will lose, so the overall trade will make money. If this happens, the trade can be closed before expiration for a profit.

You execute a straddle trade by simultaneously buying the call and the put. You can leg in by buying calls and puts separately, but it will expose you to directional risk. For example, if both calls and puts are worth $5, you can buy a straddle for $10. If you buy the call first, you become bullish — if the stock moves down, the calls you own will decrease in value, but the puts will be more expensive to buy.

This is how the P/L chart looks like for a straddle:

When to use a straddle

Straddles are a good strategy to pursue if you believe that a stock’s price will move significantly, but unsure as to which direction. Another case is if you believe that IV of the options will increase — for example, before a significant event like earnings. IV usually increases sharply a few days before earnings, and the increase should compensate for the negative theta. If the stock moves before earnings, the position can be sold for a profit or rolled to new strikes. This is one of my favorite strategies that we use in our model portfolio for consistent gains.

Many traders like to buy straddles before earnings and hold them through earnings hoping for a big move. While it can work in some cases, I don’t do it. The reason is that over time the options tend to overprice the potential post earnings move. Those options experience a huge volatility drop the day after the earnings are announced. In most cases, this drop erases most of the gains, even if the stock had a substantial move. This is the reason why we will always close those trades before earnings for whatever P/L we can get. There will be some rare exceptions, but in general, this is the rule.

How straddles can serve as a cheap black swan protection

I like to trade pre-earnings straddles/strangles for several reasons. There are three possible scenarios:

  1. The IV increase is not enough to offset the negative theta and the stock doesn’t move. In this case the trade will probably be a small loser. However, since the theta will be at least partially offset by the rising IV, the loss is likely to be in the 7-10% range. It is very unlikely to lose more than 10-15% on those trades if held 2-5 days.
  2. The IV increase offsets the negative theta and the stock doesn’t move. In this case, depending on the size of the IV increase, the gains are likely to be in the 5-20% range. In some rare cases, the IV increase will be dramatic enough to produce 30-40% gains.
  3. The IV goes up followed by the stock movement. This is where the strategy really shines. It could bring a few very significant winners. For example, when Google moved 7% in the first few days of July 2011, a strangle produced a 178% gain. In the same cycle, Apple’s 3% move was enough to produce a 102% gain. In August 2011 when VIX jumped from 20 to 45 in a few days, I had a Disney strangle and a few other trades more than double.

During broad market corrections, you can have very nice gains, as a result of both stock movement and IV increase. So the losses are usually very small, the winning percentage is around 70%+ and you get cheap black swan protection.

Here is just one example using the August 2011 meltdown.

Walt Disney (DIS) was scheduled to report earnings on August 9, 2011. With the stock trading at 37.30, you could buy a 38/36 strangle with expiration at August 19, 2011, ten days after earnings.

The P/L chart would look like this:

Fast forward to the next Monday, August 8, 2011:

That’s right, after the market was down double digits, the strangle value almost tripled.

Of course those huge gains are not common. You need a severe market correction to get them. But for a strategy that produces stable 7-10% gains with very low risk, having this black swan protection in the portfolio is a huge added value.

Profit Target and Stop Loss

My typical profit target on straddles is 10-15%. I might increase it in more volatile markets. I usually don’t set a stop loss on a straddle. The reason is that the upcoming earnings will usually set a floor under the price of the straddle. Typically those trade don’t lose more than 5-10%.

The biggest risk of those trades is pre-announcement. If a company pre-announces earnings before the planned date, the IV of the options will collapse and the straddle can be a big loser. However, pre-announcement usually means that the results will be not as expected, which in most cases causes the stock to move. So most of the time, the loss will not be too high, especially if there is still more than two weeks to expiration. But this is a risk that needs to be considered.

Summary

Earnings straddles can be a good strategy under certain circumstances. However, be aware that if nothing happens in term of stock movement or IV change, the straddle will bleed money as you approach expiration. It should be used carefully, but when used correctly, it can be very profitable, without the need to guess the stock direction.

Kim Klaiman is a full time Options Trader and founder of steadyoptions.com – options education and trade ideas, earnings trades and non-directional options strategies. Read more from Kim on his Options Trading Blog.

 

 

,

Yield Curve Inversion!? Flattening Yield Curve Explained

The Yield Curve Inversion Secrets! Understanding the Flattening Yield Curve is crucial for any trader or investor!

Today we’re going to talk about the yield curve. Recently the financial media has been raving about the yield curve getting closer and closer to inverting and how it’s a signal that a recession is right around the corner. In this video we’re going to go over what the yield curve is, how to use it, and what it’s really signalling about the market.

The yield curve is basically just a line that plots the yield of US treasury bonds (TLT) with different maturity dates. The curve lets you easily compare rates on short term bonds versus long term bonds. When long term bonds are yielding more than short term bonds, the line rises from left to right. And when this is the case, it’s called a normal yield curve. This is signal that the economy and market are doing okay.

When you start to see the yield curve flatten or even invert, meaning short-term rates become equal to or higher than long-term rates, and the line either becomes flat or sloped lower from left to right, then that usually signals trouble ahead in terms of a recession and lower market prices.

Two things happen for the yield curve to become like this. First, the Fed starts raising short-term rates. Based on their mandates, they may see the economy overheating and decide to raise rates to slow it down. Higher rates hurt economic expansions.

Second, investor expectations for the future become negative. And because of that, they buy up long-term bonds, lowering their yield. Those two together you a flat or inverted yield curve where short term bonds yield the same or even more than long-term bonds. And like this signals trouble ahead.

According to our analysis, yes the curve is beginning to flatten and invert, but we still have a lot of time left before this bull iis done. Make sure to watch the video above for more!

And as always, stay Fallible investors!

Hedge Fund Letters For Generating New Equity Ideas
,

Top Ten Hedge Fund Letters For Generating New Equity Ideas

I’m often asked how I come up with trading ideas. My usual response is that I do a lot of reading, talking to other traders, and thinking.

I don’t have a single funnel for sourcing trades. This is partly because we’re interested in all types of trades (ie, value, classic macro, special situation etc…) and don’t limit ourselves to a particular approach. What were concerned with, is asymmetry… the greater the convexity the better.

Since I can’t give you my network of traders and HF managers I talk shop with, I thought I’d do the next best thing and share with you my go-to reading list of quarterly fund letters, sites, and blogs that I read regularly for idea generation. There’s a lot of fund managers out there, and most aren’t worth their salt. The selection below includes the few I believe have the most talent.

You’ll notice this list is skewed heavily to small-cap value managers. The reason is that these are the ideas that I’m most interested in from others. I don’t read a lot of other macro work because that’s the world I live in. And many of these value fund managers can devote a lot more time to investigating a single company, than I ever could. We always do our own due diligence, of course. But when you have a stable of great value fund managers doing the initial filtering for you, it’s a big help.

Like Picasso said, “Good investors borrow, great investors steal”… or something along those lines.

Here are my quarterly must-reads. The few reports that I never miss and from which I have stolen many great ideas from. Also, reading these letters is like receiving a masters in value investing. Some great nuggets in all of them (links to report sections included on all names).

  • Greenhaven Road Capital: This is a small-cap value fund run by Scott Miller. Miller is kind of an unknown. He keeps his AUM small and maintains a low profile. But the guy knows how to value a business and his reports always make for a great read.
  • OakTree Capital – Howard Marks’ Memos: Marks is an investing legend and there’s not much else to add to that. You won’t find stock ideas in his memos but you’re almost certain to learn something.
  • Greenwood Investors: This fund is run by Steven Wood who’s also a relatively new up and comer. He’s got a similar style to Scott Miller and is a good resource for contrarian value plays.
  • Cable Car Capital: Is run by Jacob Ma-Weaver who’s a sharp value oriented investor. He always presents unique and interesting investing ideas in his letters. He also occasionally posts some great stuff on his blog.
  • Arkto Investors: Is run by Peter Rabover and focuses on value and special situations. Another great resource for the undiscovered stocks. His letters are hosted on Harvest, so you’ll have to create an account if you don’t have one already (it’s free).
  • Miller Value Funds: Run by Bill Miller, who’s another investing legend, though his record was tarnished in the GFC when his fund took a serious beating. But he’s back, with his own fund, and he’s putting up good numbers again. I really enjoy his thinking and writing and posts/letters found on the site are a great source of idea generation.
  • Horizon Kinetics: Horizon is a larger shop that specializes in bottom up fundamental research. Their quarterly letters are always an insightful and fun read.
  • Peters MacGregor Capital Management: Is another large shop, but with a global focus. It’s a great resource for stock/market idea gen outside of U.S. markets. They also regularly share decent video presentations where they talk over an investment their in.
  • Laughing Water Capital: Run by Matt Sweeney, LWC is a long-term value oriented shop.
  • Saber Capital Management: A value focused fund by John Hubner. Quarterly letters always include some great thoughts on investing theory/wisdom, along with some great investment ideas.

So these are the quarterly letters that I make sure to at least skim through each quarter if not read in their entirety. For idea generation I also find sites like Value Investors Club, MOI Global, and SumZero useful. VIC and SZ are free as long as you submit an approved idea.

Some other sites that are worth checking out are The Patient Investor’s Blog (Longcast Advisers), Wiedower Capital is pretty good, and so are Dane Capital and Breach Inlet Capital on Seeking Alpha.

Shoot me a message at alex@macro-ops.com if you’ve got a letter/resource you use that I didn’t mention here.

, ,

Samurai, Livermore, and Market Timeframes (Daily Speculations)

Daily Speculations are just a post for me (Alex) to share some quick thoughts on charts/trades I’m looking at, books and articles I find interesting, or maybe just some photos of my dog Mars. As the name states, I’ll be sharing something daily but some days I won’t because I’m lazy.

Here’s an excerpt from one of one of the weekly market Briefs I write each week for members of the Collective. I wrote this one last year some time. It’s about Samurais, Livermore and market timing, obviously. 

Enjoy.

There is timing in the whole life of the warrior, in his thriving and declining, in his harmony and discord. Similarly, there is timing in the Way of the merchant, in the rise and fall of capital. All things entail rising and falling timing. You must be able to discern this. In strategy, there are various timing considerations. From the outset you must know the applicable timing and the inapplicable timing, and from among the large and small things and the fast and slow timings find the relevant timing, first seeing the distance timing and the background timing. This is the main thing in strategy. It is especially important to know the background timing, otherwise your strategy will become uncertain. ~ Miyamoto Musashi

Miyamoto Musashi was a renowned Samurai and Ronin (meaning he served no master) in Japan during the early 17th century.

He had a unique style of fighting with double blades which was apparently quite effective; he racked up an undefeated record of 60 duels. In his later years, he wrote The Book of Five Rings — a work similar to Sun Tzu’s Art of War that covers strategy, tactics, and philosophy through the scope of sword fighting, but that’s also applicable to life in general.

In Five Rings, Musashi talks about the importance of timing and maintaining one’s awareness of the ebb and flow inherent in life and war.

Timing, as we know, is as critical an input to a deadly Ronin Samurai as it is to a Master Trader. Musashi’s wisdom on the differences of time and the warrior’s manipulation of such is a subject that every trader needs to understand and practice at the deepest levels.

I’ve been increasingly thinking about Musashi and timing because of the macro environment we now find ourselves in. It’s in this type of environment where understanding the difference of applicable and inapplicable, as well as, background and distance timing, becomes ever more crucial. Let me explain.

As traders operating in markets, we’re fighting in multiple timeframes. In these different timeframes, there are varying levels of signal to noise. We’re left to discern what timing is applicable to our trade objective and what’s not. We need to learn from experience which timeframes we can have relevant conviction in and which we simply can’t.

For instance, one cannot simply be bullish on stock XYZ. That is a meaningless statement. Are you bullish on the stock over the short term (ie, next 4-8 weeks) because of factors a, b, and c? Or do you really think the company is undervalued and price should rise at some point over the next couple of years, but you have no conviction on where it will go in the near term?

Discerning your trade objective and reasoning is vital to understanding what your “relevant timing” is. Meaning, you understand the relevant time and the factors applicable to your thesis — every timeframe has its own unique drivers.

Musashi talks about the importance of “first seeing the distance timing and background timing.”

The trading equivalent to these is price action and macro. Price action (distance timing) signals where things stand now and where they’re possibly headed in the near term (1-3 months). Macro (background timing) tells us where the larger forces and imbalances are. It provides us with a gauge of where the risks and opportunities lie in the future. Both sections of time affect one another, so the ebb and flow of the battlefield (market) is constantly evolving.

But, as Musashi says, it is “especially important to know the background timing” because that is the more powerful force that will eventually bend and dominate the near-term. It’s when these different time frames lineup that you get the most powerful and profitable trends.

Livermore (the Musashi of markets) understood the importance of timing in speculation better than anybody and talked about this lesson repeatedly in Reminiscences of a Stock Operator:

“The way to make money is to make it. The way to make big money is to be right at exactly the right time. In this business a man has to think of both theory and practice. A speculator must not be merely a student, he must be both a student and a speculator.”

“There is a time for all things, but I didn’t know it. And that is precisely what beats so many men in Wall Street who are very far from being in the main sucker class. There is the plain fool, who does the wrong thing at all times everywhere, but there is the Wall Street fool, who thinks he must trade all the time. “

“Obviously the thing to do was to be bullish in a bull market and bearish in a bear market. Sounds silly, doesn’t it? But I had to grasp that general principle firmly before I saw that to put it into practice really meant to anticipate probabilities. It took me a long time to learn to trade on those lines. “

“I think it was a long step forward in my trading education when I realized at last that when old Mr. Partridge kept on telling the other customers, ‘Well, you know this is a bull market!’ he really meant to tell them that the big money was not in the individual fluctuations but in the main movements — that is, not in reading the tape but in sizing up the entire market and its trend.”

“…the point is not so much to buy as cheap as possible or go short at the top prices, but to buy or sell at the right time.”

“I had made a mistake. But where? I was bearish in a bear market. That was wise. I had sold stocks short. That was proper. I had sold them too soon. That was costly. My position was right but my play was wrong.”

“That is what happened. I didn’t wait to determine whether or not the time was right for plunging on the bear side. On the one occasion when I should have invoked the aid of my tape-reading I didn’t do it. That is how I came to learn that even when one is properly bearish at the very beginning of a bear market it is well not to begin selling in bulk until there is no danger of the engine back-firing.”

The key to dealing with the various temporal frames (that’s a fancy way of saying lengths of time) is just to remain aware of your analysis and expectations and how they align with the march of time.

Don’t get tunnel vision and try to fit a long-term macro view into a short-term trade expectation.

Be flexible and know which timeframe you’re operating in and in which your edge lies.

Drop any questions/comments in the comment section below. And if you’d like to get my thinking, ramblings, and occasional trade ideas, then just put in your John Hancock along with your email below.

Thanks for reading,

Alex

 

 

 

Liquidity, The NFCI, And Leverage
,

Measuring Market Liquidity: The NFCI

(Note: If you’re interested in learning how to gauge liquidity and sidestep the next market selloff, then download our Liquidity Tracking Guide here.)

If you want to trade macro, you need to understand liquidity.

PTJ, Druck, Soros, Dalio — all these legends have expressed this fact multiple times.

Liquidity is what moves markets.

This is even more true now than in the macro heydays of the 70s and 80s.

With the rise of “blind investing” in the form of passively buying and holding ETFs, the majority of investors don’t care about valuation or merit. They just auto-shuttle their excess funds to the nearest robo advisor without a second thought.

This amount of “excess funds” is largely dependent on liquidity conditions.

When liquidity is loose, it’s cheap to get levered. People have extra cash and plow it into risk assets. Prices rise.

When liquidity is tight, people have less cash to spend. They may even sell stuff to service their existing debt. Prices fall.

There are a myriad of ways to measure and monitor liquidity conditions.

(Note: If you want to learn how to track liquidity to identify the next market crash, then check out this guide right now.)

No single method is best, but one of our favorites is using the Chicago Fed’s National Financial Conditions Index (NFCI).

This index combines over 105 different indicators of financial activity to form one easy-to-read liquidity measurement. Money markets, debt markets, equity markets, traditional banking systems, “shadow” banking systems — they’re all included.

The zero line represents average liquidity conditions. Positive values indicate tighter-than-average conditions and negative values indicate looser-than-average conditions.

The Chicago Fed also publishes the Adjusted National Financial Conditions Index (ANFCI).

Since financial liquidity conditions are highly correlated to economic conditions, this index isolates the uncorrelated component. It tells us what liquidity conditions are like relative to economic conditions.

Positive values indicate liquidity conditions are tighter than would be suggested by current economic conditions, while negative values indicate the opposite.

You can see the difference between the standard and adjusted index in the graph below.

We prefer the ANFCI because it isolates liquidity conditions better than the NFCI.

The NFCI doesn’t always tell you when liquidity is deteriorating. In the late 90’s and 2014/2015, liquidity conditions were worsening but the strong stock market and strong economy kept the NFCI below 0, signaling liquidity was loose.

In contrast, the ANFCI was above 0 during the same period, signaling conditions were actually tightening.

The ANFCI is a little noisy to look at, but if you smooth the data with a 12-month MA, you get a nice picture of liquidity conditions in the U.S.

The cyclical nature of our economy becomes clear and it’s easy to see how liquidity predicts business cycles. You can use this tool to help you trade on the right side of the market.

When liquidity is tightening, take bearish trades. When liquidity is loosening, take bullish trades.

This index is also broken down further into 3 sub indices — risk, credit, and leverage.

Risk is a coincident indicator, credit is a lagging indicator, and leverage is a leading indicator of financial stress.

For trading purposes, the leverage part of the equation matters the most to see where the stock market is headed.

Above average leverage sows the seeds for a recession and a falling stock market. Below average leverage precedes economic booms and stock market rallies.

Ray Dalio discovered this logic long before the Chicago Fed and has made billions trading off it.

The leverage index can be broken down yet again to only include nonfinancial leverage.

Nonfinancial leverage is one of the most powerful leading indicators of stock market performance.

Liquidity, The NFCI, And Leverage

This graph might look familiar to you because it’s basically the short-term debt cycle, which can help you time markets.

For example, debt was at obscene levels before 2008 and signaled a shorting opportunity. And by 2010 debt was back below average and signaled a buying opportunity.

People are always the most levered at a market top and the least levered at a bottom.

A skilled macro trader wants to do the opposite. Paying attention to nonfinancial leverage will help you do that.  

Lever up when others are unlevered and delever when others are highly levered.

Despite all the financial doom and gloom we’re drowned with nowadays, nonfinancial leverage readings tell a different story.

Current levels are only average.

Before making your next trade, take a look at these indicators.

How’s liquidity? Where are we at in the debt cycle?

Knowing these answers will make you a lot more confident in your trading. It’s hard to get blind sided by a big crash or miss out on a huge rally when you have a handle on liquidity.

Summary

  • Liquidity is a key variable in determining the macro landscape
  • We can monitor liquidity using the ANFCI
    • If the ANFCI is trending higher, liquidity is tightening and we want to lean bearish
    • If the ANFCI is trending lower, liquidity is loosening and we want to lean bullish
  • The nonfinancial leverage component of the NFCI tells us where we are in the debt cycle
  • We want to buy risk assets at the bottom of the debt cycle (below average leverage) and sell risk assets at the top of the debt cycle (above average leverage)

 

To learn how to gauge liquidity and sidestep the next market crash, download our liquidity tracking guide and cheat sheet here.

Exploit Errors To Find Your Edge
,

Find Your Trading Edge By Exploiting Errors

Market speculation is a zero-sum game. In order for someone to win, someone else needs to lose.

You can think of the market as a collection of players… some weak, some average, and some strong. Your goal is to take action against the weak players and relentlessly separate them from their money.

To do this you’ll need a trading edge.

Now the word edge is thrown around a lot in finance, but what it really means is the ability to exploit the errors of your opponents.

If you can’t find these errors, or if your opponents just aren’t making them, you can’t win.

Why?

Because to make a bet with positive expectation, someone else needs to make a bet with negative expectation.

A bet with positive expected value or “positive EV” means that placing it repeatedly will result in net profits. The outcome of any single instance may be negative due to variance or luck, but over the long-run the bet’s edge will express itself and profit.

The opposite is true for a “negative EV” bet. A negative EV bet may win in the short-term due to variance or luck, but over the long-term it’ll produce net losses.

To thrive in this zero-sum environment you need a relentless focus on other players’ errors. You need to find and exploit them.

How To Find Errors

Finding errors begins with asking the right questions:

  • Which market players make the most errors?
  • Why do they make them?
  • What market situations trigger these errors?

In answering these questions, we can break market errors into two types — unintentional and intentional.

Unintentional Errors

Unintentional errors are made by players who try to win, but then fail because of flaws in their process and implementation. Taking advantage of these errors can be very lucrative.

Here’s a list of the most common reasons weak players make bad bets:

  • Ego
  • Fear
  • Myopia
  • Labeling

Ego

Many players are only in the market to stroke their own ego. True or not, they want the world to know they have the “biggest dick” in the room.

In the poker world we call these guys “ballers”. They aren’t at the casino to win, but are instead trying to bully the table in order to come off as rich and aggressive. They could care less about making positive EV bets. These guys are there to show off.

You can easily spot ego-driven market players on Finance Twitter. These are the ones who hold onto particular narratives with a vice grip until the bitter end, win or lose. In the process they make tons of negative EV bets which are perfect for the astute Operator to exploit.  

Look no further than the gold bugs to see ego in action.

Gold bugs will never stop buying gold. It doesn’t matter where the price is going. They have a certain set of beliefs about inflation and central bank policy that need to be proven right. The system has to fall apart, vindicating the gold bugs who can finally yell “told ya so!” Nothing else matters.

Their desire to be right about gold is purely to satisfy their own ego.

Making a trading decision based on ego instead of positive expectation is a huge error that can easily provide you with profit. A gold bug will always be there to buy the gold you’re trying to short in a downward trend. And as you know, it’s pretty easy for a bear to crush a bug…

Fear

Fear is a key evolutionary emotion that helped keep us alive over millions of years. But in the game of speculation, it only kills us.

Succumbing to fear creates large unintentional trading errors. A great example is the investing public that consistently sells at market lows. Fear overwhelms their trading decisions and leads to them sell at the bottom when they should be buying.

It takes a considerable amount of time, effort, and mental rewiring for an investor to overcome the fear of losses. But doing so gives you an edge over those who haven’t.

Take hedge fund titan David Tepper for example. In 2009 he loaded up on shares and debt of various banks when everyone thought they were headed for bankruptcy. By the end of the year he pocketed himself a cool $2.5 billion…  

Watch for trades made out of fear. You can take the opposite side for huge gains.

Myopia

It’s tough for investors to picture a future drastically different than their immediate past. Weak players lack the imagination and foresight to do so. This can be exploited.

Many short sellers, for example, constantly step in front of innovation trains and get mowed down in the process. The unimaginative bears in Tesla have been getting flattened for years…

Tesla Revolutionize Auto and Energy Industries

Their first mistake is not accepting that Tesla could indeed revolutionize both the auto and energy industries. Their second mistake is discounting the power of other investors’ belief in that same possibility. Herding and reflexivity can push prices much higher than what “conventional” valuation methods infer.

Watch for these trigger happy short sellers fighting large upside momentum. Most of them can’t take the pain and puke out. The resultant buying pressure they create from covering their shorts will send the market screaming higher once again. It’s easy to benefit if you’re on the right side.

Labeling

In professional fund management there exists a game within a game. You have the trading game and then you have the asset gathering game. Managers have to balance both. This means that sometimes a manager may have to take a negative EV action in trading because it’s a positive EV action in asset management.

I call this “labeling”.  

Since a manager may be known as the “oil bull”, “equity bear”, or “value guy”, he’s forced to tilt his bets towards his brand. That way he can maximize the business side of his fund (sales and marketing).

The charming and brash founder of Eclectica, Hugh Hendry, paid greatly for his industry label. Hugh defined his brand by betting on a market collapse in 2008. He knocked it out of the park and his assets under management swelled.

But from then on he was forced to stick to his permabear view. That’s what his new investors hired him to do. They didn’t want him to own beta. They wanted protection if the global economy went double dipped.

Unfortunately for Hugh that meant fighting the central banks and putting up multiple years of poor performance.

Eventually this label drove him mad. In late 2013 he finally decided to flip the cards and go full bull.

I was actually on the investment call the moment he announced his decision to bet on higher prices. The fund of funds at my prior employer had money with him.

His reasons for turning bullish were sound. The central banks had too much control over the current macro narrative and it was a fool’s errand to fight them. But his investor base didn’t listen. Everyone began pulling out like crazy, including my employer.

And guess what? Hugh ended up being right!

Despite the fact that he took a positive EV bet in the trading game, Hugh took a massive negative EV bet in the asset gathering game. His fund management business suffered greatly for it. Hugh’s assets under management are now a fraction of what they were even though he’s trading better.

Errors stemming from the reality of professional fund management make fertile hunting grounds for traders on the outside. Track the “big brands” and fade their trades when the data clearly supports the opposite of their brand biases.

Intentional Errors

Capitalizing on unintentional errors is definitely lucrative, but it takes significant time and energy. Players making these errors still want to win the game. They’ll put up a fight and force you to wrestle their money away. Sometimes they’ll even beat you if you aren’t on your A-game.

On the other hand, players committing intentional errors are literally giving you their money. These guys are much easier targets.  

Intentional errors come from players who don’t care if their trade has positive expected value. They’re willing to lose on trades because their goal isn’t long-term profitability.

Now that may sound a little crazy… who in their right mind is willing to consistently lose on every trade?

Answer: Central banks and hedgers.

Central Banks

CB’s are the ultimate source of intentional errors. They’re like the guys at the casino willing to donk off millions of dollars with no regard for risk control. In poker we call these players Whales. Nothing is more profitable than exploiting a Whale. Nothing.

CB’s don’t care if their trades have positive expected value. Their goal, no matter the cost, is market stability (whatever that means). Post-2008 CB’s made their intentions very clear when injecting record stimulus into the system. They said they’d buy bonds no matter the price. You can make a TON of money exploiting scenarios like this.

Ray Dalio has been taking advantage of CB’s for decades. He modeled their behavior into his macro machine and has been benefiting ever since.  

George Soros plays the CB’s like a fiddle as well. Back in 92’ he broke the Bank of England by taking the other side of their negative EV trade defending the European Exchange Rate Mechanism. Then in late 2012, when Japan began their unprecedented QE program, Soros shorted the yen and massively increased his Scrooge McDuck sized chip stack.

These guys know how to exploit a whale — a must-have skill for any serious speculator.

Hedgers

Central banks may be the most lucrative whale in the game, but they’re not the only profit gusher. Hedgers make plenty of intentional errors you can take advantage of too.

Trader’s have been extracting profits from commodity hedgers since the beginning of the futures markets.

When a farmer shorts grain futures, he’s doing so to avoid unexpected shocks to his income come harvest time. The farmer isn’t worried about his hedges’ expected value. He’s only focused on his crop and its profits.

A large portion of the CTA industry lives off this fact. They consistently make money by taking the other side of farmers’ hedging.  

The same goes for FX markets as well. Multinationals hedge foreign currency exposure to keep their core operations running smoothly. And once again, they’re not focused on making positive EV bets on the trading side.

In equity markets, large institutions like pension and insurance funds hedge their accounts to meet short-term cash flow obligations during volatility events. They purchase protection at a premium and are willing to consistently lose money to avoid liquidity crunches.

These negative EV hedging trades create extraordinary opportunity for the nimble speculator who can take the other side when conditions align.

Attack The Whales First

Whales making intentional errors don’t care that they’re losing. They’re willing to pay you for decades without batting an eye. You can systematically extract profits without them noticing.

Compare that to a weak speculator. They need to win or at least break even to stay active. If they’re consistently losing it won’t be long until they go broke or evolve to stop the bleeding. Once they leave the game, there’s nothing left for you to harvest.

Ask yourself, “How long can I expect this player to continue making errors?” The best edges come from those who are willing to make mistakes repeatedly without changing their strategy.

Use this concept as a starting point for your search.

It’s All One Giant Competition

Speculation means fighting for a living. Instead of delivering value in exchange for dollars, you need to find weak players and take their dollars. This means constantly searching for poorly performing players and the errors they make. If you’re not thinking in this fashion… then you’re probably the one getting exploited.

I’ll let Buffett close this one out.

“If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”

If you’d like to learn more about exploiting errors, then check out our Trading Handbook here.

 

 

,

Managing Your Losing Trades

Amateurs focus on finding trades.

Operators focus on managing trades.

Inexperienced traders spend far too much time on trade identification. Their misguided goal is to find the perfect trade with the perfect entry.

The truth is… perfect doesn’t exist. You’re not gonna find some magical combination with a 98% win rate.

Identifying a trade is really only 10% of the process. The other 90% is managing the trade.

Take it from Peter L. Brandt, a legend who’s averaged over 40% compounded returns throughout his 40 year trading career(!!):

Consistently profitable commodity trading is not about discovering some magic way to find profitable trades. [T]rade identification is the least important of all. In my opinion, learning the importance of managing losing trades is the single most important trading component. Consistently successful trading is founded on solid risk management.

Consider an average year for PLB. Only 30% of his trades become winners. The rest either break even or lose. Yet he’s still extremely profitable.

How is that possible?

It’s because he keeps his losses extremely small. PLB’s major edge is in risk management. Limiting his losses ensures his winners more than make up for the losers. He consistently avoids the big mistake that would knock him out of the game. That’s how he achieves long-term success.

Recently our team dug into a stock called Neonode (NEON).

The fundamental thesis was solid.  

We had a left-for-dead company on the brink of a massive turnaround. NEON previously suffered from “too early” syndrome with its product fit, but now its market was finally catching up.

The play was contrarian to say the least. The stock had already fallen over 80% from its recent highs. Investors hated it. But these same investors were also blind to the drivers behind its soon-to-be revival…

We entered our position.

A few weeks later, quarterly earnings were released. And sure enough the stock plummeted over 20%.

Ouch.

You’d think a loss like that would put a dent in our portfolio…

But it didn’t.

And that’s because we managed our risk.

We deployed a three-pronged defense for this trade.

First, we entered on a breakout from a long-term descending triangle pattern. This technical setup gave us an intelligent price level to determine where we’d be wrong. If our risk point was hit, we’d exit our position.  

Second, we put an automatic stop at our risk point. That way if price overshot that level (as it did on earnings day) we’d automatically be out.

Third, we sized our position small. As we said, this was a contrarian play. And while these plays can be extremely lucrative, they’re also very hard to time. We weren’t surprised to get knocked out on our first attempt. That’s why we entered small with the goal of building size over time.

Had we entered NEON heavy, with no technical breakout, and no stop, we’d be in a tough situation right now.

But because of our risk management, we’re just fine. Our portfolio is intact and we plan on establishing another position when a new technical setup forms.

Our original fundamental thesis hasn’t changed. If anything, this price drop makes it an even sweeter deal. But it may take some time before the market comes around to this stock’s value. We’re willing to wait.

That’s the benefit of trade management. It allows you to play another day. Our first entry wasn’t the end all be all. We have an opportunity to try again.

PLB is no stranger to quickly getting knocked out of a position either. He gives himself three tries to hit a trend. We take multiple attempts as well.  

It’s hard being a contrarian. But the reason we not only survive, but thrive, is because of our risk management.

If you’d like to learn more about how we manage risk at Macro Ops, click here to get our Trading Handbook.