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Lessons From A Trading Great: Linda Bradford Raschke

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!

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Investing in Shipping Stocks: Lessons from Walter Schloss

He knows how to identify securities that sell at considerably less than their value to a private owner; And that’s all he does … He owns many more stocks than I do and is far less interested in the underlying nature of the business; I don’t seem to have very much influence on [him]. That is one of his strengths; No one has much influence on him.

Those words, spoken by Warren Buffett, describe one of the greatest value investors of all time. No, Buffett isn’t referring to his longtime business partner Charlie Munger nor his famed teacher Benjamin Graham.

The investor is Walter Schloss.

Schloss is a wellspring of value investing wisdom.

Over the course of this piece we’ll dive into Schloss’ principles for investing. His ideas on portfolio construction. And we’ll finish with applying these lessons learned to analyzing shipping stocks. An industry we’re particularly bullish on at the moment.

Battlefields to Balance Sheets

Schloss enlisted in the US Army Signal Corps at the end of 1945 after his stint as a runner on Wall Street. Before being shipped overseas, Benjamin Graham offered Walter the opportunity to join his firm, Graham-Newman Corporation, as a security analyst. Schloss accepted the offer after returning from service and quickly learned the ropes of value investing through real-world applications of Ben Graham’s classroom teachings.

After working under Graham for nine years, Schloss opened up a one man shop, Walter J. Schloss Associates.

As the saying goes, the rest was history.

Schloss took his original partnership money and spent the next 32 years compounding capital at 16.4% annually compared to the S&P return of 9.8%.

Schloss accomplished this impressive feat while operating out of a small room (Warren Buffett referred to it as, “a portion of a closet”) at Tweedy, Browne’s offices. He didn’t use a computer or a team of analysts. Just a monthly paper subscription to Value Line. He was the embodiment of a spartan approach to investing.

How was Schloss able to compound capital at such high rates over such a long period of time? What was his secret sauce?

Schloss kept a low profile (similar to the Chandler Brothers) and routinely shied away from press coverage or interviews with journalists for the majority of his career. However, as he got older, he started sharing his wisdom in the form of articles and speaking events. Through these sporadic public appearances we can get a better picture of just who this man is and how he invested in markets.

Investment Philosophy: Buy Stocks Like Groceries, Not Perfume

Like other successful investors, Schloss followed a simple yet robust approach to amass his fortunes. This approach can be surmised in the following bullets:

  • Start with beaten-down losers, the 52-week lows and companies with temporary issues.
  • Don’t lose money.
  • Avoid debt like the plague.
  • Try to buy stocks that manufactured products while sporting long histories of operations (20+ years).
  • Focus on assets rather than earnings, citing the claim that earnings aren’t as predictable as assets on the balance sheet.
  • Avoid talking to management.
  • Read the entire annual report and familiarize himself with the basics of each business he bought.
  • Purchase hundreds of stocks, keeping a well diversified portfolio.
  • Exhibit around 25% turnover — i.e., holding period of four years.

Above all else, Schloss didn’t want to lose money. He had a tremendous respect for his limited partners’ trust in his ability to manage their capital, and did everything in his power to limit his losses. Schloss had a tremendous grasp on the psychology of the average investor and frequently used it to his advantage. During an interview with Barron’s in 1955, Schloss said (emphasis mine),

They [stocks] tended to be ignored by the public because they didn’t have any sex appeal, there wasn’t any growth — there was always trouble with them. You were buying trouble when you bought these companies … Basically, it’s a contrarian philosophy, and people really like buying things that are doing well.

I wish Schloss was more complicated — it would help me get more pages out of the piece — but that’s really all there was to it.

He would fish in the ponds that looked like radioactive cest-pools, hold on to the ones that were the cheapest and sell when he had at least a 50% gain.

Schloss was so focused on not losing money, he often left a lot of meat on the bone — something he was perfectly fine with. In that same Barron’s article Schloss examined that,

One of the tricks of this business is to keep your losses down and then, if you have a few good breaks, the compounding works well for you.

These simple principles guided Schloss’ stellar 16.4% net annualized return.

Along with the above fundamental tenants, Schloss offered investors 16 rules, which he called Factors Needed to Make Money in the Stock Market. As with most rules / checklists, it’s not the points themselves that matter, but the individual’s ability to stick to the rules. The rules are attached at the end of this piece. I encourage you to print it out and keep it by your desk, laptop or wherever you do your investment work.

If you would like free access to my value investing checklist click here! 

Qualitative Aspects Don’t Matter

Walter Schloss didn’t care about the qualitative aspects of the business when he invested — something attributed to his inability to judge management’s acumen — and focused only on the numbers. This flies in the face of many value investors’ creeds that claim management and incentives matter amongst other areas like marketing and customer acquisition cost. There was a reason why Schloss preferred to invest this way: it helped him sleep at night.

Unlike Buffett, Schloss made a point of not talking to management or factoring them in at all. His reason was that good management would eventually show up in a higher stock price and a higher multiple

This makes sense if you’re buying the assets of a business rather than their earnings and future growth prospects. You don’t need to know how management will grow earnings and reinvest their capital if you’re investing because its asset value per share is higher than what you’re paying on the open market.

Applying Schloss’ Methodology to Shipping Stocks

Equipped with this knowledge of Schloss’ methods and criteria for investing in public companies, we can construct a framework to help us analyze shipping stocks.

Shippers represent a perfect harmony for the type of companies Schloss would be interested in buying: cyclical lows, asset heavy businesses trading at steep discounts to liquidation values. Let’s go through a few of Schloss’ 16 Rules and see how we can apply those directly to the messy, “road-kill” industry of shipping.

Rule 1: Price is the most important factor to use in relation to value

Shipping stocks are stupid cheap with prices for a majority of these companies trodding around all-time-lows. No matter how you look at shipping companies its undeniable that on a purely quantitative measure, they’re selling for pennies on the dollar.  

That’s not to say that qualitatively there are issues — i.e., bad management, low growth prospects — but on price alone, Schloss would be interested.

Rule 4: Have patience. Stocks don’t go up immediately.

I was asked via email from one of the MO members about the difference between being early vs. being wrong — and how can I tell the difference?

Schloss is frequently quoted for buying stocks “on a scale”; as share prices fell he would buy more. This is where patience comes in. Schloss reminds us that stocks don’t go up right after you buy them — especially if you’re buying the troubled, “ick” factor stocks that Schloss made his fortune on.

Having the patience to endure a short-term selloff in share prices cannot be understated. Schloss would not have generated the returns he did if he sold quickly after share prices went against him (remember his 25% turnover rate!).

Rule 6: Don’t be afraid to be a loner but be sure that you are correct in your judgement. You can’t be 100% certain but try to look for weaknesses in your thinking. Buy on a scale and sell on a scale up.”

When investing in Schloss-type stocks, you will by default be a loner. You can’t have one without the other. Shipping stocks are at all time lows because the industry isn’t experiencing that inflow of serious capital … yet.

We know the thesis for why the shipping industry will probably heat up over the next two years, but Schloss tells us that knowing our judgement isn’t enough. Schloss encourages us to look for weaknesses.

What does this look like?

Try Googling the bearish thesis for the shipping industry and compare it its bullish cousin you’ve subscribed to. This is called Red Teaming your thesis.

Is there anything you missed in your initial assessment? Can you identify major weak points to your thesis? Are there any biases possibly clouding your judgement etc…

Buying on a scale allows us to account for our inability to time when the market will become less irrational. Schloss wouldn’t take his full position all at once because he knew the stocks he bought were in trouble, and they were likely to fall further.

Selling on a scale works for the inverse reason as buying on a scale — the stock could keep going up as you unload your position, giving you incrementally higher profits as opposed to dumping the entire position at once.

Rule 10: “When buying a stock, I find it helpful to buy near the low of the past few years. A stock may go as high as 125 and then decline to 60 and you think its attractive. 3 years before, the stock sold at 20 which shows that there is some vulnerability in it.”

Following the vein of Rule 1, Rule 10 provides the investor with an increased margin of safety when making their initial investment. According to Schloss, If buying a stock at its 52-week low is good, buying a stock at its all-time low is even better.

The good news for investors is that the majority of companies in the shipping industry are trading at all time lows.

Once again, these stocks have problems (whether industry specific, company specific or a combination) they’re currently dealing with. Buying these companies at all-time lows helps us sleep at night.

Rule 11: “Try to buy assets at a discount rather than earnings. Earnings can change dramatically in a short time. Usually, assets change slowly. One has to know how much more about a company if one buys earnings.”

Schloss focused only on the balance sheet and the assets that could be liquidated for cash. Applying this to the shipping industry gives us an easier framework for analysis. We don’t have to understand management and the intricacies of the businesses if the company is selling at below half its net asset value measured by the active secondary scrap market.

Putting Words Into Action: Next Steps

How do Schloss’ principles coupled with the value opportunity in the shipping industry play out in real time? What are actionable steps to take if you want to invest in these shippers?

The plan itself is simple in theory — but like Schloss’ rules — hard to follow:

1) Find a basket of the cheapest shipping stocks with the greatest margin of safety / discount to fair value

2) Allocate a specific amount of your portfolio to this basket of stocks and

3) Forget about them for 1-3 years.

Conclusion

Walter Schloss stuck to his rules and stayed in his well-defined lane. And by doing so, he generated “super-investor” level returns.

I’m not saying you need to do a full 180 on your current strategy in order to generate Schloss-like returns, but I am advocating for an appreciation of Schloss’ tactics — and consider adding a few tools to your investment toolkit.

(** all information for this report was sourced via www.walterschloss.com **)

Walter Schloss’ 16 Rules

 

  1. PRICE IS THE MOST IMPORTANT FACTOR TO USE IN RELATION TO VALUE

 

  1. TRY TO ESTABLISH THE VALUE OF THE COMPANY. REMEMBER THAT A SHARE OF STOCK REPRESENTS A PART OF A BUSINESS AND IS NOT JUST A PIECE OF PAPER.

 

  1. USE BOOK VALUE AS A STARTING POINT TO TRY AND ESTABLISH THE VALUE OF THE ENTERPRISE. BE SURE THAT DEBT DOES NOT EQUAL 100% OF THE EQUITY. (CAPITAL AND SURPLUS FOR THE COMMON STOCK).

 

  1. HAVE PATIENCE. STOCKS DON’T GO UP IMMEDIATELY.

 

  1. DON’T BUY ON TIPS OR FOR A QUICK MOVE. LET THE PROFESSIONALS DO THAT, IF THEY CAN. DON’T SELL ON BAD NEWS.

 

  1. DON’T BE AFRAID TO BE A LONER BUT BE SURE THAT YOU ARE CORRECT IN YOUR JUDGMENT. YOU CAN’T BE 100% CERTAIN BUT TRY TO LOOK FOR THE WEAKNESSES IN YOUR THINKING. BUY ON A SCALE DOWN AND SELL ON A SCALE UP.

 

  1. HAVE THE COURAGE OF YOUR CONVICTIONS ONCE YOU HAVE MADE A DECISION.

 

  1. HAVE A PHILOSOPHY OF INVESTMENT AND TRY TO FOLLOW IT. THE ABOVE IS A WAY THAT I’VE FOUND SUCCESSFUL.

 

  1. DON’T BE IN TOO MUCH OF A HURRY TO SEE. IF THE STOCK REACHES A PRICE THAT YOU THINK IS A FAIR ONE, THEN YOU CAN SELL BUT OFTEN BECAUSE A STOCK GOES UP SAY 50%, PEOPLE SAY SELL IT AND BUTTON UP YOUR PROFIT. BEFORE SELLING TRY TO REEVALUATE THE COMPANY AGAIN AND SEE WHERE THE STOCK SELLS IN RELATION TO ITS BOOK VALUE. BE AWARE OF THE LEVEL OF THE STOCK MARKET. ARE YIELDS LOW AND P-E RATIOS HIGH. IF THE STOCK MARKET HISTORICALLY HIGH. ARE PEOPLE VERY OPTIMISTIC ETC?

 

  1. WHEN BUYING A STOCK, I FIND IT HELPFUL TO BUY NEAR THE LOW OF THE PAST FEW YEARS. A STOCK MAY GO AS HIGH AS 125 AND THEN DECLINE TO 60 AND YOU THINK IT ATTRACTIVE. 3 YEARS BEFORE THE STOCK SOLD AT 20 WHICH SHOWS THAT THERE IS SOME VULNERABILITY IN IT.

 

  1. TRY TO BUY ASSETS AT A DISCOUNT THAN TO BUY EARNINGS. EARNING CAN CHANGE DRAMATICALLY IN A SHORT TIME. USUALLY ASSETS CHANGE SLOWLY. ONE HAS TO KNOW MUCH MORE ABOUT A COMPANY IF ONE BUYS EARNINGS.

 

  1. LISTEN TO SUGGESTIONS FROM PEOPLE YOU RESPECT. THIS DOESN’T MEAN YOU HAVE TO ACCEPT THEM. REMEMBER IT’S YOUR MONEY AND GENERALLY IT IS HARDER TO KEEP MONEY THAN TO MAKE IT. ONCE YOU LOSE A LOT OF MONEY, IT IS HARD TO MAKE IT BACK.

 

  1. TRY NOT TO LET YOUR EMOTIONS AFFECT YOUR JUDGMENT. FEAR AND GREED ARE PROBABLY THE WORST EMOTIONS TO HAVE IN CONNECTION WITH PURCHASE AND SALE OF STOCKS.

 

  1. REMEMBER THE WORK COMPOUNDING. FOR EXAMPLE, IF YOU CAN MAKE 12% A YEAR AND REINVEST THE MONEY BACK, YOU WILL DOUBLE YOUR MONEY IN 6 YRS, TAXES EXCLUDED. REMEMBER THE RULE OF 72. YOUR RATE OF RETURN INTO 72 WILL TELL YOU THE NUMBER OF YEARS TO DOUBLE YOUR MONEY.

 

  1. PREFER STOCK OVER BONDS. BONDS WILL LIMIT YOUR GAINS AND INFLATION WILL REDUCE YOUR PURCHASING POWER.

 

  1. BE CAREFUL OF LEVERAGE. IT CAN GO AGAINST YOU.

 

If you want access to my personal value investing checklist click here to secure your free copy!

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The Chandler Brothers: The Greatest Investors You’ve Never Heard of

Two secretive brothers from New Zealand have perhaps THE best long-term track record in the investing world. Starting in 1986, the two turned $10 million of family money into over $5 billion just 20-years later. That’s an astounding 36% CAGR.

Compare that with Buffett (19% over 50yrs), Klarman (20% over 34yrs), Lynch (29% over 13yrs),  Soros and Druckenmiller both around (30% over 30yrs).

Yet, hardly anybody has ever heard of these guys. I live and breathe markets and I just came across them for the first time this year.

This is by design.

The two brothers have gone to great lengths over the years to maintain a low profile and keep their faces out of the news. It wasn’t until 2006 that they chose to give their first and only substantial interview. It was with Institutional Investor (link here), and they only agreed to the interview so they could counteract bad press they were receiving from Korean media over a failed activist push by the two to upseat management at a Korean Chaebol.

They were amongst the first investors to plunge into emerging markets like Russia, Brazil, and the Czech Republic. They are sons of a WWII veteran who ran a beekeeping business with Edmund Hillary (yes, that Edmund Hillary), before starting what became New Zealand’s most upscale department store.

They are perhaps THE MOST INTERESTING INVESTORS IN THE WORLD.

They are the Chandler brothers: Richard and Christopher. They ran the Sovereign Global Fund for 20-years (the two have since split off to manage their own money with Legatum and Clermont Capital).

To follow is a profile of the brothers along with some of the secrets they’ve shared in how they look at and invest in markets — also, some commentary and case studies of their investments by me. (All quotes are from the Institutional Investor interview unless otherwise noted).

First, some quick background on the brothers and their unusual origin story (emphasis by me).

The Chandler’s investing background is anything but conventional. The brothers grew up in Matangi, a rural town outside the provincial city of Hamilton in the dairy farming country of New Zealand’s north island. Their Chicago-born grandfather had emigrated to New Zealand in the early 1900s, gone into advertising and married his secretary. He died of an allergic reaction when his third son, Robert, was just one year old.

Although he never knew his father, Robert was profoundly marked by the American success literature he had left behind, notably the books of Orison Swett Marden, an early-20th-century American journalist and author who inspired such proponents of “positive thinking” as Dale Carnegie and Norman Vincent Peale. Robert’s sons were deeply influenced by this worldview as well. We are great believers in the idea of having audacious goals, breaking out and doing something out of the ordinary,” says Richard. “It’s helped us turn what most people consider a mere profession into a vocation and, beyond that, an art, where we frequently put ourselves in harm’s way.”

In 1972, Robert and his wife Marija, started a department store called the Chandler House which quickly became a booming business. This is where the two brothers, Richard and Christopher, began learning the skills of business and investing.

Richard and Marija employed their two sons at the store when not away at boarding school. The two worked sales and helped their father balance the books on the weekend. They also accompanied their mother on buying trips where they learned the key principles on how to buy right (more on this below).

Richard referred to his mother as “the most brilliant business person I’ve ever met who taught us many of the key principles we follow as investors”. Two of these key principles were, “Never buy something unless you know to whom you can sell it” and “Buy as much as possible in a narrow range of hot items.” Richard said his mother “was able to identify the best opportunities and be the master of narrow and deep and that, with stocks, we do the same thing. We back our beliefs to the hilt.

The two brothers were essentially getting an MBA when they were only kids. This undoubtedly helped shaped them into the two market masters they are today.

After college, Richard and Christopher took over the family business and rapidly expanded its size. And in 1986 they sold it for $10m which they then used to launch their fund Sovereign Global. Richard remarked on the decision to the sell the family business that, “Basically, we said, ‘Let’s do something that we love to do, not just something that we are good at.” That something they loved, was investing…  

The fund’s first investment serves as a perfect example of the style that would typify the brother’s approach. And that’s contrarian to the extreme and highly concentrated. Narrow and deep just like their mother taught them.

The two poured nearly the entire family fortune into just four Hong Kong office buildings in 1987.

That year the property market in Hong Kong was in dire straights. Real estate prices were down roughly 70% from their 81’ peaks. Britain’s lease on the territory was due to lapse in the coming decade and according to Richard, “The feeling was that China was going to take over Hong Kong, so most investors said, ‘Who cares?”.

The sentiment at the time was that the island was uninvestable. Here’s a few Newspaper headlines from the year.

This pervasive negative sentiment and over extrapolation of recent trends is what drew the two brothers to the place.

They objectively studied the fundamentals and came away with a variant perception. Richard remarked on the time that, “We had read the treaty, and it promised the status quo for 50 years, and we believed it. Even more important, rents were rising, and rental yields exceeded interest rates by 5 percentage points, which guaranteed that any investment would more than pay for its financing costs.”

The brothers leveraged up and paid $27.6 million for D’Aguilar Place, a 22-story building. They then renovated the place which allowed them to triple rents over just three years, which gave them the cash to acquire more buildings.

Low and behold, Hong Kong didn’t immediately become a communist despot as many feared. The property market recovered and the brothers sold their buildings for $110m, pocketing over $40m after paying off creditors; quadrupling their fund’s NAV in just over four years time.

The brothers also invested in Hong Kong stock index futures during this time which they viewed as another way to play the recovery in the property market, as the Hang Seng was mostly made up of real estate companies. But in the middle of the the crash of 87’ their stop losses were hit and the brother’s were forced to close out the position. The following week markets crashed around the world and the brother’s narrowly escaped a major loss.

Richard said they learned from this experience that “if you get lucky once, don’t press your luck.” It also gave the brothers an aversion to using leverage. Being unlevered “enabled the Chandlers to take a long-term view of risky markets, their key competitive advantage at a time when many investors, particularly highly leveraged hedge funds, invest with a short-term horizon.” A long-view is a critical part of their philosophy, as Richard notes the brothers “like investments where the risk is time, not price.”

With their recent winnings in Hong Kong the brothers went looking in emerging markets. Richard recalled that “The fax machine was becoming very popular” and “we felt that value was moving from real estate to communications. So we researched it and found that Telebras was the cheapest telecom company in the world.”

It was here that they ran into some analysis problems which led to them developing a unique valuation method which they would use again and again throughout their careers.

At the time, Brazil’s hyperinflation had rendered earnings and P/E ratios absolutely meaningless. So they had to turn to “creative metrics — in this case, market capitalization per access line. Telebras, the nation telephone monopoly, was trading at about $200 per line, compared with $2,000 for Mexico’s Teléfono de México and an average cost of $1,600 for installing a line in Brazil. The brothers bet that the government of then president Fernando Collor de Mello would liberalize the economy and open the country up to foreign investment.”

This practice of using unique metrics to compare and discern value is an important piece of what Richard calls “the ‘delta quadrant’ — transition economies or distressed sectors where information is not easily available and standard metrics don’t apply.”

After obtaining government permission to invest in Brazilian equities (Sovereign was one of the first foreign investors in the country) the brothers put $30m —  roughly 75% of their fund — into Telebras shares in 1991 and a smaller amount into Electrobras, an electric utility.

This was an even more contrarian bet than Hong Kong was. Not only was sentiment in the dumps in Brazil (news clipping from 91’ below) but foreign investors weren’t even looking at opportunities there. The Chandler brothers were walking their own path.

Once Collor de Mello began cutting the budget deficit and opening the market to foreigners, Brazilian equities tripled. But soon “Collor de Mello was… caught in a massive kickback scheme and was impeached that April. Stocks swooned, falling 60 percent over the next eight months. Most foreign investors fled the market, but the Chandlers sat tight.”

Richard recalls the selloff saying, “As far as we were concerned, the shock was external to the fundamentals of the company… Telebras had simply gone from extremely undervalued to outrageously undervalued.”

By 93’ the market recovered and the Chandlers sold out of their position later that year. The brothers more than 5x’d their initial investment in under 3-years, boosting their fund to more than $150m. Richard said the experience of riding out the volatility helped them “build our emotional muscles, helping us to make it through major market falls and grind through the trying times without losing our equilibrium.”

The brothers continued their run of highly concentrated and extremely contrarian investing with forays into Eastern Europe, South Korea, and Russia. Always going into markets and investing in assets that no one else would touch.

Another great example of their approach is their big bet on Japanese banks in the early 2000s. Institutional Investor writes that “In November 2002, with Japan slipping back into recession after a decade of stagnation and with stocks at 20-year lows — the Nikkei 225 index was more than 78 percent below its 1989 peak — the country’s banks were wallowing in bad debt.” It was under this backdrop that the Chandlers began loading up on shares in the sector.

The two bought a $570m stake in UFJ Holdings, “which had posted a staggering loss of $9.3 billion in its latest year. The pair went on to buy more than 3 percent of Mizuho Financial Group as well as stakes in Sumitomo Mitsui Banking Corp and Mitsubishi Tokyo Financial Group… Altogether they spent about $1 billion on their spree.”

“The banks were priced for a total wipeout of equity holders,” says Sovereign’s broker at the time at Nikko Citigroup, John Nicholis. “We were advising our clients to stay away from the sector.

Here’s a few headlines from the time showing the negative consensus of the time.

Like in Brazil, the brothers had to be creative in the metrics they used to value the banks since they didn’t have any “earnings on which to base multiples, and uncertainty about the extent of bad loans made it difficult to forecast a turnaround.”

So instead, the team looked at “market capitalization as a percentage of assets; on this daily basis they determined that UFJ and other megabanks traded at about 3 percent, compared with 15 percent for Citigroup at the time. The Chandlers concluded that Japan would have to nationalize the banks or reflate the economy with low interest rates, and bet — correctly, as it turns out — on the latter scenario.”

After riding out a near 50% decline from when they began building their position the Chandler brothers rode the stock all the way back up to new multi-year highs. They were still sitting in the stock in 2006 (when the II interview was conducted).

In talking about their big win in Japan, Richard said that, “Most fund managers are focused on what can go wrong rather than on what can go right and were too afraid to make that call. We were not.

Talk about having courage in your convictions. These guys must have to push around a wheelbarrow to haul their giant cojones around.

Richard helps shed light on how he and his brother are so effectively greedy when others are fearful in sharing one of his favorite sayings from Investor Philip Carret, who said it is essential “to seek facts diligently, advice never.” Richard explains: “Money managers have to account for their actions to their shareholders, which means they have an undue fear of underperformance. We invest only our own money. Our investment decisions are driven by optimism, not fear.

Once they establish the conviction they then have the optimism and courage to buy in size. II writes:

The brothers also prize scale, believing that the way to achieve outsize returns is to make a few big bets — Sovereign usually holds fewer than ten stocks — rather than manage a diverse portfolio. The Chandlers favor large-cap stocks in big countries. “If you are invested in big companies in big countries, that means there is a ready audience of benchmark-following investors who must buy the asset,” says Richard. “By buying big — going narrow and deep, as opposed to diversifying — you maximize your success.

Sovereign usually holds fewer than ten equity positions at any one time. Though it typically holds its larger positions for two to five years, the firm regularly trades in and out of some stocks to test the waters and take advantage of price movements.

It’s very important to note that this isn’t dumb blind conviction. You’re not a smart contrarian by just buying a hated falling asset. The crowd could be correct and the underlying could be worth much less than what it’s selling for.

The Chandlers lived and breathed business from the time they were children. Richard had a degree in accounting and a masters in Commercial studies. After college he worked for a big accounting firm where a coworker recounted his “incredible intellectual capacity and enormous, almost unbelievable thirst for knowledge. He used every project we work on as an experience to learn a new business model.”

These two know businesses. They know what’s important and the things to look for in valuing them. They know how to correctly assess a prospects margin of safety in relation to its upside.

Richard said, “Our talent is to understand the long-term potential of a business” and “the market gives you the opportunity to arbitrage what the emotional investor will pay or sell at versus the fundamental value of a company, but you’ve got to pull the trigger promptly without hesitating… We’ve disciplined ourselves mentally and prepared ourselves in terms of information, as well as relationships with brokers, to do that.”

Lessons From the Chandler Brothers

To make these types of long-term outsize returns, you have to go NARROW and DEEP.

That means putting large portions of your portfolio into just a few high conviction trades, the veritable fat pitches, when they come along.

We call this Fat-Tail Exploitation Theory, or FET for short. And it flys in the face of all the conventional wisdom that espouses the wonders of diversification. Druckenmiller talked about the importance of FET when he said the following:

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.

And Barton Briggs touched on it in his book Hedgehogging when writing about his friend and macro fund manager, Tim.

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.”

A reason why FET is key to delivering outsized returns is because of the underlying power laws that are embedded in markets. Pareto’s law of 80/20, or in markets it’s more like 90/10 or 95/5 even, which means that 90% of your returns will come from 10% or fewer of your trades.

Just take a look at the profile of Sovereign’s returns. Over a 15-year period just five investments generated 90% of their returns (chart via II).

There are two keys to this.

One is that you can’t force it and you have to really really know your stuff or else you’re assuming blind risk and opening yourself up to financial ruin. The Chandler brothers understand businesses inside and out. They could cut through the fluff in laser like fashion and get to the meat of the issue when evaluating companies.

Second is time. Fat pitches like these don’t come around often. The Chandlers would go years in between big investments without risking any substantial amount of money. Michelangelo once said that, “Genius is infinite patience” well the corollary to that in investing is that infinite patience is success.

Joel Greenblatt said this about the need for patience and taking a big picture view of things:

Legg Mason’s Bill Miller calls it time arbitrage. That means looking further out than anybody else does. All of these companies have short-term problems, and potentially some of them have long-term problems. But everyone knows what the problems are.

Next there is contrarianism.

The Chandler brothers made it a point to set up shop in Dubai and Singapore, far away from the financial centers of the world in New York and London. They did this because they didn’t want to fall victim to the powerful pull of groupthink and herd mentality.

Being able to look at the same situation as the market and form a variant perception lies at the heart of how they uncover highly asymmetric trades. A good way to develop a variant perception is to take a page from the Palindrome, George Soros, who said:

The generally accepted view is that markets are always right — that is, market prices tend to discount future developments accurately even when it is unclear what those developments are. I start with the opposite view. I believe the market prices are always wrong in the sense that they present a biased view of the future.

As humans we all have the tendency to get wrapped up in the hysteria and be seduced by compelling narratives, especially when the components of fear or greed are present. But it’s in these situations where the narrative has driven the market to extrapolate trends ad infinitum, driving prices to ridiculous levels, that create the environment where amazingly asymmetric bets exist.

You need to step back, objectively sift through the data yourself, and develop a big picture view of things. This is what Templeton referred to as “the point of maximum pessimism” which Bill Miller explains here:

The securities we typically analyze are those that reflect the behavioral anomalies arising from largely emotional reactions to events. In the broadest sense, those securities reflect low expectations of future value creation, usually arising from either macroeconomic or microeconomic events or fears. Our research efforts are oriented toward determining whether a large gap exists between those low embedded expectations and the likely intrinsic value of the security. The ideal security is one that exhibits what Sir John Templeton referred to as “the point of maximum pessimism.”

And lastly, you need to be creative and think out of the box in order to form a variant perception and see a future different from the one in which the crowd is pricing in.

The Chandler brothers used “creative metrics” and the point is that it’s not rocket science. But it does mean you need to do the thinking, do the work, and come to your own conclusions. Great opportunities aren’t found in a simple screen or low P/E. They exist BECAUSE they are difficult to find, to comprehend, to value. Greenblatt says it like this:

Explain the big picture. Your predecessors (MBAs) failed over a long period of time. It has nothing to do about their ability to do a spreadsheet. It has more to do with the big picture. I focus on the big picture. Think of the logic, not just the formula.

Narrow and Deep. Contrarian. And think of the logic, not just the formula…

 

 

Ed Thorp
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Lessons From A Trading Great: Ed Thorp

Ed Thorp, the father of quant investing, might be the most impressive market wizard. He turned seemingly random processes into predictable events, transforming the art of speculation into a science decades before Wall Street’s quants became mainstream.

His domination in the financial world began in the casino. Thorp figured out how to beat the most “unbeatable” games. In roulette, he created a wearable computer that gave him a 44% edge. And in blackjack, he developed the very first card counting system that’s still widely used today.

These gambling skills transferred perfectly to markets. Thorp’s first hedge fund, Princeton Newport Partners, never had a down year. It compounded money at 19.1% for almost 20 years — destroying the S&P 500.

His second fund, which he ran from August 1992 to September 2002, performed just as well with an annualized return of 18.2%.

Thorp’s list of discoveries, inventions, and people he’s influenced and invested in is comically long:

  • He discovered an options pricing formula before the Black-Scholes model became public.
  • He started the first ever quant hedge fund.
  • He was the first to use convertible and statistical arbitrage.
  • He was the first limited partner in Ken Griffin’s Citadel — one of the most successful hedge funds ever.
  • His books on blackjack and trading heavily influenced “bond king” Bill Gross.
  • He discovered that Bernie Madoff was a fraud many years before it became public.

And the list goes on…

Thorp’s advice on approaching games of incomplete information is methodical and scientific, making it very useful to incorporate into your own trading process. The following is his most valuable wisdom with our commentary attached:

Rare Events (Fat Pitches)

Fat pitches — the types of trades Buffett, Druck, and Soros salivate over— happen seldomly. And that makes sense because is takes extraordinary circumstances to push markets far enough from equilibrium to create these opportunities.

When these dislocations occur, it pays to go on high alert. It’s possible to make your year or even your career in a few days by hitting these fat pitches on the nose.

Here are a few of Thorp’s best plays:

1987 Crash

Black Monday was a traumatizing experience for most traders… but not for Thorp. When the crash started to accelerate Thorp was having his daily lunch date with his wife Vivian. The office called to report the news and Thorp didn’t even flinch. He had already accounted for all possible market scenarios, including this one, and didn’t have any reason to panic. He calmly finished his lunch and then went home to think about how to exploit the situation. This is what he came up with:

After thinking hard about it overnight I concluded that massive feedback selling by the portfolio insurers was the likely cause of Monday’s price collapse. The next morning S&P futures were trading at 185 to 190 and the corresponding price to buy the S&P itself was 220. This price difference of 30 to 35 was previously unheard of, since arbitrageurs like us generally kept the two prices within a point or two of each other. But the institutions had sold massive amounts of futures, and the index itself didn’t fall nearly as far because the terrified arbitrageurs wouldn’t exploit the spread. Normally when futures were trading far enough below the index itself, the arbitrageurs sold short a basket of stocks that closely tracked the index and bought an offsetting position in the cheaper index futures. When the price of the futures and that of the basket of underlying stocks converged, as they do later when the futures contracts settle, the arbitrageur closes out the hedge and captures the original spread as a profit. But on Tuesday, October 20, 1987, many stocks were difficult or impossible to sell short. That was because of the uptick rule.

It specified that, with certain exceptions, short-sale transactions are allowed only at a price higher than the last previous different price (an “uptick”). This rule was supposed to prevent short sellers from deliberately driving down the price of a stock. Seeing an enormous profit potential from capturing the unprecedented spread between the futures and the index, I wanted to sell stocks short and buy index futures to capture the excess spread. The index was selling at 15 percent, or 30 points, over the futures. The potential profit in an arbitrage was 15 percent in a few days. But with prices collapsing, upticks were scarce. What to do?

I figured out a solution. I called our head trader, who as a minor general partner was highly compensated from his share of our fees, and gave him this order: Buy $5 million worth of index futures at whatever the current market price happened to be (about 190), and place orders to sell short at the market, with the index then trading at about 220, not $5 million worth of assorted stocks—which was the optimal amount to best hedge the futures—but $10 million. I chose twice as much stock as I wanted, guessing only about half would actually be shorted because of the scarcity of the required upticks, thus giving me the proper hedge. If substantially more or less stock was sold short, the hedge would not be as good but the 15 percent profit cushion gave us a wide band of protection against loss.

In the end we did get roughly half our shorts off for a near-optimal hedge. We had about $9 million worth of futures long and $10 million worth of stock short, locking in $1 million profit. If my trader hadn’t wasted so much of the market day refusing to act, we could have done several more rounds and reaped additional millions.

Kovner Oil Tanker

In the 1980s, Bruce Kovner discovered a trading opportunity in buying oil tankers for scrap value. Thorp instantly recognized the fat pitch and invested.

Along with Jerry Baesel, the finance professor from UCI who joined me at PNP, I spent an afternoon with Bruce in the 1980s in his Manhattan apartment discussing how he thought and how he got his edge in the markets. Kovner was and is a generalist, who sees connections before others do.

About this time he realized large oil tankers were in such oversupply that the older ones were selling for little more than scrap value. Kovner formed a partnership to buy one. I was one of the limited partners. Here was an interesting option. We were largely protected against loss because we could always sell the tanker for scrap, recovering most of our investment; but we had a substantial upside: Historically, the demand for tankers had fluctuated widely and so had their price. Within a few years, our refurbished 475,000-ton monster, the Empress Des Mers, was profitably plying the world’s sea-lanes stuffed with oil. I liked to think of my part ownership as a twenty-foot section just forward of the bridge. Later the partnership negotiated to purchase what was then the largest ship ever built, the 650,000-ton Seawise Giant. Unfortunately for the sellers, while we were in escrow their ship unwisely ventured near Kharg Island in the Persian Gulf, where it was bombed by Iraqi aircraft, caught fire, and sank. The Empress Des Mers operated profitably into the twenty-first century, when the saga finally ended. Having generated a return on investment of 30 percent annualized, she was sold for scrap in 2004, fetching almost $23 million, far more than her purchase price of $6 million.

Sometimes the best trades aren’t on public exchanges. Looking outside traditional trading vehicles can reveal huge opportunities other traders pass up.

SPACs

An unusual opportunity to buy assets at a discount arose during the financial crash of 2008–09, in the form of certain closed-end funds called SPACs. These “special purpose acquisition corporations” were marketed during the preceding boom in private equity investing. Escrowing the proceeds from the initial public offering (IPO) of the SPAC, the managers promised to invest in a specified type of start-up company. SPACs had a dismal record by the time of the crash, their investments in actual companies losing, on average, 78 percent. When formed, a typical SPAC agreed to invest the money within two years, with investors having the choice—prior to the SPAC buying into companies—of getting back their money plus interest instead of participating.

By December 2008, panic had driven even those SPACs that still owned only US Treasuries to a discount to NAV. These SPACs had from two years to just a few remaining months either to invest or to liquidate and, before investing, offer investors a chance to cash out at NAV. In some cases we could even buy SPACs holding US Treasuries at annualized rates of return to us of 10 to 12 percent, cashing out in a few months. This was at a time when short-term rates on US Treasuries had fallen to approximately zero!

Runaway Inflation

Short-term US Treasury bill returns went into double-digit territory, yielding almost 15 percent in 1981. The interest on fixed-rate home mortgages peaked at more than 18 percent per year. Inflation was not far behind. These unprecedented price moves gave us new ways to profit. One of these was in the gold futures markets.

At one point, gold, for delivery two months in the future, was trading at $400 an ounce and gold futures fourteen months out were trading for $500 an ounce. Our trade was to buy the gold at $400 and sell it at $500. If, in two months, the gold we paid $400 for was delivered to us, we could store it for a nominal cost for a year, then deliver it for $500, gaining 25 percent in twelve months.

Notice the commonalities between Thorp’s fat pitches:

  • They’re rare and typically occur during crises. Crises create large dislocations that cause investors to act irrationally, creating huge opportunities.
  • They all have asymmetric risk/reward ratios.
  • Fast action was needed to capture each of them. Fat pitches don’t last long. Other traders will eventually find them and pounce.
  • They’re all “one of a kind” opportunities. The exact scenario had never happened before and creative thinking was needed to capitalize. Although history rhymes, it does not repeat. The next fat pitch won’t be exactly like the last one.  

Gambling As Training

Understanding gambling games like blackjack and some of the others is one of the best possible training grounds for getting into the investment world. You learn how to manage money, you learn how to compute odds, you learn how to reason what to do when you have an advantage.

Gambling is investing simplified. Both can be analyzed using mathematics, statistics, and computers. Each requires money management, choosing the proper balance between risk and return. Betting too much, even though each individual bet is in your favor, can be ruinous.

Notice how Thorp didn’t say anything about MBAs, economic degrees, or finance classes. Those don’t prepare you for the core challenges you’ll face as a trader like position sizing and risk management.

Our favorite cross-training exercise at Macro Ops is poker. Poker forces you to think in terms of probabilistic outcomes while managing your risk and establishing an edge.

Edge

You can’t succeed in trading without an edge. And a good way to find that edge is by asking yourself how the market is inefficient and how you can exploit it.

In A Man For All Markets Thorp details sources of inefficiency:

In our odyssey through the real world of investing, we have seen an inefficient market that some of us can beat where:

  1. Some information is instantly available to the minority that happen to be listening at the right time and place. Much information starts out known only to a limited number of people, then spreads to a wider group in stages. This spreading could take from minutes to months, depending on the situation. The first people to act on the information capture the gains. The others get nothing or lose. (Note: The use of early information by insiders can be either legal or illegal, depending on the type of information, how it is obtained, and how it’s used.)
  2. Each of us is financially rational only in a limited way. We vary from those who are almost totally irrational to some who strive to be financially rational in nearly all their actions. In real markets the rationality of the participants is limited.
  3. Participants typically have only some of the relevant information for determining the fair price of a security. For each situation, both the time to process the information and the ability to analyze it generally vary widely.
  4. The buy and sell orders that come in response to an item of information sometimes arrive in a flood within a few seconds, causing the price to gap or nearly gap to a new level. More often, however, the reaction to news is spread out over minutes, hours, days, or months, as the academic literature documents.

He then explains how to exploit these inefficiencies (emphasis mine):

  1. Get good information early. How do you know if your information is good enough or early enough? If you are not sure, then it probably isn’t.
  2. Be a disciplined rational investor. Follow logic and analysis rather than sales pitches, whims, or emotion. Assume you may have an edge only when you can make a rational affirmative case that withstands your attempts to tear it down. Don’t gamble unless you are highly confident you have the edge. As Buffett says, “Only swing at the fat pitches.”
  3. Find a superior method of analysis. Ones that you have seen pay off for me include statistical arbitrage, convertible hedging, the Black-Scholes formula, and card counting at blackjack. Other winning strategies include superior security analysis by the gifted few and the methods of the better hedge funds.
  4. When securities are known to be mispriced and people take advantage of this, their trading tends to eliminate the mispricing. This means the earliest traders gain the most and their continued trading tends to reduce or eliminate the mispricing. When you have identified an opportunity, invest ahead of the crowd.

Pay special attention to his second point: Don’t trade unless you’re sure you have an edge that’ll create better than random outcomes.

An easy way to do this is by backtesting or paper trading your strategy before investing in it.

It’s also a good idea to try finding a solid trading edge in markets you love. As Thorp explains:  

To beat the market, focus on investments well within your knowledge and ability to evaluate, your “circle of competence.”

If you love following small companies then just trade those. If you come from an energy background then focus on crude oil and natural gas. And if you like math and volatility, options are a good place to start. Only venture into a new market after spending a significant amount of time studying it!

Efficient Markets

Anyone who’s actually traded knows the Efficient Market Hypothesis is bogus. It’s a poor mental model used by lazy academics. Thorp has a much better take:

When people talk about efficient markets they think it’s a property of the market. But I think that’s not the way to look at it. The market is a process that goes on. And we have, depending on who we are, different degrees of knowledge about different parts of that process.

. . . market inefficiency depends on the observer’s knowledge. Most market participants have no demonstrable advantage. For them, just as the cards in blackjack or the numbers at roulette seem to appear at random, the market appears to be completely efficient.

Markets aren’t actually random. They only appear random to those without expertise. The right knowledge transforms the market from a sequence of random numbers into a predictable process.

Combining Technicals With Fundamentals

In the mid 2000s Thorp developed a trend following futures strategy. During the process he discovered that combining fundamental information with technical signals was superior to just technicals alone.

Here he is in Hedge Fund Market Wizards:  

The fundamental factors we took into account varied with the market sector. In metal and agricultural markets, the spread structure—whether a market is in backwardation or contango—can be important, as can the amount in storage relative to storage capacity. In markets like currencies, however, those types of factors are irrelevant.

Combining technicals with fundamentals can boost your win rate. Find the key fundamental drivers in your market and add them into your process.

Anchoring

In A Man For All Markets Thorp describes his first ever trade buying a company called Electric Autolite. In the subsequent two years the stock declined 50%. He decided to hold out, hoping it would return to his entry point so he could break even. The stock eventually did rebound and Thorp got out for a scratch, but he later realized how stupid that was. Here’s Thorp reflecting on it:

What I had done was focus on a price that was of unique historical significance to me, only me, namely, my purchase price.

Thorp’s early mistake is called anchoring. Humans tend to place special significance on price levels they originally entered at. But in reality, these prices have little significance. Don’t ever emotionally attach yourself to any price.

Interpreting Financial Headlines

It’s important to take news headlines with a grain of salt. Journalists build narratives behind every market move because it’s their job. Thorp warns about getting caught up in the noise:

Routine financial reporting also fools investors. “Stocks Slump on Earnings Concern” cried a New York Times Business Day headline. The article continued, “Stock prices fell as investors continued to be concerned about third-quarter results.” A slump? Let’s see. “The Dow Jones Industrial Average (DJIA) declined 2.96 points, to 10,628.36.” That’s 0.03 percent, compared with a typical daily change of about 1 percent. Based on the historical behavior of changes in the DJIA, a percentage change greater than this happens more than 97 percent of the time. The Dow is likely to be this close to even on fewer than eight days a year, hardly evidence of investor concern.

One way to separate signal from noise is to track the market’s expected move for the day. To calculate the expected percentage move of the S&P 500, take the VIX and divide it by the the square root of 252. If price stays within that band, any “news” for the day is likely not worth paying attention to.

Correlation

All the trading greats stress the importance of correlation. A low correlation among positions diversifies the portfolio and creates a much better risk/reward profile.

Here’s Thorp from HFMW:

We tracked a correlation matrix that was used to reduce exposures in correlated markets. If two markets were highly correlated, and the technical system went long one and short the other, that was great. But if it wanted to go long both or short both, we would take a smaller position in each.

A common problem traders face when monitoring correlation is the lookback period. Thorp found that 60 days was best. A shorter window is too noisy and a longer one will produce correlations that aren’t relevant anymore.

The Moore Research Center has a free to use correlation matrix for all major macro markets. Check it here.

Leverage

Use leverage incorrectly and you’ll blow up. But properly harness it and you can engineer a risk to reward ratio that perfectly suits you.

Heres Thorp:

The lesson of leverage is this: Assume that the worst imaginable outcome will occur and ask whether you can tolerate it. If the answer is no, then reduce your borrowing.

Don’t rely on a risk control model that uses probability to estimate your max loss. Always assume the absolute worst case and manage from there.

Position Sizing

Thorp popularized the position sizing formula called the Kelly Criterion. Here he is from Hedge Fund Market Wizards:

The Kelly criterion is the bet size that will produce the greatest expected growth rate in the long term. If you can calculate the probability of winning on each bet or trade and the ratio of the average win to average loss, then the Kelly criterion will give you the optimal fraction to bet so that your long-term growth rate is maximized.

Here’s the version of the formula that works best for trading:

So for example, if a trade has a 1:1 reward to risk ratio, with a 60% chance of winning, you would bet:

((1)(.6)-(.4))/1 = .2 or 20% of your account

The one issue with Kelly sizing is that we’ll never know our true win rate or reward to risk ratio in markets. The best we can do is estimate.

Also, the effectiveness of a trading edge changes over time. Because markets evolve, the same edge won’t work forever.

This is why Thorp only uses the Kelly number as a reference. In practice it’s better to bet around half-Kelly because you get about three-quarters of the return with half the volatility.

If you’re less certain of your edge, you should bet an even smaller amount. When Thorp was working on his trend following model in the mid 2000s, he was simulating 1/10 of the Kelly number.

Thorp also has advice on drawdowns. He suggests lowering your position size during rough patches and then ramping up again as you come out of them.

If we lost 5 percent, we would shrink our positions. If we lost another few percent, we would shrink our positions more. The program would therefore gradually shut itself down, as we got deeper in the hole, and then it had to earn its way out. We would wait for a threshold point between a 5 percent and 10 percent drawdown before beginning to reduce our positions, and then we would incrementally reduce our position with each additional 1 percent drawdown.

This is an extremely robust risk management technique used by many of the Trading Greats. To read more about them, download our special report covering by clicking here.

Lessons From A Trading Great Amos Hostetter
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Lessons From Commodities Corporation Founder & Trader Amos Hostetter

Amos Hostetter cofounded Commodities Corporation (otherwise known as CC) along with Helmut Weymar back in 1969. CC is the trading shop that produced more legendary trading talent than the Yankees have All-Stars. Alumni include: Bruce Kovner, Michael Marcus, Paul Tudor Jones, Ed Seykota and more…

Hostetter was considered the wise sage and mentor of the group. He’s credited with imbuing many of these trading greats with the wisdom and knowledge they used to achieve their grand heights.

Upon his untimely death in a car accident in 1977, the directors of Commodities Corporation commissioned one of their traders, Morris Markovitz, to gather and record Hostetter’s timeless philosophy on markets and trading. The goal was to ensure future CC traders could benefit from his invaluable teachings. The resulting work was an internal booklet titled Amos Hostetter; A Successful Speculator’s Approach to Commodities Trading.

Hostetter’s trading philosophy could be boiled down to the following (in Hostetter’s own words):

  1. Try to acquire every bit of fundamental information available. Read extensively.
  2. Simultaneously, post daily charts on commodities and develop a feel for trends.
  3. Follow the fundamentals in your trading but only if and as long as the charts do not cast a negative vote.

He regarded money management as the first priority for any serious market speculator. From Markovitz (emphasis mine):

Sound money management is crucial to successful trading. The best market analysis won’t get a trader to the bottom line — consistent profits — unless he has a sound money-management policy. This is an area where Mr. Hostetter excelled.

Sometimes it is hard to draw a sharp line between trading principles and money-management principles. If I were to paraphrase a famous saying, I think it would provide an accurate summary of one of Mr. Hostetter’s most important trading and money-management principles: the market, to be commanded, must be obeyed. As a trader, Mr. Hostetter was aware of his own fallibility. He tried to protect himself from errors by the trading rules he used and by trying to anticipate areas of potential surprise. This alone, however, was not enough. If the market moved against him for a reason he did not understand, he would often exit without waiting for a trading rule to take him out: as a money manager, he knew he could not afford the luxury of a prolonged argument with the market.

Perhaps his most important money-management principles was “Take care of your losses and the profits will take care of themselves.” This means that a trader should place strong emphasis on keeping his losses small, because two or three large losses in succession would be a crippling blow.

His risk management principle of “taking care of your losses” is similar to Howard Marks of Oaktree Capital: “if we avoid the losers, the winners will take care of themselves.” This truth is the single most important law of speculation. It sounds glib, but cutting your losses and letting your winners run is the most common thread amongst all great traders. If I could travel back in time 15 years, I’d go back and beat this fact into my thick skull… and I’d be much richer today for it.

Hostetter used a multi-pronged approach to assessing markets and potential trades. It’s from him that Michael Marcus likely developed the “Marcus-Trifecta” to gauge markets — looking at “technicals, fundamentals, and market tone”. Here’s an overview of his approach to fundamentals:

Mr. Hostetter’s fundamental approach was, to use his own phrase, “broad brush.” This means that he would look at the overall balance sheet and the statistics that applied to the commodity in which a trade was contemplated. Then, certain basic questions would be asked:

— Will production exceed consumption this season (a stocks build-up)? If so, then the initial premise would be bearish.

— Will consumption exceed production (a stocks draw-down)? If so, then the initial premise would be bullish.

The initial premise would then be refined by other considerations. For example: weather could destroy the current production estimate for an agricultural commodity; a change in general economic conditions could destroy the demand or consumption estimate; the high price of meat could increase demand for potatoes.; the low price of corn could increase demand for soybean meal; and so forth. The last two items are intended to illustrate the flexibility, or creativity, of Mr. Hostetter’s thinking, and represent the personal style he brought to commodity analysis. He held facts in the highest regard, yet he remained constantly alert to the principle that the facts can and do change.

The key phrase is flexibility of thinking, which is the opposite of stubbornness. Mr. Hostetter knew that, whatever his fundamental analysis might show today, there was a good chance it would show something different by the time the last day of the season had arrived… In brief, Mr. Hostetter would never wed himself to a precise position on the outlook for the future; he had often enough experienced the phenomenon of a significant price change before the reasons behind it became general knowledge. He kept himself prepared for surprises, in both directions, in advance. If one does a little “dreaming” about the possibilities on both sides, then he is in possession of possible explanations for surprises, and will be less hesitant to act if and when they come.

Maintaining an open-mind and staying aware of your biases is critical. Markets serve ample helpings of humble pie to those who arrogantly wed themselves to a “market prediction”.

Hostetter took a nuanced approach to using technicals, similar to how we utilize price action in our trade analysis at Macro Ops. Markovitz writes:

Mr. Hostetter definitely did not accept the clear-cut dichotomy between fundamental and technical trading. Both methods can be used successfully, but he blended the two. It is my impression that Mr. Hostetter would have agreed with the following statement:

The pure fundamentalist concerns himself with production, consumption, stocks, and other basic economic data, viewing these as the causes and price as the effect, while the pure technician regards price as its own cause. In fact, to draw a sharp line of choice between these two approaches is not the best policy. Price itself should also be regarded as a fundamental. It can play the role of cause or effect or both under different circumstances.

The market’s own behavior can, in a real sense, be classified as a fundamental variable. The method of analysis, however, is completely different. The technical aspect of Mr. Hostetter’s trading consists primarily of:

1. Trend following
2. Support and resistance areas
3. Pattern recognition

These are listed in order of their importance, although any one of them may be the dominant influence at a  given time.

Within this technical framework Hostetter employed a number of useful heuristics to help him read the tape:

Many of the techniques Mr. Hostetter used depended on a time factor. In general, as with congestion areas, most patterns accrue more significance if they take more time to form, and a trader should be aware of time as well as price when considering any technical pattern. For example, a bear market that has persisted for a year is unlikely to form its bottom in a week, nor is a two-month bull market likely to take a year to form a top. A trader should keep in mind the duration of recent major moves and expect commensurate time periods for the formation of the current pattern. (Patience is an important virtue — hastiness rarely pays).

I find Hostetter’s thoughts on the “time factor” useful in analyzing where price may be headed. Markets tend to follow a certain symmetry over long periods of time. Some technical heuristics Hostetter used are:

  • He would become seriously concerned if a bull market was unable to make a new high for thirty days (the same is true for a bear market that hadn’t made new lows for thirty days).
  • A poor price response to bullish news is itself an ill omen for long positions, especially if other cautionary signs are present (e.g., the bull market is old, the vigor has shown some signs of waning, prices are near a fundamental objective, etc.)
  • The most important timing issue is patience. One should wait for his opportunity, wait until everything lines up according to his expectations. It is far better to miss an opportunity here or there than to jump in too early without a clear plan. Too much patience is rarely the problem for any trader.
  • A trader should do his fundamental homework, keep his eye on the charts, and patiently observe. Once he is able to form a definite fundamental opinion, he should wait for confirming market action before proceeding.

Practicing the necessary patience to win is one of the hardest aspects of speculation. Fear is man’s strongest emotion and is behind one of a trader’s most common foibles — the fear of missing out (FOMO). Success comes to those who realize that Pareto’s Law dominates the distribution of returns. Only a handful of trades a year will account for the majority of profits. It pays to sit and wait patiently for those fat pitches to come along.

Lastly, here’s a list of maxims and trading do’s and don’ts as recorded by Hostetter in his own words.

GENERAL PRINCIPLES AND MARKET MAXIMS

  • A very general and important rule is: take care of your losses and your profits will take care of themselves. This is both a trading maxim and a money-management tool. A trader needs big winners to pay for his losses and he won’t capture these big wins unless he stays with the trend all the way.
  • There is never any objection to taking a loss. There must always be a good reason before you can permit yourself to close out a profit.
  • When in doubt, get out. Don’t gamble. Be sure, however, that your doubt is based on something real (fundamentals, market action, etc.), and not simply on your own nervousness about the price level. If it is only the price level that is making you nervous, then either stick with the winner or at worst use a more sensitive stop-loss point. Give the major trend all the chance you can to increase your profits.
  • All major trends take a long time to work themselves out. There are times when the best approach is just to sit and do nothing, letting the power of the underlying trend work for you while others argue about the day-to-day news. Be patient.
  • Surprising price response to news is one of the most reliable price forecasters. Bullish response to bear news, or vice-versa, means that the price had already discounted the news and the next move will probably go the other way. Actually, this is only one example of a wider principle: When a market doesn’t do what it “should”, then it will probably do what it “shouldn’t”, and fairly soon. (Note that false breakouts, up or down, are also subsumed under this more general principle. When new lows are achieved in a long-term bear market, for example, the market ‘ ‘should” follow through with weakness—after all, it is a bear market. If, instead, it rallies quickly, this provides some evidence against the bear market premise).

THE DANGERS IN TRADING CAUSED BY HUMAN NATURE

  1. Fear — fearful of profit and one acts too soon.
  2. Hope — hope for a change [in the] forces against one.
  3. Lack of confidence in one’s own judgment.
  4. Never cease to do your own thinking.
  5. A man must not swear eternal allegiance to either the bear or bull side. His concern lies in being right.
  6. Laziness prevents a trader from keeping posted to the minute.
  7. The individual fails to stick to facts.
  8. People believe what it pleases them to believe.

DON’TS

  1. Don’t sacrifice your position for fluctuations.
  2. Don’t expect the market to end in a blaze of glory. Look out for warnings.
  3. Don’t expect the tape to be a lecturer. It’s enough to see that something is wrong.
  4. Never try to sell at the top. It isn’t wise. Sell after a reaction if there is no rally.
  5. Don’t imagine that a [market] that has once sold at 150 must be cheap at 130.
  6. Don’t buck the market trend.
  7. Don’t look for breaks. Look out for warnings.
  8. Don’t try to make an average from a losing game.
  9. Never keep goods that show a loss and sell those that show a profit. Get out with the least loss and sit tight for greater profits.

SUGGESTIONS

  1. Experience must teach. Follow it invariably.
  2. Observation gives the best tips of all. Observe [market] behavior and experience shows how to profit.
  3. Buying on a rising market is the comfortable way. The point is not so much to buy as cheap as possible or go short at top prices, but to buy and sell at the right time.
  4. Remember [a market is] never too high for you to begin buying or too low to begin selling. Let your tape reading show you when to begin. After the initial transaction don’t make a second unless the first shows a profit.
  5. There is a great deal in starting right in every enterprise.
  6. When something happens on which you did not count when your plans were made, it behooves you to utilize the opportunity.
  7. In a bear market it is always wise to cover if complete demoralization develops suddenly.
  8. Stick to facts only and govern your actions accordingly.
  9. What is abnormal is seldom a desirable factor in a trader’s calculations. If a [market] doesn’t act right, don’t touch it.
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Lessons From A Trading Great: Jim Leitner

Jim Leitner is the greatest macro trader you’ve never heard of. He was once a currency expert on Wall Street, pulling billions from the markets, but now he plays the game through his own family office.

Leitner understands the Macro Ops “go anywhere” mentality better than any other trader:

Global macro is the willingness to opportunistically look at every idea that comes along, from micro situations to country-specific situations, across every asset category and every country in the world. It’s the combination of a broad top-down country analysis with a bottom-up micro analysis of companies. In many cases, after we make our country decisions, we then drill down and analyze the companies in the sectors that should do well in light of our macro view.

I never lock myself down to investing in one style or in one country because the greatest trade in the world could be happening somewhere else. My advice is to make sure that you do not become too much of an expert in one area. Even if you see an area that is inefficient today, it’s likely that it won’t be inefficient tomorrow. Expertise is overrated.

He’ll jump into any asset or market, no matter how esoteric. Some of his craziest investments include inflation-linked housing bonds in Iceland and a primary equity partnership in a Ghanaian brewer. He even had the balls to jump into Turkish equities and currency forwards with 100% interest rates and 60% inflation during the late 90’s… the man is a macro beast.

FX Trading

Leitner was one of the first traders to understand and implement FX carry trades. A carry trade involves borrowing a lower interest rate currency to buy a higher interest rate currency. The trader earns the spread between the two rates. Here’s his own words from Drobny’s Inside The House Of Money:

The most profitable trade wasn’t a trade but an approach to markets and a realization that, over time, positive carry works. Applying this concept to higher yielding currencies versus lower yielding currencies was my most profitable trade ever. I got to the point in this trade where I was running portfolios of about $6 billion and I remember central banks being shocked at the size of currency positions I was willing to buy and hold over the course of years.

FX carry trades can be extremely lucrative. But if you get caught holding a currency during a surprise devaluation, it can instantly erase all your profits and them some. Leitner was able to protect himself by keeping a close eye on central bank action:

I was always able to sidestep currency devaluations because there were always clear signals by central banks that they were pending and then I just didn’t get involved. Devaluations are such a digital process that it doesn’t make sense to stand in front of the truck and try to pick up that last nickel before getting run down.You might as well wait, let the truck go by, then get back on the street and continue picking up nickels.

Leitner understands that currencies mean revert in the short-term and trend in the long-term. He’s explored the use of both daily and weekly mean reversion strategies:

The other thing that is pretty obvious in foreign exchange is that daily volatilities are much higher than the information received. Think of it like this:

The euro bottomed out in July 2001 at around 0.83 to the dollar and by January 2004 it was trading at 1.28. That’s a 45 big figure move divided by 900 days, giving an average daily move of 5 pips, assuming straight line depreciation. Say one month option volatility averaged around 10 percent over that period, implying a daily expected range of 75 pips.That’s a signal-to-noise ratio of 1 to 15. In other words, there was 15 times as much noise as there was information in prices!

Noise is just noise, and it’s clearly mean reverting. Knowing that, we should be trading mean reverting strategies. In the short term, it’s a no brainer to be running daily and weekly mean reverting strategies. When things move up by whatever definition you use, you should sell and when they move back down, you should buy. On average, over time you’re going to make money or earn risk premia.

Options

No one has mastered global macro options better than Leitner. He knows when they’re overpriced and when they make a great bet:

Short-dated volatility is too high because of an insurance premium component in short-dated options. People buy short-dated options because they hope that there’s going to be a big move and they’ll make a lot of money. They spend a little bit to make a lot and, on average, it’s been a little bit too much. When they do make money they make a lot of money, but if they do it consistently they lose money. Meanwhile, someone who consistently sells short-dated volatility, on average, would make a little bit of money. It’s a good business to be in and not too dissimilar to running a casino. So there is a risk premia there that can be extracted.

Longer-dated options are priced expensively versus future daily volatility, but cheaply versus the drift in the future spot price. We need to make a distinction between volatility and the future drift of the currency. Since the option’s seller (the investment bank) hedges its position daily, it makes money selling options. Since some buyers do not delta hedge but instead allow the spot to drift away from the strike, they make money on the underlying trend move in the currency. So both the seller of the option and the buyer make money. The profit for the seller comes from extracting the risk premia in the daily volatility, and for the buyer it comes from the fact that currency markets tend to exhibit trending behavior.

We had a study done on the foreign exchange options market going back to 1992, where one-year straddle options were bought every day across a wide variety of currency pairs.We found that even though implied volatility was always higher than realized volatility over annual periods, buying the straddles made money. It’s possible because the buyer of the one-year straddles is not delta hedging but betting on trend to take the price far enough away from the strike that it will cover the premium for the call and the put. Over time, there’s been enough trend in the market to carry price far enough away from the strike of the one-year outright straddle to more than cover the premium paid.

If the option maturity is long enough, trend can take us far enough away from the strike that it’s okay to overpay.

This is a key concept that very few option traders understand. High vol doesn’t mean huge trends. And low vol doesn’t mean no trends. It’s possible to have low vol trends and high vol ranges.

Leitner exploits this kink in option theory by “overpaying” for optionality from a volatility perspective, but still winning from trending markets.

These overpriced long-dated options become essential in choppy markets. They allow you to “outsource” risk management. You can play for a long-term trend without the risk of getting stopped out by a head fake:

Options take away that whole aspect of having to worry about precise risk management. It’s like paying for someone else to be your risk manager. Meanwhile, I know I am long XYZ for the next six months. Even if the option goes down a lot in the beginning to the point that the option is worth nothing, I will still own it and you never know what can happen.

Psychology, Emotions, And Fallibility

Like every other star trader, Leitner has strong emotional control. He views all trades within a probabilistic framework and fully accepts his losses:

At Bankers, I came to realize that I was absolutely unemotional about numbers. Losses did not have an effect on me because I viewed them as purely probability-driven, which meant sometimes you came up with a loss. Bad days, bad weeks, bad months never impacted the way I approached markets the next day.To this day, my wife never knows if I’ve had a bad day or a good day in the markets.

Along with reigning in his emotions, he also acknowledges his own fallibility:

Another thing that I realize about myself that I don’t see in other traders is that I’m really humble about my ignorance. I truly feel that I’m ignorant despite having made enormous amounts of money.

Many traders I’ve met over the years approach the market as if they’re smarter than other people until somebody or something proves them wrong. I have found this approach eventually leads to disaster when the market proves them wrong.

It’s not possible to “crack” the market. You’re guaranteed to eventually be proven wrong no matter how smart you are. And when that time comes, you have to stop the bleeding before death occurs. The trading graveyard is littered with “smart guys” who thought they solved the market puzzle… don’t be one of them.

Investment Narratives

A compelling narrative is both a blessing and a curse.

On the one hand, understanding the dominant market narrative will keep you on the right side of a powerful trend. But it can also lure you into some dumb trades. Not all narratives are rooted in fundamental reality. Oftentimes a false trend will form and lead to a boom/bust process. Here’s Leitner’s take:

We need to quantify things and understand why things are cheap or expensive by using some hard measure of what cheap or expensive means. Then there has to be a combination of story and value. A story is still required because a story will appeal to other people and appeal is what drives markets. If there’s no story and something’s cheap, it might just stay cheap forever. But if there’s a story involved, make sure that you first look at the numbers before you get involved to be sure there is some quantitative backing to the idea.

Leitner’s team always starts with quantitative scans when hunting for equities. If the quant data doesn’t check out, there’s a higher risk of falling prey to an overhyped narrative.

In equities, we start by looking at various valuation measurements like price to book, price to earnings, and price to cash flow. It’s very important to not be too story-driven. A way to avoid that is by using quantitative screens to determine what is cheap. Once you find things that are cheap, then look for stories that argue why it shouldn’t be cheap. Maybe a stock is cheap but it’ll stay cheap forever because there’s no good story attached to the cheapness.

Longs Vs Shorts

It’s no surprise that being long financial assets has a positive expected value over time. Stocks and bonds pay a premium to incentivize investors to move out of cash and take risk.

This is why you need twice your normal conviction to go short. The system is designed to move higher over time, so you better have a damn good reason to fight that drift.

Owning assets, or being long, is easier and also more correct in the long term in that you get paid a premium for taking risk.You should only give your money to somebody if you expect to get more back. Net/net it is easier to go long because over portfolios and long periods of time, you’re assured of getting more money back. Owning risk premia pays you a return if you wait long enough, so it’s a lot easier to be right when you’re going with the flow, which means being long. To fight risk premia, you have to be doubly right.

Leverage

Mention the word “leverage” around rookie traders and they’ll run for the hills. Most think it’s a quick way to blow up a trading account. But the pros view leverage as a tool that can completely transform and enhance risk-adjusted returns. Ray Dalio is traditionally the one credited with using this concept to make billions.

Let’s say you have a 30-yr bond that returns 6% a year above the cash rate. It has a max drawdown of 20%.

You then compare it to a stock index that returns 9% a year above the cash rate. It has a max drawdown of 50%.

By applying leverage, you can transform the bond into the higher performing asset. Using 2x leverage on the long bond will give you 12% returns with 40% drawdowns. This is a much better deal than the stock index on a risk-adjusted basis. This technique is known as “risk parity.”

Leitner applies it to his fixed income investments:

When using leverage, you want the highest Sharpe ratio because you’re borrowing money against your investment, and the best Sharpe ratios are found in the two years and under the sector of fixed income. On an absolute return basis, two years and under bonds are not going to pay as much as a 10-year bond because the yields are usually lower. But the risk-to-return ratio is also very different.You could be five times levered in the two-year and get a higher payout with the same risk as a 10-year bond because of duration.

Going levered long 2-year notes is a better risk-adjusted trade than going long a 10-year note. You get the same return in the levered 2-year, but with less volatility.

Most investors can’t exploit this because they can’t use leverage. But a macro trader using futures can perform all sorts of financial wizardry and vastly outperform a typical cash-only fund.

Portfolio Construction

Over time Leitner has adapted his strategy away from traditional global macro. Instead of using market timing, trend following, and gut feel — the pillars of old school macro — he’s shifted to a multi-strategy approach.

He combines various system-based strategies across five main asset classes: Equities, Fixed Income, Currencies, Commodities, and Real Estate. His goal is to earn the risk premia present in each category. He then reserves a certain amount of his cash for special situation big bets that only come around a few times a year.

We start off by acknowledging that we are ignorant, so we need to be systematic, clip some coupons, and earn some risk premia. It doesn’t matter if it is in currencies, bonds, commodities, real estate, or equities. Of course we have to be smart about it by reading a lot, talking to smart people, and being on top of it all, while acknowledging that we’re not that much smarter than the rest of the world.Then, every once in awhile, we’re going to stumble upon an exciting idea that’s going to give us some extra alpha and the ability to outperform.

After these five main asset categories, we have a last category which we call absolute return.This is where we stick those great, out-of-the-box ideas we come across about twice a year. Sometimes we’re lucky and find major mispricings once or twice a year, and sometimes we’re unlucky and it takes 18 months before the next one comes along. When we find these fantastic ideas, we’re willing to bet up to 10 percent of our fund on one idea. One that we think will double or triple, earning an extra 10 or 20 percent return for the entire portfolio.

The absolute return category is there in order to leave us open to making unsystematic money.

The multi-strat approach is the most robust way to allocate capital. Most of the macro legends of the 70s, 80s, and 90s have moved to a family office format and implemented something similar to what Leitner describes. At Macro Ops we too use a combination of discretionary and systematic strategies to make sure the cash register keeps ringing year after year.

For more details on how Jim Leitner analyzes, sizes, and manages his trades, check out our Ops Notes by entering your email below:

 

 

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