Liquidity The Most Important Fundamental
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Liquidity: The Most Important Fundamental

I’m sure you’ve heard analysts, financial pundits, and other babbling heads yabber on and on about how these markets don’t reflect the “fundamentals”.

They’ve ranted non-stop about how the fundamentals prove that a bear market is around the corner.

They’ve raved about valuations being stretched and how stocks will collapse any day now…

If you’ve been taking investment advice from these doomsdayers, then please accept my condolences for your portfolio loss.

These broken clocks should heed the words of Mark Twain:

Denial ain’t just a river in Egypt.

No, denial is not just a river in Egypt, it’s also the perpetual state most market participants live in.

Now I’m not bashing the usefulness of what are commonly thought of as fundamentals. Things like earnings per share, book value, and revenue growth are indeed important.

What I’m saying is that these are only a few pieces of a much larger puzzle.

The dictionary defines the word fundamental as, “a central or primary rule or principle on which something is based.”

If there’s one “central or primary rule” on which all fundamentals are based, it’s liquidity. Liquidity is the Mac-Daddy of fundamental inputs. And not surprisingly, it’s the least known and understood.

Here’s one of the greatest of all time, Stanley Druckenmiller, on the importance of liquidity (emphasis mine):

Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.

So what is liquidity exactly?

In simple terms, liquidity is demand, which is the willingness of consumers to purchase goods and other assets. This demand is driven by the tightening and easing of credit.

What we usually think of as money (the stuff we use to buy things) is comprised of both hard cash + credit. The amount of hard cash in the system is relatively stable. But credit is extremely elastic because it can be created by any two willing parties. It’s this flexibility that makes it the main factor in driving liquidity/demand.

The majority of credit, and therefore money, is created outside the traditional banking sector and government. Most is created between businesses and customers. When businesses purchase wholesale supplies on credit; money is created. When you open a Best Buy credit card to purchase that new flat screen TV; money is created. And when you purchase stocks on margin from your broker; money is created.

The logic is simple. The more liquidity and credit in the system, the more demand, which in turn pushes markets higher.

Which leads us to our next question: What are the largest levers that affect the amount of credit, money, and liquidity in the system?

The answer to that is interest rates. These are set by both central banks and the private market.

The primary rate set by central banks is the largest factor in determining the cost of money. And the cost of money in turn determines liquidity/demand in the system.  

When the cost of money is low (low interest rates) more demand is created in two ways: [1] it makes sense to exchange lower yielding assets for riskier, higher yielding ones and [2] more people are willing to borrow and spend (money is created) because credit is cheaper.

This affects the stock market in two ways: [1] share prices rise as investors trade up to riskier assets and [2] companies’ total sales increase because of higher consumer demand caused by cheaper credit. Liquidity affects both the denominator (earnings) and numerator (price per share) in stock valuations as it drives markets higher.

You may be asking yourself, “well, if the primary rates set by central banks are this important, then will markets stay forever inflated as long as they keep rates low?”

No, they won’t.

Though central bank rates are the largest influence on demand and the cost of money, they are not the only influence.

The private sector assigns its own rates based off the central bank rate, but also includes an additional premium (or spread) that fluctuates according to the credit risks they see in the market.

For instance, even though the Fed Funds rate has remained near zero over the last two years, interest rates on high-yield loans (the primary lending market to the energy sector) ballooned during the recent oil collapse because of increased perceived risks. Money tightened and became more expensive as liquidity became constrained in that sector. This type of liquidity tightening is what causes markets to fall, regardless of whether the primary rate is low or not.

The way liquidity ebbs and flows directly affects market narratives.  

The 2008 financial crisis occurred because central banks cranked up liquidity to jumpstart the economy after the 2000 tech bust. All this extra money got dumped into housing. That’s how the bullish real estate narrative was born. Eventually a bubble formed and later popped as liquidity dried up.   

And of course the central bank’s response was to ease even more. They’ve now kept the liquidity spigots blasting longer than any other time in history. As long as liquidity conditions stay positive, we can expect the bulls to keep running.

Like Druck said “It’s liquidity that moves markets.” Bull markets, bear markets, everything.

Knowing how to gauge liquidity is the number one thing you can do protect your capital and profit.

To learn more about gauging liquidity, download our investment handbook here.

 

 

Lessons From A Trading Great Amos Hostetter
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Lessons From A Trading Great: 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 CC 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.

To get more wisdom from trading greats like Hostetter, click here.

 

 

The Embodiment Of Trading Greatness

Donald Trump: The Embodiment Of Trading Greatness

Paul Tudor Jones, Bruce Kovner, Jesse Livermore… forget about em.

The only name you need to know when it comes to trading greatness is Donald Trump.

He’s everything a trader should aspire to be. When it comes to having “strong opinions, weakly held”, Trump has EXTREMELY strong opinions, EXTREMELY weakly held.

At the beginning of his campaign, The Donald was 2000% sure that China was a currency manipulator. But after a single piece of chocolate cake with his new buddy Xi, China was a problem no more.

In fact, that piece of cake was SO good that Trump is now looking to improve trade relations with the country. Along with changing his stance on NATO, Trump has quickly transformed from a staunch isolationist against all imports (other than his wife) to an avid globalist.

That’s what makes him amazing. He has an ability to turn on a dime that is uncanny. You can never pin him down to one idea, because he’s always switching his stance. He’s more flexible than a Cirque du Soleil performer.

Some people call Trump a populist, changing his position to whatever the most people want, but that’s not true. In reality, he’s just extremely fallible.

Trump is a master of changing his mind as soon as “new” information becomes available.

Everyone thought Trump and Putin were best buds. But they quickly ate their words when Trump hit Syrian President Bashar al-Assad with a few Tomahawks.

Maybe Trump and Putin were friends at one time, but that was before Trump saw that infomercial of the Syrian kids. This “new” information forced him to rip off the friendship bracelet Putin gave him and take action.

See? Huuuuuuge amounts of fallibility.

As Stanley Druckenmiller once explained:

I’ve learned many things from [George Soros], but perhaps the most significant is that it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.

In Trump’s case, it’s not about doing what’s right or wrong, but how much money (or votes) you come away with in the end.

If you want to be a great trader, you need to be like Trump. Start with your fallibility and then move on to fixing your hair.

Good luck!

We’re kidding. Obviously. To learn from the real trading greats, click here.

 

 

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Do Buyers Of Options Benefit From High Volatility?

Search “options and volatility” in Google and you’ll get a dozen websites that say the same thing: option buyers want high volatility and option sellers want low volatility. Oddly enough, this old and relied upon rule of thumb isn’t completely correct.

In reality, as an option trade plays out, trend has a far more powerful effect than volatility on final P&L.

There are four scenarios that can occur before an option expires:

  • Low Vol, Low Trend
  • Low Vol, High Trend
  • High Vol, Low Trend
  • High Vol, High Trend

The charts below illustrate the P&L of a long put in each scenario.

Example 1 — Low Vol, Low Trend

Low Vol, Low Trend

The red path is the price action of the underlying stock over the course of the trade. Notice how it moves along smoothly with little volatility.

In this example, the long put would expire at a low price. The underlying (red line) isn’t far enough away from the strike price at expiration. A trader who bought this put would’ve lost money.

Example 2 — Low Vol, High Trend

In this situation the put holder would be sitting on a huge gain! The underlying trended far away from the put strike and the option expired well into the money. Just like the last example, the red line moved smoothly. But in this case it happened to trend down instead of sideways. Despite low volatility, the put holder made some serious money. The “rule of thumb” requiring high vol broke down.

Example 3 — High Vol, Low Trend

High Vol, Low Trend

The put buyer lost money here. The underlying didn’t trend far enough away from the strike to overcome the option premium. There was high volatility throughout the life of the trade, but the put buyer still got taken to the woodshed. The price of the underlying at expiration was all that mattered here. The volatility “rule of thumb” broke down again.

Example 4 — High Vol, High Trend

High Vol, High Trend

In this final example, the put buyer received a nice profit. The underlying trended downward with steep pullbacks, but price was far enough away from the put strike to deliver gains. In this situation many traders would think the high vol over the course of the trade contributed to profits. But in reality it didn’t. The trend created the profits.

Do you see a pattern here?

Volatility didn’t have any effect on the final P&L of these scenarios. The trend is what mattered.

In examples 1 and 3, the put buyer lost money in both low and high volatility. The underlying had no trend.

In examples 2 and 4, the put buyer booked some nice gains because the underlying trended. Again, the volatility of the trend did not matter.

If you do not delta hedge over the course of a trade, all that matters is where the underlying expires relative to the strike price.

Delta hedging consists of buying and selling stock against an option to cancel out its directional bias. Without offsetting delta (direction), an option trade becomes a bet on trend vs. consolidation, not high vs. low volatility. If you want the “rule of thumb” to hold true, you need to delta hedge over the course of your trade.

Market makers and investment banks typically delta hedge to create a pure play on volatility rather than direction. Here’s how they’d handle the same long put as above, but this time with delta hedging.

Example 5 — High Vol, Low Trend, Delta Hedging

High Vol, Low Trend, Delta Hedging

If the market maker is long a put, he’ll immediately buy some stock against it to hedge out the directional component. As the stock starts falling the put’s short delta will increase. This will cause the market maker to buy more stock during the dip to offset it.

If the stock starts to rally back near the put’s strike, the put’s short delta will decrease. Now the market maker will sell some of his long stock to balance things out. This is how he keeps his position “delta neutral.”

As the trade goes on, the market maker will keep buying stock on dips and selling on rips. These delta hedges end up being profitable trades because he’s buying low and selling high. By expiration he’ll generate a significant amount of gains from just buying and selling the stock.

The value of the option decayed to almost nothing by expiration (the underlying expired close to the strike) but the profitable hedge trades made up for that loss and then some.

The market maker made money!

Notice how different this trade turned out compared to example 3 with no delta hedging. In the delta hedging example here, the volatility of the underlying had a much bigger impact on the P&L than the trend.

So the “rule of thumb” — option buyers want high vol — only applies if the trader is hedging delta. If he isn’t hedging delta, then high vol won’t do much for him. He’ll still lose on the trade if the underlying expires near the strike.

Now let’s see how the market maker’s trade fairs in a low vol, low trend scenario:

Example 6 — Low Vol, Low Trend, Delta Hedging

Low Vol, Low Trend, Delta Hedging

Here the peaks and valleys of the underlying aren’t nearly as intense as in the prior high vol example. The market maker still buys low and sells high each time the underlying moves, but with much less profit than before.

By expiration the delta hedging trades aren’t profitable enough to offset the option premium (which was lost because price was too close to the strike at expiration). The market maker ends up losing money.

By now it should be a little easier to see why option buyers who delta hedge want wild, highly volatile oscillations. Without the high vol, their hedges don’t make enough money to make the trade profitable.

Example 7 — Low Vol, High Trend

Low Vol, High Trend

Most people who buy puts are used to winning big when the underlying has a large downward trend. But this isn’t the case for a market maker who’s delta hedging.

The downward low vol trend had the market maker buying dips with no rips to sell into. The result — a long stock hedge that was continually averaged down over the life of the trade.

In this case, the long put had a nice gain because of how far away the underlying trended from the strike price. But the hedge ended up being a huge loser that negated the option gains. Unlike the trader who didn’t hedge and let the trend work for him, the market maker didn’t do so well. The market maker’s position was more reliant on the volatility of the underlying rather than the trend. Low vol meant a poor end result.

Example 8 — High Vol, High Trend

High Vol, High Trend.A

In this last example, we still have the same downtrend, but this time with more spikes along the way for the market maker to sell into. These spikes allow the delta hedges to make money. And at the same time, the long put has a nice gain because the underlying expired far away from the strike. The high volatility of the trend made it possible for the market maker to profit.

The key takeaway here is:

Traders who don’t hedge delta rely on the trend of the underlying more than its volatility to profit.

Traders who do hedge delta rely on the volatility of the underlying more than its trend.

It usually doesn’t make sense to hedge your delta unless you have a professional commission structure. This is why so few do it. All those hedging trades rack up commissions. And the execution of those hedges requires a lot of screen time or advanced software than can do it automatically.  

So if you’re not delta hedging, a better question to ask yourself before placing an option trade is:

Do I believe the underlying will trend or consolidate over the life of the option?

If your answer to that question is “I think the underlying will trend”, you should buy optionality. The underlying will trend away from the strike price and you’ll make money on the option you purchased.

If your answer to that question is “I think the underlying will consolidate”, you should sell optionality. The underlying will stay close to the strike price and you’ll collect the premium from the option you sold.

For more information on how we like to trade options at Macro Ops, check out our special report here.

 

 

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James R. Keene — The Man Jesse Livermore Called The Greatest Trader Of Them All

While digging into old articles about James R. Keene for a piece I’m writing I came across this nugget that I have to share — it’s so good. For those of you not familiar with Keene, he is one of the most successful market operators of the late 19th century. Jesse Livermore, when talking about the trading legends of his day, called Keene the “greatest of them all”. The man made and lost fortunes many times over and lived a life full of color.

Here’s the article, written by Robertus Love in The Princeton Union on July 11, 1907.

Enjoy…

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Just now those who take an interest in turf matters are hearing much about the winnings of James R Keene’s horses. It is the horses that win, not the horseman. Mr. Keene seldom bets a dollar. He is not a sport. Neither on the turf nor on the stock market does he gamble. He is a speculator on the market and a sportsman on the turf. Between a speculator and a plunger the gulf is quite as wide as that between a sportsman and a sport. These distinctions should be borne in mind by any one who cares to know the character of James R. Keene.

Both as speculator and sportsman Mr. Keene’s reputation clicked into the top notch at least a quarter of a century ago. It is a question whether his cash or his colts have brought him the wider distinction.

Born in London sixty-eight years ago, of a father who also was a native of England, Keene nevertheless is really an American. His ancestors back of his father lived in Virginia for several generations. Moreover, when the father failed in business abroad the family came to America, settling in California when young James was only about fourteen.

The boy got a job taking care of cows and mules at a military post. He worked at various occupations until he grew up, when he studied law. For a time he taught school. Then he edited a country newspaper at a place called Horsetown, in northern California. The name of the town probably had no particular influence upon Mr. Keene’s career. The late Charles A. Dana, who used to read the Keene editorials, maintained to the last that for style, force and lucidity the pen of no English writer since the days of Charles Lamb surpassed that of Keene when he edited the Horsetown sheet at a salary of $20 a week.

Had Literary Ambitions.  

Keene, according to Joaquin Miller, who also frequented that part of California in those days, had literary ambitions. But as Shasta county journalism was not a money making institution he shortly stepped off this stepping stone to the literary life, and America lost a Charles Lamb. Keene, it is said, peddled milk, clerked around here and there and finally found himself in the mining camp of Virginia City, Nev. In some unrecorded manner he managed to get together a stake of $10,000. About this time Miss Sarah Daingerfield, a Virginia belle, visited her brother, a United States judge. Keene met her and fell In love. But Judge Daingerfield scorned the young man who had descended upon San Francisco and become a curbstone broker. “An upstart curbstone broker,” sneered the judge.  “Huh!'”

Nevertheless Keene loved well. Love and luck ran together. Keene soon increased his cash to $175,000, married the girl and set up housekeeping on a lavish scale. By the time he had doubled his fortune a crash came, and in one day he was wiped out to the basement, so that he was compelled to part with his splendid household furnishings. “Go get a job now, Jim,” his friends all advised. “That’s all you can do.”

Nobody had any confidence in Keene’s speculative ability—that is, nobody but himself. He believed that he could make good. He kept to the curbstone and hoed a mighty hard row until he met Senator Felton of California. The senator had a seat in the San Francisco Stock Exchange. He liked Keene. When Felton became assistant United States treasurer he gave Keene his seat on the exchange, to be paid for at whatever it might be worth when the young man was able to pay.

A few months later Keene paid Felton several times the value of the seat at the time he acquired it, but he was making money so rapidly that the outlay was not felt. By 1876 James R. Keene had made several millions — some say $6,000,000 — by speculating in mining stocks during the “Bonanza” period. Then his health failed and he determined on a trip to Europe.

When Keene reached New York the Wall street atmosphere so charmed him that he did not go to Europe for fifteen years. He stayed in Wall street and speculated. One of the most familiar stories of the street is to the effect that somebody remarked to Jay Gould, then the wizard of Wall street.

“They say Jim Keene, the California millionaire, is coming to New York in a palace car.”

“All right,” returned Gould. “I’ll send him back in a box car.”

Jay Gould After His Scalp.

Those were the days of the individual speculator. This is the day of combinations. Keene went it alone, used his judgment and made large winnings. But Jay Gould was after his scalp. By the year 1884 Keene’s fortune had more than doubled. Then he got into a combination against his own judgment to corner the world’s wheat market. Just when it seemed that all was ready for the big rake off Jay Gould and others sprang a coup that came near shipping Keene back by the box car route. There is still in the street the tradition of a forged telegram which split the corner and smashed Keene to smithereens. When he crawled out from under the avalanche he was about a million and a half in debt. Everything went, including one of Rosa Bonheur’s masterpieces, “Sheep,” which was the pride of Keene’s household. A little later a gentleman now well known in New York journalism had occasion to call at Jay Gould’s residence on Fifth avenue. Gould pointed to a magnificent oil painting on the wall.

“See there,” he said exultantly. “There hangs the scalp of James R. Keene.”

The painting was Rosa Bonheur’s “Sheep.” Gould had bought it at a fabulous price from the man who bid it In at the Keene sale. Gould gloated over it. As a work of art it meant little or nothing to the wizard, but as his badge of victory it was to him a trophy as satisfactory as is the dripping scalp of a paleface to an Indian chief. Wall street sometimes makes men so.

But Keene, when he heard of this incident, did not faint. Referring to the manipulations by which he had been cleaned out, he said:

“This has taught me caution, and the lesson will be worth while. I will still walk Wall street when every man of the band that has plotted my ruin and worked it will be either dead or bankrupt.”

Still Walks Wall Street.

Jay Gould has been dead these many years. Keene still walks Wall street, having paid off all his debts and made several fortunes since 1884. But for some years Keene was not so much of a figure in the street. Again they said that he was down and out, just as they had said it when he first lost his money in San Francisco. He became during those years more of a promoter than an independent operator. Having eaten of bitter bread in the wheat corner, Keene took up something to sweeten existence. He boomed sugar for the Havemeyers. Incidentally he boomed it for Keene, sweetening his tooth to the extent of some $2,000,000.

Then Keene bit off a large chew of tobacco, but not larger than he could chew. Practically the same ring that had tripped him up in the wheat bin tried to strangle him with tobacco juice, but Keene was keeping his own counsel then. He had grown cautious. He rushed 75,000 shares of tobacco into the market, the price dropped from 156 to 115. The ring lost and Keene won a million and a half in a day.

“Give a man rope enough and he will hang himself,” says a wise one. Keene took a lot of rope—American Cordage—and added a few more millions to his pile, incidentally stringing up a few of his enemies.

By that time, which was a matter of nine or ten years ago, James R. Keene had succeeded in convincing Wall street that if he ever returned to California he could go in his own private palace car or in an airship if he preferred to take that risk. There have been ups and downs since, but never an out, though it is understood that Mr. Keene lost largely by the failure of his son-in-law’s firm, Talbot J. Taylor & Co, about four years ago. But the Keene family larder was secure in any event. Many years ago a silent partner, Mrs. Keene, persuaded her husband to give her half of his earnings. When Mr. Keene made a million Mrs. Keene was half a million richer. As the silent partner did not speculate, the money remained in the family.

His First Big Horse Victory.

Mr. Keene is known as a man of indomitable energy. “He could get rich in a desert if any one could,” says an intimate associate. This recalls a story in connection with the first big horseflesh victory of Keene’s career. His horse Foxhall won the Grand Prix at Paris in 1881. Twenty years earlier Keene had been at his Horsetown stage, and one of his acquaintances In the California country was Dan Gaitland. When Foxhall won the Grand Prix, Dan was still prospecting up in Grant county, Ore., not far north of Horsetown. He heard the news and rushed into the presence of Tom Merry, another acquaintance of the California Keene.

“Tom,” said Dan, “did yez hear phwat Jim Keene done las’ Sundah?”

“And what was that?”

“The papers sez he bate the divil out iv the frog eaters wit’ a horse named Foxyhall.”

“Well,” said Tom, “from what I remember about Jim he’s a mighty hard man to keep down.”

“Roight ye be,” rejoined Dan. “Ye cud putt Jim Keene aboard a ship an’ send him to say, an’ if the ship wuz wrecked on a desert oisland Jim ‘uld be walkin’ around, he wud, an’ the nex’ day he’d be sellin’ maps iv the place to all the natives.”

Mr. Keene has owned some of the greatest horses on the turf. This season his colt Peter Pan earned $52,000 in four races in less than thirty days. He owned Domino, over whose Kentucky grave he erected a hand some marble shaft. Other great ones developed by Keene were Sysonby, Commando, Cap and Bells and Tommy Atkins.

Dearly Loves Horses.

Mr. Keene’s love for horses is his ruling passion. One day a horse fancier whom Keene had met in Kentucky called to see the great financier in his New York offices. Half a dozen men were in the anteroom. The Kentuckian finally requested the young man to tell Mr. Keene that Bill Scully of Kentucky had dropped in to say “Howdy.” Scully started away, but as soon as the millionaire heard that he had called the door flew open, and Keene rushed out into the hall, yelling:

“Hey, Bill! Here, Scully!”

When Scully was dragged into the inner sanctum he protested that he was taking up Mr. Keene’s time.

“Not by any means,” replied Keene. “I can talk stocks any day, but it isn’t often that I get to talk horse with a Kentuckian.

There is nothing saturnine about Keene. He likes his little joke. Not long ago he was reading a review of certain financial undertakings when he reached this sentence:

“It was then that the Rockefeller stocks came to the relief of these agitated, overcapitalized properties.”

“That’s a disguised way of saying that John D. poured oil on the troubled waters,” remarked Mr. Keene.

A country boy in Indiana wrote Mr. Keene that he wanted to make a fortune, but so many doors were closed to him that he didn’t know which one to open. “Open the one labeled ‘Push,'” wrote back the financier.

James R. Keene has one word of advice to all persons who evince a disposition to speculate:  “Don’t!”

 

 

Traders As Modern Day Hunter-Gatherers
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Traders As Modern Day Hunter-Gatherers

Entering the market is like entering an entirely different world. This world functions nothing like modern society.

Modern society has laws and social norms in place to protect you. If you screw up, you have a safety net. People will generally reach out and help.

Modern society is cushy. Even people who are disabled, suffering mental illness, or are unable to care for themselves in other ways still get by. (Maybe not as well as we’d always like, but far better than at any other time in the past.)

Markets aren’t like modern society.

They’re much closer to being like the world in its most natural state.

The strong prey on the weak.

You live or die based on your own ability.

While the system can sustain a vast array of life and species for large spans of time, each player constantly faces the risk of death. Markets are unforgiving and brutal, yet incredibly abundant places to thrive — just like natural ecosystems.

In this world… traders are the modern day hunter-gatherers.

Hunter-gatherers sustain themselves by staying in sync with the large, complex ecosystem they’re apart of. This ecosystem is full of both opportunities and threats. The hunter-gatherers don’t control anything, but instead seek to achieve harmony with the changes around them.

A key component of long-term survival in the wild is adapting and evolving. Failure to adapt to the changing landscape means you won’t be fed.

The same goes in markets. Markets trade a lot differently now than they did in 1980. If you don’t adapt your strategy along the way you’ll become irrelevant. You’ll starve.

Hunter-gatherers don’t try to extract every last bit of value from a situation. They wouldn’t kill all the deer in a herd even if they could. What would they do with all that meat? There’s no fear of “leaving money on the table” as long as they get what they need to thrive.

Instead of maximizing return, hunter-gatherers seek to achieve satisfactory returns while minimizing risk. They focus on risk-adjusted return. Risk is easily forgotten in a civilized society where nearly everything is already idiot-proofed. But risk has to be at the front of a hunter-gatherer’s mind.

Hunter-gatherers don’t have to win all the time. They just need to win often enough to stay fed. In the markets, you can make billions by calling it right just 55% of the time.

Since the world is abundant, hunter-gathers’ timeframes are shortened. Unlike farmers or industrialists, hunter-gatherers focus on the next season (or maybe next few if they build up stores to ride out the lean times). But beyond that, why worry? The world will provide endless opportunities for someone who can live off the land. There’s never a “fear of missing out”.

As a trader, embracing this hunter-gatherer mindset will align you with the reality of markets. Doing so will help you take your returns to the next level.

The above passage is straight from Operator Biren, a member of the Macro Ops Hub. To learn more about the Hub and how you can join our Operator team, click here.

 

Markets as a Range of Reasonable Opinions
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Markets as a Range of Reasonable Opinions

The following is from The Philosopher in Drobny’s classic The Invisible Hands (emphasis mine):

Some people can trade markets using only numbers, prices on a screen but this approach does not work for me. The numbers have to mean something — I have to understand the fundamental drivers behind the numbers. And while fundamentals are important, they are only one of many important inputs to the process. Just as a Value-at-Risk (VaR) model alone cannot tell you what your overall risk is, economic analysis alone cannot tell you where the bond market should be.

Let us use an interest rate trade around central bank policy as a straightforward example to illustrate my process. Economic drivers will create the framework: What is the outlook for growth, inflation, employment, and other key variables? What will the reaction of the central bank be? We then build a model of the potential outcomes of these economic drivers, weighting them according to probabilistic assumptions about our expectations. We look at what the central bank could do in each scenario, comparing this with market prices to see if there are any interesting differences. When differences exist, we then think about what can drive those differences to widen or converge.

It is important to note that a key element to this exercise is the fact that what other people believe will happen is just as important as the eventual outcome. A market is not a truth mechanism, but rather an interaction of human beings whereby their expectations, beliefs, hopes, and fears shape overall market prices.

A good example of this psychological element can be seen in inflation. At the end of 2008, U.S. government fixed income was pricing in deflation forever. At that point, the only thing of interest to me was the question of whether people might think that there could be inflation at some point in the future. Quantitative easing made it easy to answer this question affirmatively, because there are many monetarists in the world who believe that the quantity of money is the driver of inflation. Whether they are right or not is a problem for the future — what is important to me is that such people exist today. Their existence makes the market pricing for U.S. long bonds completely lopsided. Such pricing only makes sense if you are a died-in-the-wool output gapper who believes that when unemployment goes up, inflation goes down, end of story. Market prices reflect the probability of potential future outcomes at that moment, not the outcomes themselves. Some people do not believe in the output gap theory of inflation, and these people believe that pricing for U.S. bonds should be somewhere else. Because these two divergent schools of thought exist, it is possible that market sentiment can shift from deflation to inflation and that pricing will follow.

One way to think about my process is to view markets in terms of the range of reasonable opinions. The opinion that we are going to have declining and low inflation for the next decade is entirely reasonable. The opinion that we are going to have inflation because central banks have printed trillions of dollars is also reasonable. While most pundits and many market participants try to decide which potential outcome will be the right one, I am much more interested in finding out where the market is mispricing that inflation will go to the moon, then I will start talking about unemployment rates, wages going down, and how we are going to have disinflation. If you tell me the markets are pricing deflation forever, I will start talking about the quantity theory of money, explaining how this skews outcomes the other way. Most market participants I know do not think in these terms. The market is extremely poor at pricing macroeconomics. People always talk about being forward looking, but few actually are. People tell stories to rationalize historical price action more frequently than they use potential future hypotheses to work out where prices could be.

Beauty contestsPlaying the player… Second level thinking… Viewing markets as a range of reasonable outcomes… These are points we write about over and over. And that’s because the overarching concept is so important and yet so misunderstood.

Let me give you an example.

Your average retail trader (and even most “professionals”) read in the paper, magazines, blogs, etc. that Europe is on the brink of collapse. Deutsche bank is teetering on insolvency… populism is rising… the UK is leaving… it’s all going to hell in a handbasket.

They think to themselves, “Man, Europe is in trouble. I need to short some European banks and sell the euro.”

But those playing the game at the second level and above read the same articles and come away with a completely different train of thought:

Bearish sentiment on Europe is really reaching a zenith… Every market pundit and blogger is railing about how bad Europe is… Bearish positioning is extremely one-sided as there’s definite market consensus… Which means this narrative is likely baked into the price as everybody who’s going to sell has already sold… And if the public narrative is this bearish then the central bankers will be too… So they’ll err on the dovish side for the foreseeable future… Which means that the entire market is standing on the wrong side of the boat… I need to buy Deutsche call options and go long the euro.

The first level thinkers are part of the herd and the second level thinkers are the wranglers anticipating where the dumb herd will swing to next.

First level traders believe trading is about correctly predicting the future. They are wrong.

Successful trading is about understanding prevailing market expectations.

Understand the narrative and you can understand the key drivers. Understand the key drivers and you can identify the fulcrum point of the narrative (the data point that if changed, will force a new narrative to be adopted).

Then you take this understanding and closely watch how reality unfolds in comparison to expectations, all while keeping an eye on divergences (mispricings) that create asymmetric trade opportunities.  

Here’s the Palindrome (George Soros) on the topic (emphasis mine).

There is always a divergence between prevailing expectations and the actual course of events. Financial success depends on the ability to anticipate prevailing expectations and not real-world developments. But, as we have seen, my approach rarely produces firm predictions even about the future course of financial markets; it is only a framework for understanding the course of events as they unfold. If it has any validity it is because the theoretical framework corresponds to the way that financial markets operate. That means that the markets themselves can be viewed as formulating hypotheses about the future and then submitting them to the test of the actual course of events. The hypotheses that survive the test are reinforced; those that fail are discarded. The main difference between me and the markets is that the markets seem to engage in a process of trial and error without the participants fully understanding what is going on, while I do it consciously. Presumably that is why I can do better than the market.

Understand that the things you read in the paper, see on Twitter, or hear on TV, are all popular knowledge — in game theory this is knowns as common or mutual knowledge. The more widely known the information, the more likely it’s already been discounted by the market.

Markets lead the news… not the other way around.

Truly understanding this and applying it is how you become an effective contrarian. And operating as an effective contrarian is the only way you can win in the game of speculation.

If you want to learn how to become an effective contrarian, then check out our Trading Instructional Guide here.

 

 

Bill Ackman Finally Pukes Beware Of False Narratives
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Bill Ackman Finally Pukes: Beware Of False Narratives

A year ago we wrote about why Bill Ackman should learn a bit of technical analysis. We weren’t suggesting he become an Elliott Wave nut or anything, but that he should adopt the risk management philosophy of a technician. TA clearly defines when to exit a trade. And with this clarity comes superb risk control — our number one job as traders.

But of course our advice fell on deaf ears. Ackman continued to ignore all the technical sell signals in his very public Valeant position. From that time, the stock has dropped another 65%…  

Fundamental investing relies on narratives. This is both a feature and a bug. Without a compelling narrative, other investors won’t flock to your stock and bid up prices.

But narratives aren’t cut and dry like an MA crossover or trend line. This reality makes it’s hard for a portfolio manager to cut risk at the right time. Before he realizes the narrative has departed from reality, the stock could’ve already made a nasty drawdown.

The key is to use narratives to initiate trades. But after the trade is on the book, let technical analysis take over and manage the risk. That’s why we’re proponents of combining different styles of investment analysis. Fundies and techs can add value.

In Valeant’s case, the dominant narrative during its rise was how its CEO Michael Pearson created a new, highly profitable way to run a drug company. Instead of using gobs of money to research new drugs, just acquire old drugs and jack up their prices. This practice slashed costs, boosted revenues, and made Wall Street happy. Ackman and many other hedge funds bought into this narrative and created one of the largest hedge fund hotels of all time.

But eventually the narrative started to turn bearish. Skeptics argued that Valeant’s “growth” was achieved through price gouging. Then more news came out that a speciality pharmacy was in cahoots with Valeant — changing codes on doctors’ prescriptions to Valeant’s brand even when much cheaper generics were available. Valeant was basically ripping off insurance companies to juice their own sales numbers.

By the Fall of 2015 the stock had already fallen 70% from its highs. Here’s where technical analysis could’ve come in handy for Ackman. Technicals clearly signaled that the narrative had changed. It would’ve been easy to observe a trend break on the chart and exit.

But Ackman didn’t have this risk control method in his toolbox. He was instead forced to reassess the narrative and evaluate whether or not his original thesis was still intact. This is an impossible task that requires advanced mental gymnastics. It’s too easy to get emotionally attached to a narrative and succumb to things like confirmation bias and the sunk cost fallacy. Ackman did just that as he continued to buy more Valeant.

That’s why investment narratives should be used to initiate trades, not manage them.

Compelling narratives create large trends which are what you need for huge gains. But technical analysis is what you need to manage your trades. It lets you objectively define your exit. If you’re relying on your interpretation of a complex narrative as an exit strategy, you’re exposing your portfolio to huge drawdowns.

The reality of the market is that no matter how rich or how smart you are, you’ll eventually be wrong. The best in the business call it right a little over 50% of the time. It’s crucial to have a reliable and objective risk management process for when things go south. Without it, you’re setting yourself up to follow in Ackman’s shameful footsteps.

If you want to learn how our team at Macro Ops successfully manages risk, then check out our Trading Instructional Guide here.

 

 

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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. (Side note: this is the risk premia we harvest in Vol Ops, one of our portfolios in the Macro Ops Hub).

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:

 

 

Flying Too Close To The Ground
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Flying Too Close To The Ground

It’s not how close you get to the ground, but how precise you can fly the airplane. If you feel so careless with your life that you want to be the world’s lowest flying aviator, then you might do it for a while — but then a great many former friends of mine are no longer with us, simply because they cut their margins too close. ~ Bob Hoover

Bob Hoover was known as the “pilot’s pilot” — one of the greatest to have ever flown. He learned his skills as a fighter and test pilot for the Air Force and is best known for revolutionizing modern aerobatics.

As a crack flyboy, Hoover understood risk better than most. And it was this firm grasp of calculated risk-taking that allowed him to become one of the best aerobatic pilots in the skies and still live to the ripe old age of 94.

There’s an old trading adage that goes “There are old traders, and bold traders, but no bold old traders.” Like the pilots that “cut their margins too close”, markets are constantly claiming the accounts of those who recklessly risk their capital in search of easy profits.

Here’s a rule of thumb to live by: Your margin of risk is dependent on your experience. But no matter how deep your experience, never cut your margins too thin that you risk hitting the ground.

First and foremost, trading is about survival. And to survive, you need to protect your capital.

Many traders, especially inexperienced ones, fly way too close to the ground. This makes their blow up an eventuality.

Bruce Kovner said, “My experience with novice traders is that they trade three to five times too big. They are taking 5 to 10 percent risks on a trade when they should be taking 1 to 2 percent risks.”

Newer traders don’t respect risk because they haven’t gotten burned badly enough… yet. On average our team at Macro Ops risks a fraction of 1% per trade.

A good trader is a good risk manager above all else. Everybody should follow Buffett’s two rules of investing, “Rule number 1, don’t lose money. Rule number 2, don’t forget rule number 1.”

This will not only protect you from fighting the powerful headwinds of negative compounding, but it’ll keep you alive and in the game. Stay alive and you can continue to grow. Continue to grow and maybe someday you’ll acquire the skills to become an ace.

I got my tail clipped roughly ten years ago. Getting your tail clipped is when they cut off the tail of your shirt after your first solo flight (the photo is of me after my successful landing).

First Solo Flight

My first solo was supposed to take place a week earlier than it did. But it was cancelled. As I was going through my pre-flight checklist that morning, there was a horrible crash on the runway.

Another student working towards his pilot’s license botched his landing. Unlike other students flying slow and easy Cessnas, he insisted on learning to fly in a P-52 Mustang. The difference is like learning to drive a Toyota Camry versus a drag racer.

He was learning on a powerful machine… like a trader learning to trade while using too much leverage.

When coming in to land, he knew he wasn’t going to stick it, so he tried to do a pass through. A pass through is when you push the throttle and climb back into the air to circle around and try again. He put his throttle all the way in — on a Cessna this is fine — but on a P-52 Mustang the engine is so powerful that the torque flipped the plane over. The pilot stuck the landing on his head. The crash was fatal.

As traders we’re not dealing with anything as serious as our lives — it’s just money. But to make it in this game, you need to take the preservation of your capital just as seriously.

Paul Tudor Jones said, “… at the end of the day, the most important thing is how good are you at risk control. Ninety-percent of any great trader is going to be the risk control.”

Keep your margins wide. Stay well above the ground and carefully calculate risk. Only press the leverage as you gain the experience.

If you want to learn how our team at Macro Ops manages risk, then check out our Trading Instructional Guide here.