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The Label Stupidity Loop
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The Label Stupidity Loop

“I’m a Democrat… I’m an Evangelical Christian… I’m a Trump Supporter… I’m a Value Investor… I’m a Bernie Bro… I’m a Neo-Keynesian… I’m a Scientologist… I’m a… I’m a…”

Humans love adopting labels.

We don them proudly, wearing them like sports jerseys. We proclaim our chosen identity to anybody that’ll listen. We want everyone to know what we stand for… and that we’re on the “right” side.

It’s impossible to know everything, and we hate that fact. People abhor uncertainty.

Labels fix this.

They give us pre-packaged sets of beliefs/heuristics/frameworks for dealing with and understanding the world.

Labels also give us a tribe.

By declaring yourself a Republican, you’re signaling to other Republicans that you’re “one of them”. You’re letting them know that you share the same beliefs and values. You’re part of the team. The same goes for Democrats, Libertarians, and every other label.

Having a tribe is important to us. It gives us a sense of safety and community — two things we’re evolutionary wired to crave.

So adopting labels is great.

They help us operate in a complex world and make it easier to choose the people we want to identify with — our tribe mates.

The only thing is… labels make us stupid.

Really, really stupid.

Because once we don a label, it becomes part of our identity.

And there are few things we hate more than attacks on our identity.

Ideas, evidence, events, or questions that don’t confirm our adopted labels feel like personal attacks.  

Humans will do just about anything to repel these attacks and maintain their belief in their beliefs.

And since no packaged belief set is 100% correct, it means all of us carry belief structures that fall somewhere on the scale between somewhat wrong and very wrong.

We employ mental contortions that would impress the US Olympic gymnast team… all to avoid acknowledging the wrongness of these beliefs.

Psychologists call this, “Identity Protective Cognition”.

Vox described IPC as:

A way of avoiding dissonance and estrangement from valued groups, individuals subconsciously resist factual information that threatens their defining values… What we believe about the facts, tells us who we are… And the most important psychological imperative most of us have in a given day is protecting our idea of who we are, and our relationships with the people we trust and love.

Why does this matter?

Well, if we all carry some number of untrue beliefs, yet hold them with high conviction, it’ll inevitably lead to friction when our packaged beliefs don’t conform to how reality actually is.

It also makes getting at truth (finding out how things really are) much more difficult.

Take politics for example.

All 200 million US registered voters are pretty evenly split amongst Democrats and Republicans.

These political labels have become a big part of our identities. The sense of tribe within each is strong.

Most of us passively adopted these labels.

We may like to think we actively chose them because of their superiority, but that’s generally not the case.

Most of us adopted the political label of the family we were born into, of the friends we grew up with, of the community we live within.

Just like our religion, this belief set was given to us. Just as it was given to those who gave it to us and on and on. So we passively adopt most of our labels and beliefs without any true stress testing.

The problem is that it’s our default condition to value knowing and “feeling right” over actually being right and getting at truth.

We adopt and cling to false beliefs because we’re afraid of accepting that we don’t know, that we don’t have an answer. We don’t want to acknowledge that the world is infinitely complex and uncertain, and that maybe the things our identities are built upon are wrong.

So we all live in varying degrees of an illusory reality dominated by cognitive dissonance and kept unaware by pride.

And with the rise of the digital era and the constant algorithmic selected news flow, that’s mathematically curated to cater to our labels and flip our emotional switches, we’re becoming more and more attached to these belief sets.

To manage the information/stimulus overload we more tightly cling to our labels to help manage the uncertainty. And the more we do this, the more our belief sets are likely to drift further from reality, from being true.

So we live in an increasingly vicious “Label Stupidity Loop.”

Where the more large and complex the things we’re supposed to care about become, and the more information we’re inundated with, the more fiercely we defend our packaged belief sets and the more wrong we all become.

Blogger Paul Graham wrote about this phenomenon in a post titled “Keep Your Identity Small.” He concludes the piece with:

If people can’t think clearly about anything that has become part of their identity, then all other things being equal, the best plan is to let as few things into your identity as possible.

He’s saying that the way to align more closely with reality and to end up with better outcomes is to be wary of the labels you adopt. And try to keep these labels to a minimum.

This requires a big shift in the way you interact with the world.

You’ll have to transition from a state of false-certainty to one of accepted unknowing.

You’ll need to embrace your fallibility and acknowledge that the world is large and that human nature is complex and that no one has all the answers.

You need to realize that humans will always operate at a knowledge deficit. Where the amount of things we don’t know will always outweigh the things we do. And even those things we “think” we know, need to be held with suspicion, because it’s just as likely that we’re wrong on them too.

In short, be humble and open minded… about everything.

Now since this is a trading blog about markets and such, here’s how this is relevant to you.

Do you classify yourself as a Value Investor? Technical trader? Macro guy? Elliott Wave Theorist?

Do you believe that your method is the best and the other methods are lacking?

Do you identify with your market approach?

Do you think that there’s nothing to gain by objectively studying and putting to the fire the validity of the other styles?

Is it not the most important thing to find any tool or method that you can logically understand and apply to extract money from the markets?

So why would you care what label it falls under?

I’ve long called myself a Macro trader. But that doesn’t mean that I only take what’s considered typical macro trades or only apply macro tools and thinking.

I say macro because I have to give a response. But really, all macro means to me, is to be unconstrained, not boxed in, capable of using all available and effective means to win.

I like the idea of being able to go anywhere and trade anything for whatever compelling reason that makes me think there’s asymmetry.

A trade is a trade is a trade in my book.

And I study all the disciplines that logically make sense to me and which I know others have successfully employed.

These are tools that I get to add to my trading kit.

Value investing? Yeah it works, tons of evidence of it working and lots of successful value only investors out there.

Technical analysis? Of course, PLB is living proof it’s effective… Top down classical macro? Absolutely… another valuable approach to understand and implement.

If it works I want to study it. I want to study the best and I want to know what they know. I want to dive into it with an open mind and find what makes sense, what doesn’t, and what maybe can be approved upon.

We should seek to imitate Bruce Lee and his approach to martial arts and living. Lee explains:

Each man belongs to a style which claims to possess truth to the exclusion of all other styles. These styles become institutes with their explanations of the “Way,” dissecting and isolating the harmony of firmness and gentleness, establishing rhythmic forms as the particular state of their techniques.

Instead of facing combat in its suchness, then, most systems of martial art accumulate a “fancy mess” that distorts and cramps their practitioners and distracts them from the actual reality of combate, which is simple and direct. Instead of going immediately to the heart of things, flowery forms (organized despair) and artificial techniques are ritualistically practiced to simulate actual combat. Thus, instead of “being” in combat these practitioners are “doing” something “about” combat.

Worse still, super mental power and spiritual this and spiritual that are desperately incorporated until these practitioners drift further and further into mystery and abstraction. All such things are futile attempts to arrest and fix the ever-changing movements in combat and to dissect and analyze them like a corpse.

Set patterns, incapable of adaptability, of pliability, only offer a better cage. Truth is outside of all patterns.

What labels do you wear?

What type of belief cage have you built for yourself?

Are you willing to step outside of all patterns, into uncertainty, in order to move closer to truth?

 

 

The Dark Side of Jesse Livermore
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The Dark Side of Jesse Livermore

Jesse Livermore is commonly cited as one of the best market speculators of all time.

But is this true?  

On the one hand he did invent solid trading rules that have stood the test of time:

  • Cut Your Losses: Never average down and never hope your losses reverse. Just cut them.
  • Infinite Patience: Good trades are rare. Trade for profits, not for action.
  • Learn Macro: Understanding general conditions is essential to market mastery.
  • Price Action Is King: Learn to read the tape and don’t argue with markets — they know more than you.
  • Bet Big / Sit Tight: Ride your winners for all they’re worth.
  • Self-mastery: You are the greatest impediment to your own success. “Know thyself”.

But this widely worshipped man also had a fatal flaw.

Jesse Livermore could create tremendous wealth, but he couldn’t hold onto it.

When you go back and read the newspapers from later in JL’s career, it’s not a pretty picture.

Here’s an NY Times excerpt from April 18th, 1934, right in the middle of the Great Depression, when Livermore was filing for bankruptcy:

Mr. Livermore filed a bankruptcy petition in Federal court on March 5, listing liabilities of $2,259,212.48 and assets of $184,000. It was his fourth failure and second formal bankruptcy. After each previous failure he has been able to come back and repay his creditors, and he appeared confident yesterday he would be able to so again.

Going bust multiple times is not something you’d expect from a master trader. It’s what amateurs do…  

After the 1929 crash, Livermore had amassed $100 million dollars ($1.39 billion in today’s terms). Yet somehow, within just five years, he managed to torch that lofty sum and find himself back in bankruptcy court…

JL definitely had an edge — it’s hard to run up multiple accounts like he did without one — but why did he keep going broke?

It’s because Jesse Livermore habitually bet too large.

This explains how he accumulated mind boggling amounts of money in short periods of time, only to lose it all just as quickly.

And unfortunately for him, JL’s fatal flaw created his fame.

The larger the swings, the more interesting the news story. And since JL took the biggest swings around, he was the one written about in the papers.

The upswings reinforced his bad habit, while the downswings were explained away as “bad luck.”

JL consistently underestimated the size of his edge and bet amounts that guaranteed his bankruptcy over time.

Even if you have a solid edge, luck still plays a role in the outcome of any particular trade. You have to size your positions so that a string of losers won’t blow out your trading account.

At Macro Ops we’re all for sizing large when the stars align — it’s how the trading greats achieved stellar returns. But there’s a limit to how much you can safely bet.

Take the simple example of an unfair coin where heads comes up 90% of the time. And say you’re playing someone willing to give you 1:1 on your money if you guess right.

Obviously betting on heads makes the most sense here. There’s a huge edge. But how much money should you bet?

  • 10% of your net worth?
  • 20%?
  • 100%?

It’s easy to see that if you bet your whole wod every time you’ll eventually go broke. Hit just one tails and you’re in bankruptcy court with Livermore.

You could make huge bets and make astronomical sums in a short time, but keep playing like that and there’s a 100% chance of going belly up.

Jesse Livermore kept betting too large on his unfair coin, hence the nickname “boy plunger.” The deck was stacked in his favor but he lacked the bankroll management to successfully realize his edge over the long haul.

The science behind bet sizing came long after JL’s colorful career. A math genius by the name of Edward Thorp popularized the use of the Kelly Criterion in markets. The Kelly number tells us the maximum amount we can bet on an edge without risking bankruptcy.

Had Livermore known about this concept back in his day, he might of been able to avoid the insane swings that ultimately drove him to suicide.

It takes balls to bet big and jettison yourself to trading greatness. But be aware of the consequences.

The larger you size your trades, the more your success becomes a function of luck rather than skill.

Food for thought: If Livermore bet smaller, would we even know of his name today?

If you would like to know how we approach the bet sizing problem you can check out our investment handbook here.

 

 

How George Soros Finds His Trades

How George Soros Finds His Trades

The following is straight from Operator Kean, a member of the Macro Ops Collective. To contact Kean, visit his website here.

One of the things that makes George Soros a market legend is his uncanny ability to identify lucrative trading opportunities.

Let’s take a look at how he does it.

(I) Look Forward!

Most traders realize they need to be forward looking. But few practice it.

The reality is… herd mentality and groupthink are hard forces to overcome.

Instead of looking at the recent past and extrapolating into the future, Soros focuses on variables that might be misunderstood or overlooked. If one of these variables upsets the present consensus, he knows a large move will likely occur and reward those who anticipated the potential disruption.

In John Train’s Money Masters Of Our Time, Jim Rogers, an ex-colleague of Soros, explained their process:

We aren’t as much interested in what a company is going to earn next quarter, or what 1975 aluminium shipments are going to be, as we are in how broad social, economic, and political factors will alter the destiny of an industry or stock group for some time to come. If there is a wide difference between what we see and the market price of a stock, all the better, because then we can make money.

Stanley Druckenmiller, Soros’ right hand man during Quantum’s epic performance, outlines this concept further:

[My] job for 30 years was to anticipate changes in the economic trends that were not expected by others, and, therefore not yet reflected in security prices.

Too many investors look at the present; the present is already in the price. You’ve got to think out of the box and visualise 18 to 24 months from now what the world is going to be and what (level) securities might trade at… what a company has been earning doesn’t mean anything, what you’ve got to look at is what people think a company’s going to earn and if you can see something in 2 years that’s going to be entirely different than the conventional wisdom, that’s how you make money.

Soros’ Japanese trade in 2012 and 2013 is the best modern example of the master riding a forward looking idea to enormous gains.

After the 2011 Fukushima disaster, foreign investors fled Japanese financial assets. Pessimism surrounding the struggling economy was extremely high.

There were talks of a “nuclear holocaust” as people became concerned about a radiation fallout. And the Eurozone’s sovereign debt crisis (happening at the same time) didn’t help either.

Together they fueled risk aversion across global financial markets, causing the Japanese Yen to strengthen relative to other currencies.

The stronger JPY caused Japanese exporters to earn less after currency translation, which meant their stock prices struggled as well.

For nearly a year after the Fukushima disaster sent prices tumbling lower, the market did next to nothing. Valuations were cheap and depressed.

No one was interested in Japan. Investors were convinced the country would continue its decades-long battle with deflation.

With all this negative sentiment, the market completely overlooked Shinzo Abe taking leadership of the LDP in September 2012…

But Soros didn’t.

Forbes reported that Soros was actively participating in the Japanese equity markets while being short their currency as early as October 2012.

Abe-san only assumed the role of Prime Minister in December, meaning Soros’ firm was early in anticipating the “Abe” variable’s potential effect on Japan’s asset markets. He was positioned before reality materialised.

Anticipating how variables (that the majority aren’t thinking about) could change current security pricing is the hallmark of a successful speculator.

We all know what happened after that.

PM Abe pushed for his promise of “ending deflation’” and the Bank of Japan (BOJ) launched its aggressive monetary easing programme in April 2013.

The JPY got crushed and Japanese equities took off.

An investor using either traditional valuation metrics or plain old technicals would likely have been reluctant to foray into Japan before Abe-san was elected (there would be no buy signal according to their framework). But Soros was able to stay ahead of the crowd and capitalise when the unexpected situation materialised. 

This is macro investing on a higher level. Learn to anticipate!

(II) False Trends —  Learn To Play Them!

Soros once said there are 3 realities:

  1. Things that are true
  2. Things that are untrue
  3. And things that are reflexive

He believes we need to differentiate our circumstances to understand these 3 types of realities. In particular, he emphasises defining false trendswhich occur when a belief is founded on false assumptions, but many believe it.

Since there’s nothing in financial markets that can be determined for sure (with 100% confidence), false trends and reflexive realities are prevalent.

According to Soros, false trends can be so dominant, that they move financial markets, causing a cascading effect on asset prices and secondary effects that reinforce the initial false beliefs. This reflexiveness creates a false reality, which is exactly how bubbles form.

Soros believes you can make money from these trends, even when you know they’re false. Doing so requires establishing positions at appropriate times while maintaining objectivity and flexibility. And of course, sticking to your risk management plan is key.

The steps to exploit a false trend are:

  1. Analyze assumptions to determine if they’re true or not
  2. Identify false trends based on those assumptions
  3. Evaluate how feedback loops form and affect the fundamental reality

Don’t strive for an ideal or perfect explanation in the markets. Be sober, analytical, and pragmatic. Seek to invert your thinking and understand all possible viewpoints.

Big questions of our time like ‘Is China imploding?’ or ‘Are cryptocurrencies the future?’ are issues that fall into these realities. Whether they’re true or not doesn’t matter to the master speculator. What matters is whether you can exploit them to profit!

(III) Look For “Experimental Economics”

Soros is constantly on the lookout for financial situations where there’s a “great amount of experimenting”.

Experimenting with complex systems like economies generally leads to imbalances and unintended consequences. Soros loves to exploit these. As he once said, “the accumulated drawbacks of specific imposed economic models simply provide a playground for financial market speculators”.

Is there a government meddling with the free market (capital controls and such)?

Is there a central bank, for whatever illogical reason, pegging its currency?

These are circumstances that pique Soros’ interest. He’s ruthlessly speculated in many of these situations during his career. The most famous example is his bet against the Bank of England in 1992.

There was also another situation in the 1990s where Soros observed that the boom in Asian economies would reverse and come crashing down if liquidity conditions changed.

The stage was set as most Asian economies had their debt denominated in hard currencies like the US Dollar, while they booked their revenues in their own local currencies. Additionally, many Asian central banks maintained a peg to the greenback to help them tap into international debt financing.

This was a classic reflexive scenario where a strengthening USD would cause severe economic contractions throughout emerging Asian economies. A stronger dollar would also lead an even stronger dollar as the situation reinforced itself, trouncing the Asian economies.

This eventually forced Asian central banks to break their dollar peg after finally being overwhelmed. Soros positioned himself in several markets like Thailand, profiting from the 1997 crisis.

Macro dislocations, far-from-equilibrium situations, politicians meddling with free market affairs… these are all playgrounds for the macro speculator. Look around you — is there any ‘experimental economics’ going on?

(IV) Fade Extreme Investor Positioning

In December 2012, activist investor Bill Ackman went public in his crusade against Herbalife (HLF). He was shorting the company’s stock while accusing it of conducting a huge pyramid scheme.

Ackman’s war against Herbalife also sparked “billionaire battles” as other well-known Wall Street tycoons took sides. The most prominent of them all was Carl Icahn, who went long HLF and publicly sparred against Ackman, debating his claims.

It was reported that Soros went long HLF  sometime in the second quarter of 2013, which spurred a rally in the stock price. About 2 years later, Soros fully exited his long position during the third quarter of 2015.

Soros slipped in and out of the stock while Ackman and Icahn were playing tug-of-war over who was right…

We don’t know who’ll eventually be right, but we do know that Soros profited during that tug-of-war. Regardless of his fundamental view, market sentiment and positioning gave Soros the opportunity to profit off a gigantic short squeeze.

Look for popular trades or overcrowded positions. You may agree with the consensus view, but if most participants are positioned that way, you may want to fade them.

This fourth point may be unorthodox, but that’s how the Palindrome played the game. Remember, you’re here to make money, not to prove whether your opinion is right or wrong!

To learn more from George Soros and other investing legends, click here.

Review:

  1. Be Forward Looking
    • Anticipating how variables (that the majority aren’t thinking about) could change current security pricing is the hallmark of a successful speculator.
  2. Learn To Play False Trend
    • Analyze assumptions to determine if they’re true or not
    • Identify false trends based on those assumptions
    • Evaluate how feedback loops form and affect the fundamental reality
  3. Look For Experimental Economics
    • Governments experimenting with complex economic systems generally leads to imbalances and unintended consequences ripe for exploitation by smart speculators.
  4. Fade Extreme Investor Positioning
    • When everyone is on one side of the boat, sometimes it pays to take the other side!

 

 

Stanley Druckenmiller On Liquidity Macro and Margins
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Stanley Druckenmiller On Liquidity, Macro, & Margins

What’s obvious is obviously wrong… The present is already in the price… And it’s margins and capacity that matter ~ Stanley Druckenmiller

The following are some more words of wisdom from Druck pulled from an old Barron’s interview in 88’. There’s a few notes from me as well…

Gauging the macro environment through three different lens (emphasis by me):

We look at the market in three different ways — and each of them is flashing warning signals. First of all, we look at valuations. We use them to determine, really, the market’s risk level, as opposed to its direction… Valuation is something you have to keep in mind in terms of the market’s risk level… when catalyst’s come in and change the market’s direction… the decline could be very major if you’re coming from the kinds of overvaluation levels witnessed in ‘29 and the fourth quarter of last year (note: this was in the year following the 87’ crash). So valuation is something we keep in the back of our minds.

The major thing we look at is liquidity, meaning as a combination of an economic overview. Contrary to what a lot of the financial press has stated, looking at the great bull markets of this century, the best environment for stocks is a very dull, slow economy that the Federal Reserve is trying to get going… Once an economy reaches a certain level of acceleration… the Fed is no longer with you… The Fed, instead of trying to get the economy moving, reverts to acting like the central bankers they are and starts worrying about inflation and things getting too hot. So it tries to cool things off… shrinking liquidity [While at the same time] The corporations start having to build inventory, which again takes money out of the financial assets… finally, if things get really heated, companies start engaging in capital spending… All three of these things, tend to shrink the overall money available for investing in stocks and stock prices go down…

Druck has also said:

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.

This is absolutely true. Liquidity is a key metric we track at Macro Ops. It’s also the most misunderstood by market players. To read more on the topic of liquidity, check out this piece.

Also, this next line is so important to understand:

…the best environment for stocks is a very dull, slow economy that the Federal Reserve is trying to get going.

Once you understand how and why liquidity works, you’ll fully grasp the old Wall St. adage of “Don’t fight the Fed”. The Fed controls the biggest lever on global liquidity. And liquidity is what drives stocks… NOT the economy.

Think about the last eight years of the current bull market. Economic growth has been pathetic, inflation fleeting, and confidence in the direction of the economy dour. But at the same time we’ve experienced one of the largest and longest bull markets in history…  

The pundits and fin-twit bears who’ve been shouting about impending doom and gloom, crying about how detached the market is from the “fundamentals”, don’t understand the most important fundamentals of them all: liquidity and sentiment.

The worse thing that could happen to this current bull market is for the economy to markedly pick up. That growth would spur inflation, which along with improved sentiment, would make the Fed a lot more comfortable tightening at a faster pace. Liquidity would then be pulled from the system and drive the stock market lower.

Don’t confuse the stock market with the economy. Understand that the market is forward looking and the biggest lever on future demand is liquidity. That’s why you need to understand the reaction function of the Federal Reserve.

On valuations and market moves:

In this century the stock market has tended to trade between 1.1 and 2.2 times book… And stocks generally yield between 6% or 7%. When people are feeling good about the world, for some reason, 2.1 to 2.2 times book and 3% yield tend to be the cap…

I do know that every time the stock market has gone down 30% in this century, we’ve had a recession. The only good economist I have found is the stock market. To people who say it has predicted seven out of the last four recessions, or whatever, my response is that it’s still a lot better than any of the other economists I know.

Concentrated bets and the importance of focusing on margins:

To try to add value to our portfolio, we make very concentrated bets in industry sectors, rather than simply being overweight or underweighted in terms of the S&P. If you look at our portfolios over time, four to five industries tend to represent 90% of the holdings — long and short… We choose these industries by trying to buy companies where we feel the margins are going to be higher in one to three years and selling companies where we feel they’re going to be lower in one to three years.

[In response to the question of why focus on margins?] It’s tied in with my liquidity argument. When corporate America is operating at very high rates, it starts building capacity, which sucks out liquidity; it also lowers companies margins two years out. And that’s the opposite of when a bull market starts…

With the longs, we are trying to identify situations where we feel that margins are going to be higher over the next year or two. We’re trying to identify industries that are operating at fairly low rates, which will be rising, but where you won’t see capacity increases for at least a couple of years, and where the profit margins will be much higher by then. [And] we don’t sell things just on a valuation basis… We need to see what is going to make the margins come down…

There are a number of important points here. Druck is noting the importance of trading off future outcomes in relation to current expectations instead of trading the present reality. In a talk at USC a number of years ago he said:

Too many investors look at the present, the present is already in the price. You have to look think of the box and sort of visualize 18 to 24 months from now what the world is going to look like and what securities might trade at.” What a company is earning right now doesn’t mean anything. What you have to look at is, what a company is earning and what people think it’s going to earn and if you can see something that in two years is going to be entirely different than the conventional wisdom, that’s how you make money. My first boss said “what’s obvious is obviously wrong.”

A useful tool for valuing potential future outcomes is the margins of sectors and industries. There’s a cyclicality in margins that provides a window into the point of the capital cycle a particularly industry or sector is in.

Fat profit margins attract competition. Competition leads to increased investment. Increased investment leads to glut and contracting margins until capacity is taken offline. And then the cycle begins anew.

Stanley Druckenmiller is among the greatest traders to ever play the game. His big advantage is that he understands liquidity and how it drives macro. And knowing macro is one of the most important keys to market success. As one of Druck’s proteges, Scott Bessent put it:

Recently, I was at a money manager roundtable dinner where everyone was talking about “my stock this” and “my stock that”. Their attitude was that it doesn’t matter what is going to happen in the world because their favorite stock is generating free cash flow, buying back shares, and doing XYZ. People always forget that 50% of a stock’s move is the overall market, 30% is the industry group, and then maybe 20% is the extra alpha from stock picking. And stock picking is full of macro bets. When an equity guy is playing airlines, he’s making an embedded macro call on oil.

For a deeper look into how our team’s evaluates liquidity, check out our Macro Ops Handbook here.

 

 

What Traders Can Learn From Professional Horse Betting
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What Traders Can Learn From Professional Horse Betting

Thegreek.com, a horse racing blog, discusses the “seven deadly sins” losing horse bettors commit. Repeat these sins in your trading and you’ll suffer the same fate as the losers at the track.

Here are the four most important sins to avoid:  

Deadly Sin No.1: The most important thing is picking winners.

Wrong! Professional horse bettors will tell you that trying to pick the winner of the race is a failed strategy and that it’s far more important to get value. What’s “value?” Consider this: A horse that you handicap as a legitimate even-money favorite should win about half the time. So that horse is a bad play at 4/5 or less. A horse that you analyze should win about one in four times the race is run, should be about 3/1. That horse won’t win as often as the even money shot but if you can get value, say 5/1 or higher, you’ll make money in the long run.

The few horse bettors good enough to make a living know it’s not about picking a winner. It’s about identifying positive expected value. Oftentimes that means the lower probability play is the better bet.

If an option is currently priced to profit 1 in 10 times, but you think it’ll profit 2 in 10 times, then buy it. It’s a value. It doesn’t matter that most of the time the option will expire worthless. Over the long haul, the buyer will walk away profitable.

Deadly Sin No.3: You should bet more on a horse you really like, such as your “best bet.”

Ridiculous. Why bet if you don’t like who you’re betting? Put another way, any horse worth betting is one worth betting significantly. Sophisticated bettors usually bet about the same amount on every bet. After all, as one professional gambler told me, “If I knew what my ‘best bets’ were I’d only bet those.” A “best bet” is a media creation. If you know what you’re doing, your best bet always should be the next bet you make.

Professional track gamblers understand that bet size is incredibly important. Sizing your bets based on “hunches” leaves you susceptible to accidently betting big on losers and tiny on winners.

Imagine three trades where you’re right on the first two and wrong on the last. And since you thought you had a “hot hand”, you bet really big on that last loser. This would result in the losses from the last trade cancelling out the gains from your first two winners. Your account would end up net negative.

Sizing up has a time and a place in trading. Soros would bet big when the stars aligned. But you need lots of experience before you can start sizing up on what you think are great trades.

Until you’re seasoned and able to decipher between a good and great bet, keep your position sizes consistent. If you don’t, you risk going broke from bad luck.

Deadly Sin No. 4: Statistical betting trends are important.

Actually, they’re not. “Technical handicapping,” as it’s called, is another of those manufactured disciplines used by professional touts, not professional horse racing bettors. Mostly, technical handicapping—wherein statistics are employed to predict an outcome—are little more than “backfitting,” a practice where someone makes up a theory to fit a set of numbers. It’s a lazy handicapping shortcut and no replacement for hard analysis.

Ever wonder why those really smart quants with the fancy degrees end up blowing up? It’s because they have too much trust in a model tightly fit to past data.

Studying the past can help you figure out what’ll happen in the future, but only within reason. If you create a trading model based on the premise that the future will play out exactly like the past… it will fail.

Keep historically based assumptions as simple as possible. That will help thread the needle between useful insight and robustness.

Deadly Sin No. 7: Specialize in certain aspects of the game and pick your spots.

Why limit yourself? If you never bet grass races or stay away from maidens you may be missing some great betting opportunities. When you gamble, having more options always is preferable.

That’s why our team at Macro Ops trades global macro. If stocks dry up, we have the flexibility to drop into the grains market or currencies or any other market where there’s high expected value profit opportunities. The more markets you learn to trade, the easier it is to trade only the most attractive setups.

For a deeper look into our team’s trading strategy, check out our Macro Ops Handbook here.

 

 

The Man Behind Quantum George Soros Philosophy and Mindset

The Man Behind Quantum: George Soros’ Philosophy & Mindset

The following is straight from Operator Kean, a member of the Macro Ops Hub. To contact Kean, visit his website here.

The Quantum Group of Funds is one of the most successful hedge funds in history. Built by uber-investor George Soros, it was only recently overtaken by Bridgewater to become number 2 on the list of the most profitable hedge funds of all time. Given Quantum’s success, there’s much we can learn studying the investment philosophy and mindset of the man who ran it.

(I) Uncertainty is the name of the game!

Have you ever been 100% sure about something which turned out to be completely wrong?

Soros has.

That’s why he understands that humans are fallible creatures. We’re imperfect beings with an imperfect understanding of the world around us.

Soros was originally intrigued by a concept from Quantum Mechanics called the Heisenberg Uncertainty Principle. It postulates that the precise position and momentum of a particle cannot be measured 100% accurately. No matter how sure you are of the process, there’s always an element of uncertainty involved.  

Understanding and accepting uncertainty is crucial. Doing so gives you the courage and conviction to:

  1. Admit you can be wrong
  2. Acknowledge the markets can be wrong
  3. Accept that both you and the markets can be wrong in varying degrees

Soros believes that markets cannot be understood merely through traditional economics. There’s nothing real and tangible involved. It’s all just a mix of opinions and belief systems. This means that in order to survive, we need to think in possibilities, and constantly adapt to an ever-changing paradigm.

(II) Risk is inevitable. Manage it!

Most believe risk is two-dimensional — to make higher returns, you need to assume higher risk.

But Soros sees it differently. He believes in asymmetry. Instead of abiding by “more risk = more return”, Soros obsesses over risking as little as possible to make as much as possible.

He also understands that everything has an element of risk that’s unknowable (uncertainty principle). In reality, what most consider a “risk-free” asset could actually be disastrous in extreme and unexpected circumstances. Instead of “risk-free”, Soros would prefer calling these assets “low risk based on what I or others know”. Notice the difference? It’s subtle, but comes with a drastic shift in mindset.

Soros’ deep understanding of risk allows gives him comfort in tough times. Multiple biographies quote Soros calling his period as a refugee during WW2 as the “best time of his life”. He was comfortable “living riskily” in that environment during his youth. Later on in life, while managing Quantum, Soros was known for taking big bets that seemed overly risky to others. He’s the one who pushed Druckenmiller to size up their pound trade and “break the Bank Of England”.

The point is that Soros fully understands and accepts risk down to his core — both the known and unknown kind. This allows him to maintain a healthy relationship with risk through which he can successfully manage it. That’s what it takes to win in this game.

(III) The bottom line is all that matters!

Soros is limitlessly flexible. He doesn’t care about abiding by a particular investment strategy or set of rules. He only cares about profits.

In fact, when recalling his investment activity, Soros failed to find just one system or list of rules that he maintained throughout his career. He instead found constantly changing patterns that were unforeseeable beforehand. Every new form of speculation was different than the prior. It all depended on circumstances. In both Inside the House of Money and Soros on Soros he’s quoted as saying:

I don’t play the game by a particular set of rules; I look for changes in the rules of the game.

This is why Quantum was unique. They never had a set strategy. The fund was highly opportunistic, investing across all asset classes, across the world. They had no directional bias and played both the long and short sides. Soros believed that setting a strategy was merely an ego-building exercise that would turn one myopic.

Soros also had no qualms about riding bubbles and manias. He once said that when he sees a bubble forming, he rushes in to buy, “adding fuel to the fire”.

He doesn’t mind going against the crowd either. Soros famously crusaded against various central banks in the 1990s, betting big and capitalising on the collapses of currency pegs in Europe and across emerging markets.

This unconstrained and ruthless approach evolved Quantum into what is now — a family office that consists of everything from real assets, to private equity, and even venture capital vehicles. The fund adapted to whatever made money…

This philosophy and mindset is what made George Soros the market legend that he is today. Following his principles will help you on your road to market success as well.

To learn more from George Soros and other investing legends, click here.

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.

 

 

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.