Hedge Fund Market Wizards

trade long side of a bubble

1. get in early

2. limit the downside in worst case scenario because bubble burst are sharp

   • low volatility bubble markets are implemented with long calls instead of long outright positions

sometimes there is no fundamental reason for the trade but price action can reveal important things like:

• magnitude of the move
• invest first, investigate later - G. Soros

2 key factors:

1. growth
2. inflation

2 states:

1. increasing
2. decreasing

4 market conditions:

1. growth increasing
2. growth decreasing
3. inflation increasing
4. inflation decreasing

split world into 2 types of countries:

1. creditors
2. debtors

2 characteristics:

1. countries that can exercise independent monetary policies
2. those that can't

4 classifications of countries:

1. debtors countries with independent monetary policies - e.g. US, UK
2. debtors without independent policies - e.g. Greece, Portugal
3. creditor countries with independent monetary policies - e.g. Brazil
4. creditors without independent policies - e.g. China (Yuan is pegged to USD)

from Principles book:

• recognize that mistake if it results in learning
• create a culture where is OK to fail but unacceptable to not analyze and learn from mistake
• bring mistake in the open and analyze objectively
• treat mistakes as learning opportunities
• radical transparency, openness and honesty
• never say anything to a person that can't say it directly

template for understanding economy as 3 acting forces:

1. productivity growth

2. long term credit expansion/deleveraging cycle

   • debt payments become larger that amount we can borrow and spending must decline
   • when it can't raise more credit then process reverses and we have deleveraging
   • money coming into debtors hands is not enough to meet obligations then assets need to be sold and spending cut to raise cash
   • this leads to assets value fall, which reduces the value of collateral and in turn reduces incomes
   • because both lower collateral and lower income reduces credit worthiness is reduced and they can't get enough credit
   • and it continues in self reinforcing manner
   • deleveraging is different from recession
   • unlike in recession when cutting rates to raise money can fix the problems, in deleveraging monetary policy is ineffective

   • in recession interest rates can be cut to:

     1. ease debts
     2. stimulate economic activity
     3. produce a positive wealth effect
   • in deleveraging interest rates are already 0% and cant be lowered and
   • credit growth is difficult because borrowers remain indebted
   • in inflationary deleveraging monetary policy is ineffective because increased money goes into other currencies and inflation-hedge assets are inflated
3. business cycle - fluctuations in economic activities

really big pictures (centuries time frame):

1. countries are poor and they think they are poor
2. countries getting rich quickly but they still think they are poor
3. countries are are rich and think of themselves as rich

4. countries become poorer and still think of themselves as rich - leveraging up phase, the debt rises relative to income until they cant;

   • spending is still strong and they appear rich while balance sheet deteriorate
   • twin deficits: both balance of payments and government deficits
   • accumulation of debt that cant be paid back in non-depreciating money which leads to next stage

5. countries goes thru deleveraging and relative decline which are slow to accept

   • after bubbles burst, deleveraging occur, private debt growth and private sector spending, asset value and net-worth declines in self reinforcing manner
   • to compensate gov debt growth, gov deficits and central banks printing of money increase
   • these countries have to compete with less expensive countries that are in earlier stages
   • currencies depreciating and power in the world declines

3 type of trading styles:

1. fundamental traders say that will buy this stock for the next 6 months
2. technical traders say that if stock goes to this level will sell or buy if goes to different level
3. Larry lets the market speak to him to buy or sell

2 keys points:

1. limits portfolio risk to 2.5%
2. when the draw-down is reached he reduces the size until he is profitable again

he wanted 3 things:

1. to be a trader
2. to use computerize approach
3. to do it differently than anyone else

3 types of systems:

1. trend following
2. counter trend (mean reversion)
3. patterns of higher/lower prices

4 rules:

1. is possible to find systems (that are neither trend-following nor mean-reversal) and work better than the standard systems
2. it possible to data mine and search for patters without falling victim to curve fitting
3. all price data (30 years old) can be as meaningful as recent data
4. systems that work in multiple markets are better than systems that work in specific markets

2 ways of looking at his record:

1. he was unbelievably lucky
2. efficient market hypothesis is wrong

a lot of first-time achievements:

1. wearable computer to win at roulette
2. blackjack winning strategy
3. systematic approach to trade warrants (long-term options) and convertible securities (options, convertible bonds, preferred stocks)
4. formulate options pricing model equivalent of Black-Scholes model
5. founder of the first market neutral fund
6. quant hedge fund
7. convertible arbitrage
8. statistical arbitrage
9. likely the first to uncover that Bernie Maddoff was a fraud

5 main pillars:

1. find mis-priced options in theoretical priced world
2. select trades with a positively skewed outcome, probability weighed gain must be upside of probability weighed loss
3. implement trades asymmetrically - buy mis-priced options
4. wait for high conviction trades
5. use cash to target portfolio risk - 50% to 80% in cash

5 generally accepted assumptions that sometimes might be invalid:

1. prices are normally distributed
2. the forward price is perfect predictor of the future mean

3. volatility scales with the square root of time - this might understate potential volatility because:

   1. the longer the time period the more likely volatility will revert to the mean from current levels
   2. longer periods allow for more opportunity for trends to result in larger price moves that the one implied by the volatility
4. the trend can be ignored in the volatility calculation
5. current correlations are good prediction for future correlations

two biggest mistakes in trading:

1. not enough homework
2. they are bit too casual about risk

uses a systematic trend-following strategy:

1. system will liquidate positions when trend is over-extended while waiting for reversal signals
2. continuous improvements, system trading is a dynamic process, "a research war"

a lots of traders deviate from what they do best

1. good long term traders take short term positions with no edge
2. other traders have effective systems but get bored and overwrite it with discretionary decisions

3 characteristics:

1. favorable macro outlook, 2 keys ways:

   1. concentrate longs in countries with positive fundamentals
   2. global macro outlook can influence net portfolio exposure
2. supportive very long-term trend
3. good company - growth, value priced at its future prospects

investment rules:

1. find companies you understand
2. take profits when they reach valuation levels
3. sail into a cash harbor when market is stormy
4. stick to the basic process
5. treat investment as a business, not as a gamble
6. stick to business you understand

3 lessons with general applicability:

1. the need to adapt to continuously changing market conditions

2. trading around the positions

   • if he is short will reduce the position on price breaks and rebuild the positions on rally
3. avoid euphoria - parabolic move