# Hedge Fund Market Wizards

## Review

An actionable, bullet points summary for one of my favorite, all time best-seller and trading bible: Hedge Fund Market Wizards book, released in 2012.

### Part 1 - Macro Men

#### C1 - Colm O'Shea: knowing when it's raining

• he does not forecast what will happen but recognize what has happened

• very difficult to pick tops/bottoms, better wait for confirmation events like the drying up liquidity in money market in Aug 2007

• 2007: yield curve spread (long short-term rate/short long-term rate) instead of long/short rate instruments

• NASDAQ peak: long bond (economic slow down, lower interest rates) instead of short position in stocks (very likely to be stopped out on a 40% re-bounce)

• flexibility is important quality in trading - be ready to get out of a trade if price action is inconsistent with the hypothesis

• Apr 2009 was pessimistic about market outlook but price action was telling the opposite and market started a Asia-led multi-year rally

• 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

• decide at what price your initial hypothesis is wrong and set the stop loss there

• right skewed trades, maximum loss is constrained, win is unlimited

#### C2 - Ray Dalio: the man who loves mistakes *

• fundamental systematic computer model, both alpha and beta funds

• alpha is skill/volatility, beta is directional with benchmark index

• timeless and universal approach

• 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

• diversification is the holy grail of investing

• correlation can be misleading statistics - highly variable and prevailing circumstances

• gold and bonds are inverse correlated but in deleveraging cycle they are correlated because of monetary easing that decreases interest rates

• focus on underlying drivers that are expected to effect the positions; drivers are the cause, correlation is the effect

• forward looking approach, based on drivers: anticipate when gold and bonds are likely to move in the same direction

• backward looking: based on correlation

• different positions have different drivers

• markets behave differently in deleveraging and recession environments

• government actions that might lead to sustained rebound in recession have little effect in deleveraging

• U.S. out of gold standard and Mexico default followed by a huge market rally

• mistake provide the path to improvement and ultimate success

• write down mistake and learn from it

• 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

#### C3 - Larry Benedict: beyond tree strikes *

• the road to success is often paved with mistakes

• mean reversion trader: seller in the short-term up swings and buyer in short term declines

• entry level determined by the volatility and bias

• long / short in different markets

• very good Sharpe and gain to pain ratio

• cuts the trading size in half after 2% loss, liquidate portfolio and start clean

• 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

• technical discretionary trader that does not use charts

• he looks at market in contrast with other markets: correlation come and go

• discretionary process starting with inter-market correlation

• 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

• you are not a trader, you are a risk manager

• never stay in loosing trades, don't freeze, you need to know how to respond in each situation

#### C4 - Scott Ramsey: low-risk futures trader

• discretionary trader in highly liquid futures in FX markets

• broad fundamental macro view and direction bias in each market and goes short the weakest market if bearish and long the strongest market if bullish

• in futures the only meaning full metric is return/risk

• identify big picture fundamental factors to derive the market and use technical to trade in that direction

• fundamentals as contrarian indicator - bearish fundamental has bullish price action because it was not effective

• buy the strongest, sell the weakest, novice traders do the opposite

• price movement in related markets can reveal one strength of weakness

• 0.1% on each trade from the point of entry and allows for more risk if ahead on the trade

#### C5 - Jaffray Woodriff: the third way *

• he wanted 3 things:

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

• change position size according to volatility

• as all successful traders he found a method that suits him

• was very good recognizing systems that do not match his personality even after 3 days of testing

### Part 2 - Multi-strategy players

#### C6 - Edward Thorpe: the innovator *

• can the market be beat?

• if you have enough monkeys that hit keys they will ultimately write Shakespeare

• the problem is that you need a lot of monkey that can't fit into visible universe

• track record (227 winning months out of 230) or 227 heads in 230 coin tosses with a probability of 1 in 10^63

• 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

• his sister said that "do what you love and money will follow"

• 44% edge in roulette by predicting the ending zone

• vary the bet size to improve the odds in classic blackjack strategy

• trade smaller (or not at all) for lower probability trades and larger for high probability ones

• quantitative traders: statistical analysis of past results

• exposure reduction on draw-downs in directional trades in contrast to arbitrage trades where edge can be easily calculated

• don't bet more than you are comfortable with, betting $1 on bad hands and$10 on good hands in Blackjack

• there is no single winning solution and existing edges are continuously changing

• starting with hedging long positions in stocks that got down the most with short positions in stocks that got up the most - delta neutral

• then added market/ sector neutrality

• Kelly criterion for calculation the optimal size for each trade

• Kelly criterion assume the probability of winning and win/loss ratio are precisely known in advance (like in gambling but not in trading)

#### C7 - Jamie Mai: seeking asymmetry *

• profiled in the book The Big Short by Michael Lewis

• profit of 80x the premium paid on betting on sub-prime mortgages in 2008 crisis

• implementing structured highly asymmetric positive skew trades, long shots where profit is far larger than loss

• Sharpe ratio is a volatility (standard deviation) measure (calculated as (return - free rate risk) / volatility) which will penalty win spikes

• gain to pain ratio (return/risk) is a measure of loss (rather than volatility)

• 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

4. wait for high conviction trades

5. use cash to target portfolio risk - 50% to 80% in cash

• options are priced by using certain assumptions that sometimes are not aligned with prevailing fundamentals

• 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

• risk != volatility

• good traders get out of positions when they realize the assumption was wrong

#### C8 - Michael Platt: the art and science of risk control

• two biggest mistakes in trading:

1. not enough homework

2. they are bit too casual about risk

• he is a master of risk control

• risk management begins with trade implementation: long options or spread structures instead of outright long/short positions

• close a trade if it does not work within a reasonable amount of time

• extremely tight range of what a rookie trader can loose: 3% loss triggers a 50% reduction in allocation

• large percentage loses require increasingly percentage gains to get back to even

• losing trades makes you feel like an idiot and you are not in the mood to put anything on

• 80/20 rule: 80% of the profit comes from 20% of the trades

• attention to how market react to news as confirmation of his trading ideas

• 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"

### Part 3 - Equity traders

#### C9 - Steve Clark: do more of what works and less of what doesn't

• poor guy living in outskirts of London

• 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

• find what you are best in and focus on that - analyze past trades

• entry size is more important than entry price - you wake up thinking about it

• in 2007 he reduces the trading size by 75% in response to increased volatility

• good traders can change their mind in a minute if price action is inconsistent with their hypothesis

• when trading badly, get out of everything and go in vacation, regain objectivity

• you can't be objective if you are in the market, taking physical break will stop downward spiral

• be aware of trades born of euphoria

• staring at the screen all day is counter-productive

• the job of a trader is to protect the equity line

#### C10 - Martin Taylor: the tzar has no clothes

• decreased AUM to 1/4 of original amount

• 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

• sometimes is better to be in the market with modest exposure than be outside of the market and chase the whipsaw moves to get in

• need to know your modest net exposure

• obsession for monthly returns can adversely influence long term investments

• during the bubble the most profitable are imprudent traders, not the skilled ones

#### C11 - Tom Claugus: a change of plans

• vary net exposure based on opportunity within the 95% price band of all the price observations

• when price is near the lower band, he will hold max long and the opposite when touching upper band

• looking for company that benefit from future plans that are not being priced-in: new tech, new sources of prod, increase assets

• if revenue source is more than 2 years in the future the market will fail to assign significant value to it

• fundamental screens fail to identify these because the source of bullish potential is not reflected in current statistics

• shorting stocks at the end of 1999

• as long as a profitable strategy is implemented, a loss is not a trading mistake

• trading is a matter of probabilities and any strategy will be wrong a certain % of the trades

• a good trade follows a process that will be profitable if repeated multiple times even if it can loose money in individual trades

• a bad trade follows a process that loose money if repeated multiple times but might make money on individual trades

• an analogy: a slot machine is a bad bet because has a higher probability of loosing money if repeated multiple times

#### C12 - Joe Vidich: harvesting losses

• the author found Joe in a hedge fund database, not recommented like the most of the market wizards

• don't try to be 100% right: taking partial loss instead of all or nothing

• limit your position size in such a way that fear does not become the prevailing instinct guiding your judgment

• long time bull but also took short side once in a while

• don't make trading decision based on where you bought or sold

• get used to frustrating experiences when market turns around after you closed the position

#### C13 - Kevin Daly: who is Warren Buffet?

• he looked up who is Warren Buffet during his job interview and follows Warren's investment philosophy

• mostly long only fund and cash from time to time

• superior stocks selection was main strategy, not participating in the bear market

• importance of patience when environment is adverse to your approach, or opportunities are lacking

• largely in cash during 2000 - 2002 bear market

• 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

• small assets size (\$50M) investing in small cap stocks, move in and out of positions

#### C14 - Jimmy Balodimas: stepping in front of freight trains *

• he breaks all the rules, adds to looses and cuts the profits short

• mostly short in a up-trend market

• no emotions regardless he is up or down for the day or month

• don't try this at home

• 3 lessons with general applicability:

1. the need to adapt to continuously changing market conditions

• if he is short will reduce the position on price breaks and rebuild the positions on rally

3. avoid euphoria - parabolic move

• if you are long in a market that you are afraid to sell, it might not be a bad idea to reduce your position

• very skilled in identifying turning points before they happen

• even the best traders might not execute their strategies the best way

• proficiency is achievable with hard work but performing at an elite level requires some degree of innate talent

• he found an approach that fits his personality: independent, competitive, contrarian, comfortable with risk

• the same approach might be disastrous for most other traders

• you cannot succeed in the market by copying someone else approach

#### C15 - Joel Greenblatt: the magic formula

• investing strategy inspired from Warren Buffet

• he believes in efficient market theory that stocks will ultimately trade at fair value

• but price can deviate substantially from their fair value for long periods, even years

• you don't have to trade all the time, wait for right strike

• past performance to select managers

• stock indexes are better investments than hedge funds because of less fees

• options are based on mathematical formulas and might provide great risk/reward trades

### Conclusion

#### 40 Market Wizard lessons

1. there is no holy grail

4. flexibility is an essential quality for trading success - O'Shea, Mai, Clarke

5. the need to adapt - Thorpe, Platt, Balodimas

7. do more of what works and less of what doesn't - Clark

8. if you are out of sync with the market, trying harder won't help - Clark

9. the road to success is paved with mistakes - Dalio

10. wait for high conviction trades - Mai, Greenblatt

11. trade because of perceived opportunity not out of the desire to make money - Benedict

12. the importance of doing nothing - Daly

13. how a trade is implemented is more important that the trade idea itself - O'Shea

14. trading around the position can be beneficial - Balodimas

15. position size can be more important than the entry price - Thorpe

16. determining the trade size - Thorpe

17. vary market exposure based on opportunity - Claugus

18. seek an asymmetric return/risk profile - O'Shea

19. beware of trades born of euphoria - Balodimas, Clark

20. if you are on the right side of euphoria or panic; lighten up

21. staring at the screen all day can be expensive - Clark

22. risk control is critical - Ramsey, Platt, Benedict, Woodriff, Clark, Thorpe

23. don't try to be 100% right - Vidich

24. protective stops need to be consistent with the trade analysis - O'Shea

25. monthly loses is good idea if consistent with the strategy - Taylor, Greenblatt

26. the power of diversification - Dalio

27. correlation can be misleading - Mai, Dalio

28. price action in related markets provides trading clues - Benedict, Ramsey

29. markets behave differently in different environments - Dalio

30. pay attention to market response to news - Platt

31. fundamental events might be followed by counter-intuitive price movements - Dalio

32. situation characterized by potential for a widely divergent binary outcome might provide buying opportunity for options - Greenblatt, Mai

33. a stock can be well-priced even if it has already gone up a lot - Taylor

34. don't make trading decisions based when you bought/sold a stock - Vidich

35. potential new revenue sources might not be reflected in stock price - Claugus

36. value investing works - Greenblatt

37. the efficient market hypothesis provides an inaccurate value of how the market really works - Greenblatt

38. it is a mistake for a manager to alter investment decisions to please investors - Greenblatt, Taylor

39. volatility and risk are not synonymous - Mai

40. it is a mistake to select managers based on solely past performance - Greenblatt