Trading 201: Position Sizing

By Jared Dillian 

This is going to be the last of the trading lessons for a while. I don’t want to turn this into a trading blog, and there are important macro things to talk about (especially next week). Here’s an imaginary scenario: someone tips you that an acquisition is going to happen. Of course, that would be insider trading, which is illegal—but let’s pretend for the purpose of this exercise that insider trading were legal.

So someone tells you that Company A is going to buy Company B and is going to pay a 100% premium.

Question: how much of your money do you put in Company B? If the answer is anything less than “All of it,” then you are an idiot.

We are talking about a 100% return in one day. Can you do better than that? No. Also, assume that the guy who told you this is 100% reliable. The information is legit. There is no chance that it’s wrong. Rationally, you should put every penny of your money into Company B stock. If you put in any less than 100%, you are behaving irrationally.....Got it?

Scenario 2: you have a vague idea that GE is going to go up. Just a hunch. How much GE should you buy?

Answer: not very much. Maybe it should be the smallest position in your portfolio. At this point in the story, think about your portfolio, or maybe even log into it. My guess is you have some very high-conviction ideas alongside some very low-conviction ideas, and that everything is just about weighted equally.

People do this all the time. They have $100,000 in 10 stocks—$10,000 a stock—regardless of conviction level. This is going to be hard for novice traders to understand. Novice traders pick stocks like I bet on baseball. I might bet against the Royals because Edinson Volquez wears his hat sideways, or I might bet on the Nationals because I am a huge Bryce Harper fan, or I might bet against the Red Sox just because.

Novice traders find it hard to believe that someone can be that sure about a stock. But I meet professional gamblers who are “that sure” about baseball games. I don’t understand how they do it, but they do it. Soros and Druckenmiller were pretty gosh darn sure when they bet against the British pound. Imagine if they had been wrong! But they knew they wouldn’t be.

Winner, Winner, Chicken Dinner

Let’s go back to about 10 years ago when Ben Mezrich wrote Bringing Down The House: The Inside Story of Six MIT Students Who Took Vegas for Millions. That was when the general public got to learn about advantage play in blackjack, that is, counting cards.

How does it work?
In one paragraph, you count cards so you can keep track of face cards (which are good) and low cards (which are bad), so if you know there’s a concentration of face cards left in the shoe, you will have a temporary statistical advantage over the dealer.

And how do you take advantage of that statistical advantage?
Duh, you bet more!

That’s what the card counters in the book did. When the count was high, they were putting in 10, 20, or even 50 times their normal bet. In fact, that’s how most casinos know they’re dealing with a card counter. Average players don’t vary their bet size. They bet the same size all the time. Average traders do too.

If you want to read more on this concept (and I highly recommend that you do), read David Sklansky’s Getting the Best of It.  It’s a gambling book, but most people I know on Wall Street have read it.

Oink

So I’m going to preach what I practice. My highest conviction position is about 80% of my portfolio (using leverage). Now, that’s varying your bet size. Most of my ideas are actually bad. Seriously. I knew a guy at Lehman who said he was wrong 80% of the time. I figured he was lying. The guy made a ton of dough. How could that be true?

If you bet the farm on the 20% of the time you are right, you can do very well. This, I think, is one of the limitations of an investment newsletter. You have these ideas, and they are in a portfolio, but they are not weighted. Some are clearly better than others. And there they all are, line items in the portfolio update, and the good ones look the same as the bad ones.

A word of caution. Novice traders should not, absolutely not, make one position 80% of their portfolio. I do it because I have 16 years of experience. You should not do this any more than you would bet 80% of your money on a baseball game (unless you know a lot about baseball). Novice traders can’t vary their bet size because they don’t know enough to tell which ideas are bad and which ones are a “sure thing.”

It’s a good way to blow yourself up.

But at some point in your investing career, you are going to come across one of those really great ideas, and you will be tempted to weight it as 10% of your portfolio, along with everything else.

Diversification! Screw diversification.

How do billionaires get to be billionaires? Funny, if you look at a list of billionaires, there’s not too many money managers in there. Some. Like Dalio, Tepper, Soros, Jones. But not many. Most billionaires got to be billionaires by starting companies and growing them. In other words, they had 100% of their portfolio in one stock. Their own.

You don’t get to be a billionaire by putting $10,000 in 10 stocks. We all can’t be billionaires. But you don’t have to be a piker.

Jared Dillian

If you enjoyed Jared's article, you can sign up for The 10th Man, a free weekly letter, at mauldineconomics.com.

The article The 10th Man: Trading 201: Position Sizing was originally published at mauldineconomics.com.

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Distressed Investing

By Jared Dillian 

When most people think of distressed investing, they think of buying CCC-rated bonds at 20 or 30 cents on the dollar, then maybe sitting in bankruptcy court to divvy up the capital structure, making healthy risk-adjusted returns in the end. You just need to hire a few lawyers.

Distressed investors are a different breed of cat. It’s one of those countercyclical businesses, like repo men, who do well when everyone else is getting hammered.

I remember distressed guys killing it in 2002. Most people remember the dot-com bust, but there was a nasty credit crunch that went along with it. Nasty. High yield/distressed investments had some amazing years in 2003 and 2004. Convertible bonds in particular.

Funny thing about distressed investors is that they like to stay within their comfort zone. In my experience, they’re not keen on commodities. Like coal mining, which this week saw one bankruptcy filing and another one in the works. Distressed guys hate commodities because they are just timing the earnings cycle – which is the same as market timing.  Distressed guys want less volatile earnings so their projections aren’t totally dependent on commodity prices rising.

Coal is distressed, all right. But you don’t see the distressed guys getting involved. Even they are too scared!

Here’s a somewhat controversial statement: I think most commodities are distressed. Coal is definitely distressed. So is iron ore. Copper, too. And yes, even gold. Corn and beans have had a nice little run, but metals and energy in particular have been a complete horrorshow.

So I think it’s time to start looking at commodities as a distressed asset class. The assumption is that fair value of these commodities/producers is well above current market prices, and current market prices are wrong because of, well, a lot of things. In particular, a self-reinforcing process where selling begets more selling.

If you’re a distressed investor and you’re buying something at a deep discount, if you have a long enough time horizon, you’ll be vindicated eventually. Sometimes, it takes a long time. Sometimes, not very long at all. It’s pretty great when it works.

I have never had much aptitude for it. But I am trying it now.

Gold: A Special Case

Gold is a little different.

How do you value gold? It has no cash flows. An industrial commodity like copper is pretty easy to value. With gold, you’re trying to gauge investment demand (at the retail or sovereign level), which is hard, against mining production, which is a little easier.

But what an ounce of gold is worth is entirely subjective. More subjective than copper or cocoa or coffee. For example, if everyone started using bitcoin, there would be little to no demand for gold. (For the record, I think cryptocurrencies indeed have had an impact on gold demand.)

Basically, people want gold when they think their government no longer cares about the purchasing power of their currency. In our case, that was when the Fed was conducting quantitative easing, known colloquially as printing money.

But that’s not really what people were nervous about. Think about it. The Fed was printing money for monetary policy reasons. They were trying to effect monetary policy with interest rates at the zero bound. That’s different from printing money to buy government bonds because nobody else wants to. That’s called debt monetization.

When budget deficits get sufficiently large, people worry about things like failed bond auctions, that the Fed will have to step in and be the buyer of last resort. This is the nightmare scenario described in Greenspan’s Gold and Economic Freedom essay.

We had $1.8 trillion deficits not that long ago. The bond auctions were a little scary. I thought debt monetization was a possibility.

The deficit is lower today, mostly because of higher taxes, more aggressive revenue collection, and economic growth. As you can see, the price of gold has corresponded almost perfectly with the budget deficit.

With a small deficit today, nobody cares about gold.

Is the deficit going higher or lower in the future? Higher. Ding-ding-ding, we have a winner. One of the reasons I’m happy owning gold as a part of my portfolio.

Paper vs. Things

Asset allocation gets a lot easier when you figure out that the financial markets are a tug-of-war between paper and things. Sometimes, like now, financial assets (stocks and bonds) outperform. Stocks are overpriced, and bonds are way overpriced. Other times, like 10 years ago, commodities outperformed.

It has to do with the degree of confidence people have in… other people. A bond is a promise to repay. A stock is a promise to pay dividends, or that there will be something left over at the end. A dollar is a promise that it’s worth something, namely, a divisible part of the sum total of the productive abilities of all the people in the country.

These are pieces of paper. Paper promises. When confidence in promises is high, nobody needs gold, coal, or copper. When confidence in promises is low, time to build that underground bunker in the backyard. Confidence in promises is currently at all-time highs. Without making a positive statement either way, I’d say that only in the year 2000 were commodities more undervalued than they are right now.

Sidebar: it is tempting to treat commodities as an asset class, but you should try not to. They are idiosyncratic, and for most commodities, the cost of carry is high enough that it’s impractical to hold them for long periods of time.

Commodity related equities are a different story.

Disclaimer

I’m kind of biased on this, and I always think commodities are undervalued because I’m a deeply suspicious person and I don’t believe promises. I’ve owned gold and silver for years (plus GLD and SLV, and GDX and SIL), and if prices get low enough, I will add to those positions.

Keep in mind that I worked for the government under the Clinton administration. Clinton’s mantra to government employees was, “Do more with less.” The man did a lot to restrain the growth of government—and he was a Democrat!

People resented him for it. They wanted their fancy toys and their boondoggles. Public servants have been much happier under Bush and Obama. Not coincidentally, gold bottomed in 2000, at the end of Clinton’s presidency, and has basically been going up since.

So here is the secret sauce: You want to know when commodities are going up?
Watch the deficit. If someone dreams up free college for everyone, buy commodities with veins popping out of your neck.

Jared Dillian

If you enjoyed Jared's article, you can sign up for The 10th Man, a free weekly letter, at mauldineconomics.com. Follow Jared on Twitter @dailydirtnap

The article The 10th Man: Distressed Investing was originally published at mauldineconomics.com.

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Socialism Is Like a Nude Beach - Sounds Like a Great Idea Until You Get There

By Jared Dillian

I’ve been following the activities of Syriza for a long time. They started putting up big numbers in the polls in Greece three or four years ago. Syriza has a message that’s very popular with Greeks: Screw Germany. The word they use to describe what’s happened to Greece during the period of time since the debt crisis is “humiliation.”

To be fair, if you owe a lot of money to someone, it can be tempting to give them the finger. When Greece’s debt was restructured, it was done in such a fashion that none of the debt was really forgiven, but the maturities were extended far out in the future. Since Greece doesn’t grow (for structural, demographic, and cultural reasons), this is known as extend and pretend. Everyone knew, even back then, that the only hope Greece would have to avoid default would be whatever ability they had to refinance.

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Greece has been struggling under the yoke of this debt over the last few years, and the Greeks are sick of being serfs. So Europe gets the bird, although deep down, Greece doesn’t really want to drop out of the euro. They get a lot of benefits from being part of the Eurozone, namely purchasing power and low interest rates.

So naturally, having and eating their cake simultaneously is the goal.

But Alexis Tsipras (the head of Syriza) will threaten to not pay to get what he wants, and it will be interesting to see if Germany will call his bluff. The German people have a pretty low opinion of Greece these days, so if it’s politically palatable to eject Greece from the euro, Merkel might do it.

But Tsipras at least has a credible bargaining chip: He says he can deliver higher tax revenues through better enforcement, as Greeks are notorious tax cheats. If he can pull it off, then Greece may not default. That’s all a very nice story, but I don’t believe it for a second. There will be no increased tax revenue. It’s all talk.

I want to talk a little about Syriza and who they are, because the mainstream press likes to frame them as an “anti austerity” party. But they are much more than that. In reality, they are just one step away from full communism.

If you don’t believe me, take a look at the Syriza Wikipedia page. SYRIZA, which is an acronym of the Greek words for Coalition of the Radical Left, until recently, wasn’t really a party at all—just a collection of parties cobbled together under the auspices of screwing creditors.

Here’s a list of the parties that coalesced under the umbrella of Syriza:

• Active Citizens
   
• Anticapitalist Political Group
   
• Citizens’ Association of Riga
   
• Communist Organization of Greece (KOE):
   
• Communist Platform of Syriza: Greek section of the International Marxist Tendency
   
• Democratic Social Movement (DIKKI)
   
• Ecosocialists of Greece
   
• Internationalist Workers’ Left (DEA)
   
• Movement for the United in Action Left (KEDA)
   
• New Fighter
   
• Radical Left Group Roza
   
• Radicals
   
• Red
   
• Renewing Communist Ecological Left (AKOA)
   
• Synaspismós
   
• Union of the Democratic Centre
   
• Unitary Movement
   
• And a number of independent leftist activists

Sounds like some nice folks you’d have over for dinner and a game of Trivial Pursuit.

In addition to debt forgiveness, Syriza wants a bunch of other stuff, including forgiveness of bank debt for people who are unable to meet their obligations. It’s no coincidence that the Greek stock market was down 13% when the snap election was announced, led by the banks.

In the entire post-World War II period, you’d be hard pressed to find a farther-left national government in Europe than what Greece has now.

In the interest of full disclosure, I think it’s important to point out that I’m a very free-market kind of guy, and if something is bad for markets, I oppose it. I think the Greek Syriza experiment will turn out very badly, and the Greeks will end up with a sharply lower standard of living, however that comes about.

If it comes about by exiting the euro, an immediate consequence will be that they can count on a very weak drachma and high interest rates, possibly followed by high inflation. There will be food and energy shortages. There will be pretty much everything you had in Cuba and Venezuela, just in a less extreme form. Economic misery will abound. And just as a reminder, it is very hard for such places to be governed democratically.

Every once in a while finance gives us these gifts—little controlled experiments where you can watch how two competing economic philosophies play out. East and West Germany. North and South Korea. Even among the 50 US states. As you go around the world, you can see what works and what doesn’t.

Many people think the Scandinavian countries are socialist, but they aren’t—they are very capitalist economies with high levels of redistribution. Sweden was socialist from 1968-1993, but not today. Don’t confuse that with what is going on in Greece. Greece’s economy already is dysfunctional, and it’s going to get worse. We are going to see what happens to this little Marxist archipelago, formerly a member in good standing of the European Economic Community.

But I am getting ahead of myself. As of today, they’re still a member.

The trades here are very easy. It’s hard to have a stock market in a country where property rights barely exist. It’s hard to have bank loans or bonds where debt can be arbitrarily forgiven by the government. The nonexistence of capital markets is bad, contrary to what some folks think.

I don’t usually say things like this, but any Greek stock above zero is a potential short. Politics, like stocks, has a habit of trending—for a very long time.

P.S. Thanks to David Burge (@iowahawkblog) for the inspiration for this week’s title.

Jared Dillian

The article The 10th Man: Socialism Is Like a Nude Beach—Sounds Like a Great Idea Until You Get There was originally published at mauldineconomics.com.

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EFPs and The Unanticipated Consequences of Purposive Social Action

By Jared Dillian

Pretend you are a corn trader. As such, you have two choices: have a position in corn futures or own physical corn. It may seem silly to even consider owning physical corn, because corn futures are easy to trade—just click a button on your screen. But assume you have a grain elevator, and whether you own futures or physical corn is all the same to you. How do you decide which you prefer?

If one is mispriced relative to the other.

If you consider owning physical corn, you have to take into account the cost of storage and any transportation costs you may incur getting the corn to the delivery point. You also have to think of the cost of carrying that physical corn position, or the opportunity loss you incur by not investing the money in the risk-free alternative.

The thing is, there’s nothing keeping the spot and futures markets on parallel tracks, aside from the basis traders who spend their time watching when the futures get out of whack from the physical. That basis exists in just about every futures market, even in financial futures that are cash settled. In fact, that was pretty much my life when I was doing index arbitrage—trading S&P 500 futures against the underlying stocks. I was basically a fancy version of the basis trader in corn.

With stock index futures (like the S&P 500, or the NDX, or the Dow), the basis is slightly more complicated. Not only do you have to calculate the cost of carry—which is usually determined by risk free interest rates and the stock loan market for the underlying securities—but you also have to take into account the dividends that the underlying stocks pay out. Remember, futures don’t pay dividends, but stocks do. At Lehman Brothers, we had a guy whose sole job was to construct and maintain a dividend prediction model for the S&P 500.

So far, so good. However, one of the first things I learned about on the index arbitrage desk was EFP, which stands for Exchange for Physical—a corner of the market almost nobody knows about.

Basically, we could take a futures position and exchange it for a stock position at an agreed-upon basis with another bank or broker. Interdealer brokers helped arrange these EFP trades. The reason so few people know about them is probably because, historically, the EFP market has been very sleepy. The most it would usually move in a day was 15 or 20 cents in the index, or in interest rate terms, a few basis points.

Now it is moving several dollars at a time.

A Basis Gone Berserk

Back when I was doing this about ten-plus years ago, we had a balance sheet of about $8 billion, which is to say that we carried a hedged position of stocks versus S&P 500 futures (also Russell 2000 futures, NASDAQ futures, etc.).

We did this for a few reasons. One, it was profitable to do so—the basis often traded rich so that by selling futures and buying stock and holding the position until expiration, we would make money. Also, by carrying this long stock inventory, we were able to offset short positions elsewhere in the firm and reduce the firm’s cost of funds. At Lehman and most other Wall Street firms, index arbitrage was a joint venture with equity finance.

During the tech bubble in 1999, the basis got very, very rich because money was plowing into mutual funds and managers were being forced to hold futures for a period of time until they were able to pick individual stocks.

During the bear market in 2008, the basis traded very cheap, up until very recently, because inflows into equity mutual funds were weak, and index arbitrage desks were willing to accept less profit on their balance sheet positions.

But now, the basis has gone nuts.

It always goes a little nuts toward year-end because banks try to take down positions to improve the optics of their accounting ratios. If you have fewer assets, your return on assets looks better. So when banks try to get rid of stock inventory into year-end, they buy futures and sell stock, pushing up the basis.

But now it has skyrocketed, and the cause seems to be the effects of regulation.

We’ve talked about this before, in reference to corporate bonds. Banks aren’t keeping a lot of inventory anymore, because there’s no money in it. The culprits here are a combination of Dodd-Frank and Basel III. There are all kinds of unintended consequences, and the EFP market going nuts is probably the least of it.

But even that is a big one. Basically, it has introduced significant costs (about 1.5% annually) to the holder of a long futures position, which includes everyone from indexers all the way down to retail investors. These are the sorts of things that don’t get talked about in congressional hearings. Did XYZ law work? Sure it worked. But now it costs you 1.5% a year to hold S&P 500 futures and roll them, and you can’t get a bid for more than $2 million in a liquid corporate bond issue.

It’s All About Liquidity

The liquidity issue is the biggest one, and the one I harp on all the time. Pre Dodd-Frank, the major investment banks were giant pools of liquidity. You wanted to do a block trade of 20 million shares? No problem. You wanted to trade $250 million of double-old tens? It could be done.

Not anymore. Liquidity has diminished in just about every asset class, from FX to equities to rates to corporates, because compliance costs have gone up and it’s expensive to hold more capital against these positions. Someday, someone might take up the slack, like second-tier brokers or even hedge funds.
But here’s the biggest consequence of the equity finance market blowing up: High-frequency trading (HFT) firms that aren’t self-clearing now find it difficult to trade profitably and stay in business. With fewer of them around, we will finally get an answer to the question whether they add to liquidity or not.

So if you talk to an index arbitrage trader about what is going on with the EFP market, he can tell you precisely why it is screwed up. It’s an open secret on Wall Street. Introduce a regulation over here, an unintended consequence pops up over there. Then there are more regulations to deal with the unintended consequences. Regulations have added 100 times the volatility to one of the most liquid and ordinary derivatives in the world—the plain vanilla EFP.

Less liquidity, more volatility—welcome to 2015.

Jared Dillian

The article The 10th Man: EFPs and The Unanticipated Consequences of Purposive Social Action was originally published at mauldineconomics.com.

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The 10th Man....What a Correction Feels Like

By Jared Dillian

Back in the summer of 2007, when I was working for Lehman Brothers, I had a vacation to the Bahamas planned. This was unusual for me. Up until that point, in six years of working for Lehman, I had taken about five vacation days—total. But my wife and I were going to a semi primitive resort on Cat Island, the most desolate island in the Bahamas. Interesting place for a vacation. Suffice to say that it’s plenty hot in the Bahamas in August.

The market had been acting funny for a while, and I had a hunch that there was going to be trouble while I was gone, so I bought the 30 strike calls in the CBOE Market Volatility Index (VIX). I was betting that volatility was going to go up a lot in a short period of time. In fact, these options—which I spent a little over $100,000 on—would be worthless unless there was outright panic. I gave instructions to my colleagues to sell the call options if the VIX went over 35. (Note: my memory on the details of the trade, like the strike of the options and the level of the VIX, is a little hazy. The specifics might have been different, but you get the general idea.)

So there I was, sunning myself at this primitive resort on Cat Island and the world was melting down, and I was completely oblivious to what was going on back on Wall Street. Coincidentally, the local Bahamas newspaper had a picture of black swans on the cover one day. I staged a photo of me in a hammock reading the newspaper with the black swans on it. I still have that photo.

I got back to civilization and checked the markets. I saw the chart of the VIX. I could hardly contain myself. If my colleagues had executed the trades properly, I would have had a profit of over $800,000. But when I got back to work and opened my spreadsheet, I found that I’d made less than $100,000. What I had failed to consider was that if the world actually was blowing up, the guys would have been too busy to execute my trade.

So there is this whole idea of state dependence that we have to consider when we’re talking about the market. Like, you might have a plan to buy stocks when the index gets below a certain level, but when the market gets to that point, you: a) may not have the capital; and b) might be panicking into your shorts. It’s nice to have a plan, but, paraphrasing Mike Tyson, everyone has a plan until they get punched in the face.

I remember reading Russell Napier’s book about bear markets, called Anatomy of the Bear. It talked about all the big bear markets in the US, including the granddaddy of them all, the stock market crash of 1929 and the Great Depression. One of the things that I learned from this book was that if you can time the bottom exactly right, you can make a hell of a lot of money in very short order. For example, if you had bought the lows in 1932, you could have doubled your money in a matter of months.

I wanted to do that. I prayed for a bear market, so I would get my chance.

Little did I know that I would get my chance just two years later—and blow it.

When the market is down 60%, it’s scary as hell to buy stocks. Hindsight being 20/20, you can say, “What, did you think it was going to zero?” Actually, yes—in March of 2009, people thought it was going to zero.
But for those people who: a) had capital; and b) weren’t terrified, it was a once in a lifetime opportunity.

A Thousand Days with No Correction

So let’s talk about a). Does everybody have capital? Remember, the hard part of this is not picking bottoms. Many people can do this quite capably. Panic/liquidation is very easy to spot. But few people have the ability to take advantage of it, because they’re fully invested.

As for b), you tend not to be terrified if you have capital.

Everyone knows by now that the stock market is correcting. The price action is pretty terrible. Will it get worse? I think so. We’re seeing excesses (corporate credit, growth stocks, IPOs) that we haven’t seen in many, many years. It’s been over 1,000 days since we’ve had a correction of any magnitude. With the market down about 5%, nobody is particularly worried, because every other time the market was down 5%, it ended up going higher.

Back to state dependence. What is it going to feel like if the market goes down further? How will people behave if the S&P 500 gets to, say, 1,700?

I can tell you what it will be like if the S&P gets to 1,700. It’s going to be like it was in August of 2007 when my coworkers forgot to sell my VIX calls because they were buried under an avalanche of panicked sell orders from institutional money managers. Pre-algorithmic trading, the trading floor used to get pretty noisy. I used to be able to tell you what the market was doing just from listening to the floor. At SPX 1,700, trading floors will be very noisy.

It’s been so long since we’ve had a correction, I’m guessing that most people have forgotten what a correction feels like. When you go that long in between corrections, people are sitting on a mountain of capital gains. And unless the capital gains really start to disappear, there is little pressure to sell. But if you’re the owner of, say, airline stocks, and you’ve watched them evaporate to the tune of 30%, that tends to focus the mind a little bit.

As with any steep correction, there will be fantastic opportunities, but they will only be available to those who have capital. Remember, bear markets don’t just destroy the bulls’ capital, they destroy the bears’ capital, too.

Bear markets destroy everyone’s capital.

Jared Dillian

The article The 10th Man: What a Correction Feels Like was originally published at mauldin economics

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