Cookies and leverage

There is a place on West 74th Street in New York, called Levain Bakery. From the outside it's fairly anonymous. On a Sunday morning, there's often a queue outside. Descend the steps into the bakery, and you find many bakers frantically producing trays and trays of cookies. For several of your US dollars, you can buy (and most importantly enjoy) one of these cookies . Admittedly, they aren't very cheap. However, they do taste something somewhere near a place I would call perfection. On the downside, they are very filling, and I had trouble eating lunch after having one of these mini masterpieces.

Just imagine, if however, you could eat as many cookies as you wanted, without ever putting on weight or even feeling full? Of course, such a notion is highly unrealistic (and I doubt anyone reading this would dispute this).

However, for whatever reason, in markets, it is somewhat easier to fall foul to what I shall term the "cookie fallacy". This is simply, the belief that somehow, we can break the link between risk and return, or we can focus on returns, rather than risk. Hence, we focus on the upside rather than the potential downside of a trade. The difficulty is of course, the key to generating returns is not so much about positive returns, but also the lack of losing trades. If we deploy more and more leverage, taking greater risk, then we increase the potential downside at the same time. This is not a diatribe against taking risk (or indeed eating cookies). It is merely that the case of how we take risk (or have cookies) should be reflective of what losses we are able to stomach.

I have been in the market for a decade. Much has changed in that time. I have run systematic trading strategies both within banks and also over the past year and half with my own capital, alongside consulting on systematic trading strategies. Perhaps unsurprisingly, this has very much focused my mind on the whole idea of risk taking!

Despite the fact that nearly all my trading has been on systematic trading strategies, I still have to use my own discretion to size my trading book. My main criterion is never how much money I could make. Instead, it's how much money could I lose. Indeed, this is the same approach I have used whether one of my strategies has been traded using a bank's capital or my own (although in a bank, of course, risk limits are imposed on you too).

In terms of trading my own cash, I have had a respectable Sharpe ratio, at over 2, since I started over a year and half ago. If I had leveraged up significantly of course on a theoretical basis, I would have made more money! However, looking back at my P&L stream, I have at times (inevitably) had some drawdowns. These have been painful but also tolerable. Had I leveraged a lot more, I suspect these periods of poor performance would have been too much to take. As a result, it might have been the case that I would have simply cut all my risk. Is the risk I've taken "optimal"? Probably not, but I prefer to have taken a bit less risk than too much.

Whilst there are similarities when it comes to taking risk on your own cash and external capital, there are important differences, which we discuss below.

First, capacity becomes more crucial when handling external capital. If you deploy too much capital on a strategy, performance might begin to downgrade. Nearly all the strategies I trade with my own cash are intraday strategies. The capacity of such strategies is relatively low compared to daily or monthly trading strategies. When trading your own capital, you probably won't come up against capacity issues. However, when trading large amounts of capital, if you take on external capital, you might well come up against this, which would curtail your leverage (unless you came up with more strategies to trade).

Second, somewhat stating the obvious, the limit of the drawdowns you can tolerate on your own personal capital is likely to be somewhat lower. Also the pool of strategies you might be able to run might be lower with similar levels of leverage. Say for example you might like a certain strategy which trades relatively volatile assets. When it comes to running in your own personal portfolio, the weighting you give it might be lower than with a larger external portfolio. Obviously, if you would never be prepared to trade a strategy with any sort of leverage with your own money (but you would with others money), there's the question of whether you should really be investing in that portfolio with anyone's cash!

Leverage (like cookies) isn't intrinsically bad, it's just that it need to be used with care. If we just eye a healthy return, without an appreciation of the risks we take, we might end up perversely curtailing our long term upside. Indeed, this is one of the themes of my new book, Trading Thalesians!

Like my writing? Have a look at my book Trading Thalesians - What the ancient world can teach us about trading today is on Palgrave Macmillan. You can order the book on Amazon. Drop me a message if you're interesting in me writing something for you or creating a systematic trading strategy for you!

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The first rule of fight club

Many years ago, I remember sitting in a cinema watching the film Fight Club. Before seeing the film, I had little idea what to expect. In the film's most famous scene, Tyler Durden, played by Brad Pitt, stands up and starts a speech:

The first rule of Fight Club is: You do not talk about Fight Club. 
The second rule of Fight Club is: You do not talk about Fight Club. 
Third rule of Fight Club: Someone yells stop, goes limp, taps out, the fight is over. 
Fourth rule: only two guys to a fight. 
Fifth rule: one fight at a time, fellas. 
Sixth rule: no shirts, no shoes. 
Seventh rule: Fights will go on as long as they have to. 
And the eighth and final rule: If this is your first night at Fight Club, you have to fight.

Several years later, I walked into a bookshop near Union Square in New York. My eyes scouring the bookshelves spotted the book of Fight Club. This time I read Brad Pitt's speech. It's kind of exciting, reading famous words on a page, that you know. For me, it's like seeing a famous painting in an art gallery or hearing a musician perform live.

Whilst I don't advocate Fight Club as being some sort of recommendation of how to behave, the rules of Fight Club do spur some thought, when it comes to financial markets. Markets can often only focus on one theme at a time (fifth rule). If you hit your stop loss one too many times, your capital is withdrawn (second rule). Trades should go on as long as they have to (seventh rule). If you are a trader, you have to trade, you cannot simply be flat all the time (eighth rule). The first rule is of course not to discuss Fight Club. In financial markets, we break this rule repeatedly: the topic du jour (somewhat mangling the French language) is by contrast discussed and dissected by everyone.

Take for example currency volatility. For much of 2014, FX vol had been extremely low. In other words nothing was happening. There were grumbles that it was too low. Volumes for market makers had slowed to a trickle. Investors were having difficulty profiting from a market which was not moving sufficiently. Fast forward several months and of course currency volatility has picked up. Now, the grumbles are that currency volatility is too high. The most notable example of the pickup in FX volatility was in EUR/CHF following the removal of the peg, which both stung (but also aided) a lot of currency traders.

The problem is that we do not pick what regime markets settle into. We cannot choose. We are simply faced with price action we are given. I remember one of my friends saying more succinctly, that the most important job of a trader was to pick the "right seat". If you pick the right "trading" seat at the right time, for the hottest market, that will be one of your most important decisions. Take for example in the earlier part of 2000s, when for EM traders the best strategy only trade was simply long EM. Swim when the tide is with you. This is akin to adapting your trading strategy to fit the current environment. For the best discretionary traders, this is one of the critical questions they ask themselves: what is the current (and potentially next) narrative or theme of the market? In the market, all the lights are on, as in the picture above, but which one do we need to follow?

In practice, this again is somewhat difficult. From a systematic basis, we can create regime switching models. Often this is done for FX carry, where we use risk factors to scale back exposure during times of risk aversion. Indeed, I've done a significant amount of work on this for a client, RavenPack, using news data to filter exposure to FX carry.

Another approach is simply to diversify your strategies and run them at the same time, with similar weightings. For example, trend following strategies might work well, during times when volatility picks up. By contrast, harvesting carry performs less well during periods of heightened turbulence. We see the opposite during periods of risk aversion. So why not run them both, so their strengths and weaknesses compliment one another as an example. Rather than picking the one "right seat", we can pick several seats at the same time!

Like my writing? Have a look at my book Trading Thalesians - What the ancient world can teach us about trading today is on Palgrave Macmillan. You can order the book on Amazon. Drop me a message if you're interesting in me writing something for you! 

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When the seagulls follow the trawler

It is just over twenty years ago that the words Eric Cantona and kung fu came together, as immortal words in the minds of football fans. The Manchester United player had been playing away at Crystal Palace. He had been sent off and was walking away into the tunnel. On his way, he launched into a kung fu kick at a Crystal Palace fan who had been shouting abuse at him. In a press conference following the incident, Cantona uttered the following words:

When the seagulls follow the trawler, it is because they think sardines will be thrown into the sea

Some thought Cantona's statement was amusing, perhaps because they did not think too deeply about it. Whatever could Cantona have meant? What is clear is that there is ambiguity tin this statement, a somewhat paradoxical notion. Could he have been referring to journalists assembled at the press conference, waiting for soundbites? Was he referring to the fan, who confronted him?

Ambiguity is something which pervades real life. Markets are not immune to the notion of ambiguity. Indeed, the idea of what precisely constitutes risk on or risk off in markets is perhaps an example of this. People tend to think of risk on as a buoyant risk environment. By contrast risk off is interpreted as a poor risk environment. Typically, we might expect risky assets to do better in risk on, and underperform in risk off periods. Beforehand, people have an idea of what are precisely high risk and low risk assets. Whilst this generalisation holds true, it can sometimes come unstuck, when we consider the market interpretation of price action.

A year ago, I doubt many would have felt that drastically lower oil prices, would be "bad" on a broader basis. Today, this idea seems to have gained traction judging by Twitter for example. Whether this is right or wrong is immaterial, if the market has a certain price dynamic, we might well have to accept it (the market is right mantra).

To some extent, we could argue that another definition for risk on is essentially the case when most market participants make money. Conversely, we could define risk off, as the market as a whole losing money on a trade, which is typically known as the pain trade. To be able to understand these market dynamics, we need to understand how the market is positioned.

Hence, we can sometimes end up with the following contradictory notion. Even if the market is long what is usually a "safe" asset, a large sell off in that asset could cause enough pain to spur a broader based risk off market (and indeed vice versa, which is perhaps closer to the current relationship between crude and stocks). So maybe, there are times where market positioning and repercussions of the move are more important than the market's previous ideas of what are safe or risky assets?

As for me, when I see seagulls, I remember the legend. The legend who is Eric Cantona.

Like my writing? Have a look at my book Trading Thalesians - What the ancient world can teach us about trading today is on Palgrave Macmillan. You can order the book on Amazon. Drop me a message if you're interesting in me writing something for you! Also come to our Thalesians systematic trading workshop at alphascope this week in Geneva, sign up here

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