How do you answer when someone asks you "What is your edge"? - Part 2

This is part 2 of my post about the different types of edges that traders can apply to become profitable. Here is part 1 in case you missed it.

Being able to imagine a world vastly different from today.

I once worked with a trader who, when asked for his opinion on where a market was going, would regurgitate the most recent consensus view he read from bank research, and provide a forecast not far off from the market. As a trader he would frequently take profit too early on his positions and then get frustrated with himself with lamentations of “what ifs” and “if only I had…” Because the profits on his winning trades were too small to make up for the losses on his losing trades, his pnl curve looked like a steady line from the middle left of the page to the bottom right. He didn’t survive very long on the trading desk.

Great traders are creative and imaginative and can conjure versions of the world and markets that look vastly different from the present. They understand that change happens in non-linear fashion, sometimes slowly and then all at once. They are always looking for the fat left tail and right tail scenarios, and either protecting their portfolio or positioning to profit from them.

I remember back in Jan 2020, there was this bug called Covid19 that was spreading around China, causing the economy to shut down and the stock market to crash. Cases were popping up around the world, but the S&P 500 was blissfully chugging along at all-time highs. Analysts dismissed the situation as being similar to the Asian SARS epidemic in 2003, which didn’t impact Western markets much at the time.

Meanwhile in Singapore, I was following the pandemic with terrifying fascination. Every morning I would look up global databases on my computer to see what new countries covid had spread to and how many new cases had popped up in the countries I was tracking. Covid was highly contagious and didn’t require very close contact to jump from one host to another. I noticed how the virus had a long incubation period, making it difficult to detect and prevent its spread. I saw how China had been helpless to slow down the epidemic despite locking down all of Wuhan. I happened to take a trip to the US in February and told everyone who would listen that covid would spread through the entire world and bring the global economy to a halt within weeks. I could tell by the look on some faces that they thought I was nuts. To them, this prediction was outside of the realm of possibility. To me, it was obvious and inevitable.

Betting on inevitabilities

The wonderful thing about inevitabilities is that they lie in plain sight, and once you identify one, it’s like seeing into the future. At the heart of every inevitability is an economic, political, or physical constraint. The central bank trilemma is an example of the economic constraints that central banks face. An example of a political constraint is that you can’t impose suffering on your people and expect to get democratically reelected. Oil going negative in April 2020 was an example of how physical constraints (lack of storage) drove the market to a place nobody thought it could go.

The physical constraints of containing covid meant that it would quickly spread throughout the world, and that humans would respond by staying at home, shutting down businesses, and ceasing all travel. Politicians would inevitably attempt to contain the virus by imposing various forms of lockdowns. Knowing this, I bought puts on equities and went long short-dated interest rate futures betting that the Fed would cut rates from 1.5% to 0% within a couple months. This ended up being the most profitable trade of my career, in what was my most profitable year ever.

Once you develop the mindset of looking for inevitabilities, you realize how they happen abundantly throughout the history of global macro. Inflation soaring after the Fed and US government delivered record stimulus to the economy - inevitable. Ever read The Big Short? That was a bet on an inevitability. Even in today’s uncertain and difficult markets there are inevitabilities waiting to play out that I am positioning for (I have discussed them in previous posts and will continue to highlight them in my work).

Executing perfect end-to-end process, getting rid of negative edges

Everyone talks about developing their trading edge, but have you thought about what your negative edges are, and how to work on them? I’ve known many traders who have a winning strategy but have gone through rough patches because they couldn’t avoid human mistakes. Ultimately, your long-term trading performance is the sum of your positive alpha-generating actions minus your mistakes. Sometimes traders spend all their energy on improving alpha generation when they can be equally impactful by making simple improvements to their process. Mistakes can happen at every point of your process, from idea generation to sizing and stop placement to management of the exit. I recommend reading this prior post, which discusses common mistakes and how journaling can help identify and fix them.

Having a strong mental map and solid flow of research and analysis, and synthesizing them into trade ideas

Idea generation is the bedrock of a discretionary trader’s process. It all starts with developing a mental map of the market. Ask yourself what type of regime are we in (ie stagflation, disinflation, recession, etc), what are the biggest three things driving the markets you follow, and how are markets moving in relation to one another? How are market participants positioned and what is the consensus that is priced in? This mental map needs to be updated constantly with a steady flow of research, analysis, and data. I rarely take time off from the market because the energy it takes to update my mental map after an extended period away is just too costly.

Experienced traders with a good mental map of the market are like trackers in the rainforest. Bird calls, broken branches, and insect trails have meaning and tell a story of what is happening around them. Market reversals and regime shifts leave telltale signs that can be picked up by traders before they happen. Once a trader picks up an interesting signal, he can validate it with fundamental research and develop a plan that dictates the timing, size, and structure of the trade. The idea can also start with a fundamental view, and take shape as price signals develop.

These days we have an overload of information, analysis, and opinions at our fingertips. Experience and a strong mental map become a filter for what is useful information and what isn’t. If you find a good source of information and analysis, then integrate it into your research process so that it doesn’t go to waste.

There are three types of research that don’t fit into my process. 1) Permas (such as permabears and permabulls) - people who always have the same view no matter what. Their ideas should always be taken with a grain of salt because their views never change. 2) Big picture thinkers - people who may have great ideas and views of the world but prognosticate in such general terms or in long time horizons that it’s hard to come up with any actionable insights from them. I appreciate their views but hearing them once is enough. People with “PhD” after their name often fall into this category. 3) Bank forecasts- There are a lot of banks, and all of them have a different opinion on where the market is going. There is not one bank that gets it right consistently. If you spend a lot of time reading bank research, what you end up getting is a high noise-to-signal ratio. I still read bank research from time to time, but I read it mostly to gather interesting data and insights, and I ignore the forecasts altogether.