Central Banks Teach 2015 Trading Lesson

Arguably, the three biggest Central Bank (“CB”) driven surprises so far this year:

  • January 15, 2015 –  SNB de-pegged the Swiss Franc, causing catastrophic revaluation.
  • August 11, 2015 –  PBoC suddenly devalued the RMB; a historic change in stance.
  • December 3rd, 2015 –  ECB dealt a disappointment to the doves causing a massive rebound in the Euro, as well as Euroland yields.
  • The three events listed above were particularly educational for me, as each CB action and marketresponse had its own unique impact on the portfolio given three different positioning environments:

    • SNB –    No significant CHF positioning into the moveo 
    • PBoC –  Large, specific CNH positioning in anticipation of the move
    • ECB –   Large portfolio positions and substantial risk exposure

    The market shocks I observed and their corresponding impact on my portfolio all rang strong truth towhat I have discussed in detail in Chapter 10, “Portfolio Paralysis”, of my book, The Next Perfect Trade:

    Huge optionality lies in having unencumbered capital.

    I have described Portfolio Paralysis as the instance when you cannot take advantage of a sudden market dislocation because your capital is already tied up in existing positions.

    Aware of my previous tendencies to be overconfident and stretch positions enough to become vulnerable to portfolio paralysis, I had introduced a discipline of limiting exposure during the “good times”, when everything seems to be going my way.  Hence when the market suddenly turns I can take advantage of the dislocation and increase positions, rather than being forced to cut.

    My long bonds, long dollar, long stocks portfolio had been tremendously productive through 2014 and into the first quarter of 2015. Correspondingly, I exercised some caution proceeding further into the year. Retrospectively, it was still not enough caution.

    One could make an argument that I was sized correctly because I survived the vicious correction in the second quarter and was even able to incrementally add risk. Yet by June 2015, the drawdown put me uncomfortably close to the edge of the cliff. In action movies, heroes repeatedly dodge bullets or cars by a millimeter, narrowly slip under the drop-down gates or deftly defuse bombs with only seconds remaining.  I posit that in markets, as in real-life action sequences, such circumstances are a sign of failure to be in the position in the first place rather than success in getting out.  In other words, if you teeter too often on the edge – you are bound to fall off sooner or later.

    How does this lesson relate to the three central bank surprises?

    Going into the ECB meeting, I considered myself not to be overextended. Having said that, an important tenet of my strategy is not to reduce my core positions ahead of important data releases or policy meetings.  My rationale is that if markets were to gap in my favor, I would irrevocably lose a portion of my profits. Alternatively, if the markets were to gap against me, I would still expect to recover the money given that my long-term view is likely to be correct.

    So, I took some profits on the favorable Euro move in November 2015 and was not losing any sleep over the ECB. The result, however, is self-evident:  EVERY position in the portfolio was hit, causing a multi-standard deviation loss (not that I believe in the Bell Curve probabilities). December 3rd turned out to be the single worst trading day of my career in percentage terms.  Yet, it was nowhere near the most painful or stressful day.  

    In fact, I started the day at an all-time High-Water Mark with a decent amount of profits locked up. While the move was ferocious in total drawdown terms, my portfolio was under much less pressure than during the second quarter compression and other tough spots in my career.  I was able to judge this time that the ECB-related contagion and sell-off in the US Treasury Bonds was largely position driven and likely to be short-lived.  I not only held on to all my positions, but also was marginally able to increase my long bonds exposure. Even so, it felt and still feels a little too close for comfort. Importantly, caution precluded me from SIGNIFICANT increase in positions, and therefore, I didn’t really take advantage of the volatility.

    Now, I am not so arrogant to believe that I should make money on every instance of a violent market move. All you can hope for as an experienced trader is that the aggregate of your first buy/sell reactions puts you slightly ahead of the game over your career. A long-term trader faces a tradeoff: keep your position larger to profit more on the underlying trend and risk portfolio paralysis OR decrease risk size to have “dry powder” when the market dislocates.

    There is no exact criterion for the right level of risk. But consider this: I was spot on with China,anticipating both the equities sell-off and the currency devaluation. Fearing a short-squeeze, I expressed my views via options with the intention to hold them into expiration. But options entail additional risks of failure discussed in Chapter 9, “Adding Unnecessary Complexity”, of The Next Perfect Trade. As Chinese markets were recently progressing in my direction, I explained in my October 5th blogpost, complete success was far from certain.  Indeed, due to imperfect timing and time decay on the options I have only managed to break-even on the equity trades. The currency options are deep in the black, but as I have written, the battle is far from over.

    Finally, the CHF de-pegging in January caught me completely by surprise.  In fact, in December 2014 I wrote about initiating a short CHFMXN position. However, my exposure to CHF had been sufficiently small and overall performance sufficiently good, that on January 15th, I experienced no hint of portfolio paralysis.  I was able to think clearly and take advantage of the panic by selling CHF. This is what I wrote on that day. By diving into the unexpected dislocation, the trade turned out to be one of my best money-makers, both in absolute terms and in terms of the ROC in 2015.

    Hence, the lesson of 2015 taught by Central Banks:

    During extreme market events, a clear head and free capital may often trump correct, but unwieldy positioning.

    Good Luck with the Fed this week.

    Image: A New Japanese 7th Grade Classroom by Angie Harms

    Superior Trades Aim for Wider Targets.

    This has been a busy month, already! 

    In my book the “The Next Perfect Trade – the Magic Sword of Necessity”, which is now available on ebookit and amazon, I take the reader step-by-step through the process of selecting trades that are aided by market tailwinds. Broadening your range of success is the focus of my portfolio approach.

    Also, I recorded my newest interview with Raoul Pal on  RealVisionTV (my first interview is available for free on its site using this link; for the latest one you’ll need to subscribe but I find its content invaluable so please take the step to sign up using promotion code “Alex”). It was an excellent chance to review the concepts I was pondering as I was writing the book over the last year, and apply them to the current turbulent markets.

    There is no longer an easy equivalent of the logically irrefutable long dollar/long bond trade of 2014; however, chaos breeds opportunities. What does my current investing strategy dictate?

    The approaching Federal Reserve meeting is the most contested one in years. In the past, I worked hard to predict the exact path of the Fed Funds, and I was not bad at it. But nowadays I often feel that there are bigger fish to fry.

    Some people think they will tighten several times in a row and some people think they are not tightening in our market lifetime. Let’s accept this uncertainty and try to come with a portfolio which will work regardless.

    Long-dated bonds were my beacon through this cycle. Again and again, I have been repeating the mantra:

  • No hike means bonds earn carry
  • Hike means stronger dollar, curve flattening and long bond rally
  • Another beacon of value in the times of stock market correction, may be cheap, established technology companies that are unburdened with excessive debt and have proven to be able to adjust to the change.

    On the other hand, the world of currency trades has shifted from “slam dunks” to merely “good risk-reward propositions”. My significant bets on weaker euro, yen, Swiss Franc, and yuan, after the original surge, have meaningful downside.

    Chinese currency devaluation is coming into focus. I am inclined to stay with the trade as I can’t imagine any other way to stem the tide of capital outflows.

    I have to face that sitting here today having little conviction about the direction of the stock market or economic growth (both domestic and global). This doesn’t mean I can’t have a position.

    In my book and in my recent interview, I explain how I rely on my understanding of causality chains between various asset classes, rather on predicting the market direction.

    So don’t get flustered by volatility. Take a deep breath, and instead of aiming for the narrow target of precisely anticipating the price action, look for trades that will succeed even when your views are wrong.

    Image: Target »» 0o.o0 «« by Erika

    Greece and China: Crisis doesn’t happen on schedule.

    It has been a fun weekend. Between the escalation of Greek crisis and the surprise liquidity measures in China, it was as if the market never closed.

    When considering market significance of a geopolitical event, it is important to distinguish between

    • The actual economic effect
    • The immediate impact on market players

    In the case of the on-going Greek debt crisis and the potential so-called “Grexit”, remember that Greek economy commands only about 2% of the Eurozone GDP. Whether Greece muddles through or exits, the long-term economic impact should be moderate.

    Two points that have been made by multiple people:

    • Greece exit might create a blueprint for an exit by other countries on the periphery, such as Portugal or even Spain.
    • Eurozone might be actually economically better off and the euro incrementally stronger without Greece.

    What concerns me now though, is whether whatever happens in Greece may trigger a market panic or even a new crisis. There I encounter the “positioning” conundrum.

    Paradoxically, it is easier to describe what would happen to the  markets in the aftermath of a completely unanticipated and destructive event such as 9/11. We would expect a sharp equities sell-off, a flight to U.S. Treasuries and to defensive currencies such as dollar, swiss franc, and yen. The reason is that if market players are not positioned for this particular event, it is easy to guess what they would do.

    But when an event was in the making for five years, the prediction is much harder. The “buy the rumor, sell the fact” paradigm comes into play. If we assume that most of speculative money was already positioned defensively with respect to Greece, any resolution may come as a relief.

    But let’s go to the next level. If the speculators anticipate the post-resolution relief rally in Greek bonds and stocks, they may actually not be positoned defensively.

    You know that I know that you know…

    A parallel begs to be drawn with the Russian crisis of 1998. Russia didn’t default exactly overnight. But market players were anticipating either default or devaluation of ruble, not both. Caught by surprise, over-leveraged hedge funds folded like dominos, liquidating all positions, good or bad. Everything, from swap spreads to implied equity vol to municipal bonds went into a crisis mode.

    So the question we have to ask ourselves is not just what exactly going to happen to Greece, but how is the “fast money” positioned.

    Greek banks are not opening on Monday.

    Stock market is likely not opening.

    Virtually nothing should surprise us on Monday morning. Not a huge market commotion, not a relief rally,  and not even business as usual.

    Generally I am a fan of the concept that “crisis doesn’t happen on schedule”. We have learned it after the Y2K. And we knew in advance, about all the deadline for Greece and the dates for Brussels summit. 

    As I write this on sunday afternoon in California, the euro is down moderately (1.5-2%) and US Bonds are rallying quite a bit. My usual intuition would be not to get overexcited and stay with my core positions without adding anything. Which happen to short euro and long bonds as all my readers know.

    If anything my bias would have been to expect for things to calm down and pull back to normal on Monday.

    However, for me China is the enormous extra variable in this equation. I have tweeted earlier that extraordinary measures taken by the PBOC over this weekend indicate to me that might more problems there than it looks from the outside. Indeed, the correction in the stock indices like SHCOMP which are still tremendously up on the year is hardly a disaster by itself. But the aggressive central bank’s response may instill further doubt rather than inspire confidence.

    But beware of contagion! Risk aversion in Europe may spill into Asia and converse. And when it comes to positioning in China  – I have a feeling – the majority market players expect the government to be able to back-stop any crisis.

    This type of confidence has been a path to disaster over and over again in the course of history.

    My readers know me as a general global growth and economy bull. I don’t cry “crisis” often. But the confluence of events over last few days is making me view risks as highly elevated.

    William Faulkner’s advice to traders: “Kill your darlings!”


    A story sometimes needs to be edited down, and so does a trade. Indeed, if you don’t have portfolio discipline, sooner or later you will have no portfolio.

    Whatever form of risk management you use for individual trades, there are times when your risk, as a whole, needs to be trimmed.

    When this dreaded moment of a severe drawdown comes, it is easy to fall prey to the delusion of “simplifying” your portfolio.

    If you are running a diversified strategy, even at the worst moment, you probably have trades on, which are not doing so badly. So the temptation is to first cut the “winners” and keep the trades which are deep under water. The trades causing you the greatest losses at the moment are bound  to look most attractive.

    “I liked this stock at $80, I must love it at $60, right?”

    I had a painful drawdown over the last few weeks. My long dollar and long bonds strategy came under a lot of pressure. While my positions had been sized to withstand this type of correction, I still had to put myself on  “orange alert”.

    The morning of April 29th, before the FOMC meeting release, I overviewed my positions to decide how I would reduce risk, if I ended up having no choice.

    My biggest short against the dollar was the euro, but I was also short other currencies, including NZD. My conviction stayed with EURUSD, as I wrote in my recent post (May 3rd).

    Most currencies had moved against the dollar, but by April 29th, NZD had just stalled. My temptation was to cut NZD first: the negative carry was undercutting my certainty, and at the moment EURUSD was getting juicier.


    What would have happened if I had followed through on that instinct? On paper my total risk would have gone down for sure. But while in the following two days my portfolio was still drawing down, EUR and NZD went in the opposite directions. I would, in fact, be losing more money without NZD. The “risk-reduction” would have been self-defeating.

    William Faulkner had famously admonished us against self-indulgence:

    “In writing, you must kill all your darlings.”

    If you decide to reduce market risk, you must cut the positions you love most. Don’t delude yourself by taking off winners, and holding on to cherished losers.

    Indeed, if your portfolio is under pressure, what should you be worried about most? The worst case scenario is that things will continue the way they are going now and your losers will continue losing, while your winners may continue winning.

    Reduce risk to protect yourself against the worst-case scenario or don’t reduce it at all.

    Image by Dr. John B. Padgett

    Eurozone: economy bull, currency bear.


    When the euro was going down in a straight line, it was easy for currency bears to call for the exchange rate with the dollar as low as 0.80. Now when, after a year of beating, EURUSD at last had a good month, the bearish convictions are being put to the test.


    Some believe the economic data is beginning to support the reversal. Indeed, the US releases have been mixed at best lately. The debate is raging, how much the recent weak GDP and employment reports were induced by the unusual weather. But the doubt remains.

    On the other hand, there are signs that the European QE is getting traction. The economy is picking up, the fears over the Greek exit are being assuaged, the stock markets are setting records, and the bund yields are rising.

    I am not denying the possibility that the relative economic performance of the Eurozone is improving. In fact, I have been bullish on European equities for quite a while. The experience of the QE impact on the stock markets both in the USA and in Japan is very convincing.

    But does better economy mean a stronger currency? Counterintuitively, this is not automatically so. Indeed, if a stronger economy causes the Central Bank to raise rates in order prevent overheating, it is reasonable to expect the domestic currency to strengthen.

    In fact, we’ve to grown to associate inflation fears with stronger currency, as we are so certain that the central bank would step in with tighter policy.

    But what if a central bank is locked in its course?

    The Fed has now been following an almost two-year program of tapering/waiting/tightening with very little deviation from the original timeline.

    Meanwhile, the ECB had committed to Draghi’s “whatever it takes” and has just embarked on the QE path. It is hard to imagine them changing policy based solely on leading economic indicators, without reaching their formal inflation target.

    Paradoxically, assuming that the path of monetary policy is fixed, the pace of growth may be counterindicative to the currency strength. Economic growth increases the supply of domestic currency and stimulates imports. All else being equal, it would lead to the currency decline.

    Consider the extreme case: if a central bank maintains a super-easy policy and ignores inflationary overheating, a fiat collapse will be eventually inevitable.

    Hence, my view:

    1. Despite the mixed data, the Fed policy is set to be prudent relative to the growth, supporting the dollar.
    2. Despite stronger Eurozone performance, the ECB policy is set to be super-easy, continuing to debase the euro.

    I am sticking with my short EURUSD position.

    Image: “Janus” by Códice Tuna

    Chart sourced from Yahoo! Finance