VC Inspired Reflections on QE3

September 13, 2012
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As you know if you’ve been with us for a while, we believe there are multiple conceptual overlaps between trading, poker and investing – particularly venture capital investing.

In all cases risk management, position sizing (bet sizing) and lumpy / fat tail profit distributions are the norm. In that light venture capitalist Paul Graham, founder of Y Combinator, has an interesting piece out titled Black Swan Farming.

Here is an excerpt:

The two most important things to understand about startup investing, as a business, are (1) that effectively all the returns are concentrated in a few big winners, and (2) that the best ideas look initially like bad ideas.

The first rule I knew intellectually, but didn’t really grasp till it happened to us. The total value of the companies we’ve funded is around 10 billion, give or take a few. But just two companies, Dropbox and Airbnb, account for about three quarters of it.

In startups, the big winners are big to a degree that violates our expectations about variation. I don’t know whether these expectations are innate or learned, but whatever the cause, we are just not prepared for the 1000x variation in outcomes that one finds in startup investing.

That yields all sorts of strange consequences…

Trading is not quite as extreme in respect to 1000x variations. But the general idea has merit and similar “strange consequences” apply. As documented by Ken Grant, risk manager to many of the top hedge funds in the world, in his book Trading Risk, many top traders develop a 90/10 type return profile over time, meaning 90% of their profits come from 10% of their trades.

This does not mean that 9 out of 10 trades are insignificant, only that, in the long run, the opportunity to take a few positive outliers and build them into monsters through controlled risk layering into a big trend is what makes the major killing.

Furthermore, as diverse time-frame traders, with the ability to target short, intermediate and longer term returns, we employ a mix of swing trades (with relatively close profit targets and fast exits) and higher conviction trend trades (in which the goal is to hold much longer, for a potentially significant trend, with multiple pyramid points along the way). The higher conviction trades will be far fewer in number, but can have an outlier impact on the portfolio over time because of their huge size when they pay off.

The other counter-intuitive thing, as Graham points out, is that you don’t know in advance which investments are going to be huge. Similarly, it is hard to know which conviction based trend entries are going to develop into monsters. Many will wind up being scratches or tight controlled losses, because it is hard to distinguish which will be winners beforehand and the embedded uncertainty is part of what creates the opportunity in the first place.

Those tight controlled losses wind up being ridiculously worth it, however, because they facilitate the process by which low risk entries develop into payoff profiles that can return 50x or even 500X initial risk.

At any rate, this brief sidetrack into the waters of expectation and position management seems especially appropriate on FOMC day, as we wait to hear “QE3 or no QE3″ with significant easing expectations already priced in…

In recent trading of the US dollar, stimulus expectations and reigning conventional wisdom – and you know by now we don’t think a whole hell of a lot of conventional wisdom! – have combined to create an exploitable environment extreme.

Yesterday we tweeted this chart of the US dollar (via UUP):

click to enlarge

 From a high probability swing perspective we are mostly on the sidelines at moment.

But from a potential trend trade perspective, in which tight risk points and inflection point entries can pay off with position profits orders of magnitude larger than initial risk, the dollar’s setup (or rather various forex plays counter to it) now look very interesting… the common view of what the Federal Reserve can do, and is able to do, looks very overdone to us.

This creates the opportunity for a powerful snapback rally in the $USD and a recalibration to widespread global slowdown conditions, which are becoming more apparent by the day.

In the Mercenary Live Feed we put on some light forex positions yesterday that could benefit from a dollar resurgence. We will also consider audible short calls on the major indices today, post-Fed, depending on how the market reacts.

Again, our bias to the short side does not reflect a congenital or permanent bearishness here. We agree with Jesse Livermore that “there is only one side to be on in the stock market – not the bull side or the bear side, but the right side.”

With that said, awareness of odds and probabilities will often wind up situationally favoring one side of the market vs the other, in terms of excellent reward to risk opportunity given certain outcomes.

Right now, you have a lot of bullish investors precariously positioned, with “baked in the cake” QE3 expectations and embedded possibility of great disappointment. (Just imagine if Bernanke waits until December, for example… a lower probability outcome but certainly a statistically non-trivial one, with strong “pot odds” implications for upside tail risk exposure in that direction.) You also have multiple Soros style “false trends” (in our estimation) relating to unrealistic dollar weakness expectations vis a vis the rapidly slowing rest of the world.

In the Live Feed our general positioning remains light and resolutely bearish, with an increasing interest in short positions that have two ways to win: Via surprise disappointment from the Fed, or via “QE3 delivery as expected” from the Fed that, given existing anticipation, results in a poor / lackluster reaction anyway.

JS (jack@mercenarytrader.com)


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