Saturday, 25 February 2012

Reflections on Bruce Kovner

Bruce Kovner was interviewed towards the end of the 1980s.  This is a summary of what I found useful about how he traded.

Primary Market
Currencies and fixed income, commodities.

Risk Management
No single trade ever risks more than 1% of the portfolio size.  By 'risks' he means, when the position has made a loss of approaching 1% of the size of the portfolio then absolutely get out.   In the decision making process that decides where to put a stop and how any contracts to put on, he tends to have wider stops at the expense of a smaller number of contracts to bring him in under his preferred (<)1% level.  When he has lost, he reduces his position size (and, I assume, potentially the number of positions too).  Why?  Is this a protection valve, something he flags as good advice, or is it a habit he just notices and comments on?  I'd say the former.  So the implication is, without this clam-up rule, he'd otherwise have a tendency to ...?  What?  Double down?  Play catch up by risking up?  Get back in too soon?  If it isn't a specific behavioural issue he's trying to stamp on maybe he is in a less than ideal place emotionally after a big loss?  He also advises to take correlation into account when judging the riskiness of your set of open positions.  He also says he likes to (loosely, by the sound of it) balance long positions with short ones too.  Kind of like a loose form or pairs trading.  I guess to be able to do this, one essential tool would be charts of rolling inter-market correlations.  His advice to novices is to under-trade, since they're probably 3-5 times too big in their size.  This is actually, when I think about it, a function of the modest capital they often have available, and the minimum magnitude of bets they're allowed to initiate on their trading platforms.  Sometimes it is physically impossible to risk no more than 1% of your modest capital in a market given the size of the smallest lot you can execute.  You compromise by tightening the stop, which can seem like a mistake on the cautious side, and end up getting stopped out sufficiently for gambler's ruin to occur.  Or, having gotten frustrated by all the stop-outs, the novice trader 'takes a flyer' and breaks his stop discipline, only to see his pot value drop by 40% in one sickening move, leading him to conclude that trading's not for him.

Early indisciplined trading episode shocks his self-opinion as a trader
Early on in his career, he initiated a soy-bean futures spread which he, in retrospect, unwisely legged out of.  The implication being that the unhedged long futures position was "insanity" He also didn't handle the moment well as it all turned against him.   Describing himself as in "emotional shock" at his behaviour, in the face of all his years of cautious study, discipline, his lack of understanding of just where a market might go to - and how quickly - to inflict most damage.  This shock seems to have been a big deal for him - as well as having a sick feeling in his stomach, he didn't eat for days.  He viscerally felt that markets could burn you.  "I had lost a process of rationality that I thought I had...At that moment, I was confronted with the realisation that I had blown a great deal of what I thought I knew about discipline".  What I'm taking from this is that you do not always have to feel rational and disciplined in all interactions with the market, but you should behave rationally and with discipline (which mostly means sticking to your plan - and in particular to that side of the plan which deals with the scenario when the market moves against you).  

Making regular trading mistakes is a good thing
He sites this as deeply important for a trader.  I guess he's emphasising the familiar point that failure to realise losses (small and early) results in bigger losses in the end.  I'm thinking about what he says about sizing down on losses.  If he finds losses affect his near term trading adversely, perhaps his emotional well-being too, then part of the strength he mentions is the strength to frequently put yourself through this wringer by following the rule of taking regular losses.  Clearly the pain is in proportion to the size of the loss, so smaller losses will do less behavioural/psychological damage than big ones, so taking regular losses could actually be a protection mechanism against those feelings.

Markets can really move to that level in that time frame
As well as sticking to the plan during moves against him, he attributes his success to his ability to understand that the markets can move quite a long way.  That big moves can happen.  And not just in markets.  This is perhaps a wider point - political systems can crumble (the book came out in 1989, around the time of the fall of the Soviet empire), commodities can go dramatically up or down.  Currencies can make enormous moves.

Distinguishing traits of good traders
Strong, independent, contrary.  All three of these are related.  Core, I guess, is independence.  Since it in a way implies a certain strength of will.  As does holding a contrary view.  Notice, too, that it probably needs to fit in balance with his view that taking your mistakes in small and regular doses is key.  You might think that strong, independent and contrary thinkers would find it difficult to admit they're mistaken potentially most of the time.  Perhaps it is best to think of trading as a two phase operation - ideas generation and execution.  Maybe you get to firmly express your contrariness when generating the ideas, but need to switch to a more precautionary style when you're in the market.

Price action
When the market moves big on fundamentals, the initial move is an indicator/confirmation of direction.  In general though price action analysis ought to be an intellectual discovery concerning how some traders have just now behaved may or may not influence how other traders are about to behave.  This to me is the core of a fundamentalist approach to technical analysis. Kovner says it helped him form a hypothesis on this question: how is everybody voting?  He's not afraid to jump on breakouts even if a rational cause cannot easily be hypothesised.   The higher the speculator-to-hedger ratio in a market, the more likely you get 'false' signals.  He reckons bear markets have sharp down moves and quick retracements.  So if you're short the market and you get in too late in a down move, be prepared to be stopped out by the subsequent quick retracement.  His advice is to go short in bear markets only on the quick retracements.  This sounds like the bear market partner of the ancient 'buy on dips' advice.  In a bear market, buy on dips* in spades. [* where dip is a conter-trend movement].  

He also reckons a trend following approach is more likely to be successful in an inflationary environment.  Equities price action versus commodities: the equities market has a lot more counter-trends. "After the market has gone up it wants to come down".  Whereas commodities supply and demand makes for a continuation of price action in those markets. This chimes with my understanding that equities fat tails are more in the left tail, whereas commodities are more in the right tail.

Markets, life even, undergoes structural change and that can break many quant or programmed systems, which can have, as an implicit support, an assumption that the future will remain sufficiently like the past to warrant encoding the set of rules.

Stops  (a.k.a. Markets shouldn't really move to that level in that time frame)
Put stops at points where the market shouldn't move, beyond some technical barrier.  On the face of it, this is just generic stop placement advice.  But the implication is a hope, a degree of certainty that markets can't get there from the moment the trade goes on.  There's another slight dissonance with his advice, which he sees as essential, to understand that the market really can move to some level in your given time horizon.  If he rationally believed this for both sides of his bet, then any stop would be perhaps too close.  Saying 'the market really can get there' is a way of saying that the market can blast through the support and resistance of technical analysis.  Saying 'the market can't really get there, so I'll put a stop there' sounds contradictory. 

Client money represents owning a call
I bet he regrets offering that rather honest view on client money.  It isn't just serving as leverage - it is a call.  He's getting leverage without exposing himself to downside vis-a-vis their money.  Clearly, it is a different story with his own money.  But I guess, to continue the analogy, if he fails to deliver, then it is a call with very  high implied vol.  Has he paid a fair price for the vol?  Plus, the call he owns can itself be called away by investors under a range of circumstances.

Approach to fundamentals
The market price is the correct one; find out what will happen economically, politically to change this price at the margin.  Wait for a market to confirm one of his several scenarios concerning what might happen.  He's trying to get into the heads of real people (central bankers, politicians) and I guess, perhaps of leviathans and other non-humans too (the state, the average oil purchaser, the average consumer).