Week 8: Top-down vs. bottom-up
Short NQM2
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Welcome to Fifty Trades in Fifty Weeks!
This is Trade 8: Top-down vs. bottom-up
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50in50 uses the case study method to go through one real-time trade in detail, about once per week. This Substack is targeted at traders with 0 to 5 years of experience, but I hope that pros will find it valuable too. For a full description of what this is (and who I am), see here.
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Update: Open and recently closed trades
EWC long at 37.85 is doing OK currently trading at 40.09.
The bitcoin long was a good idea but I got bored and cut it at flat. Classic bad decision / bad outcome. It is almost always better to stick to the plan because markets don’t always move at the speed you wish they would! I acknowledge and inspect that little lump of frustration I feel in my throat—and I move on.
The May XPO puts are worth about 70 cents (paid $2.60). Plenty of time left on the clock. Despite the rally in XPO, I still think this is a good trade.
Update complete!
Today, I am going to talk about the idea generation process and how I try to deal with conflicts between top-down and bottom-up reasoning.
Top-Down vs. Bottom-Up
I am a currency trader and the natural way to approach FX is from the top down. You look at the global macro picture, drill down into country specifics, look at asset classes within each country, develop a thesis, then implement it through various currency pairs or derivatives thereof. If you think global growth looks good, you buy commodity currencies, for example. If you think US rates and oil are going higher, you buy USDJPY. And so on.
In contrast, equity traders tend to be more bottom-up. They will analyze companies and make determinations on individual stocks based on their assessment of the company, its future earnings prospects, quality of management, and so on. For what it’s worth, here’s my opinion of three styles of bottom-up equity analysis:
Neither top-down nor bottom-up is necessarily the right or wrong approach. I believe the combination of both is almost always best.
That can mean different things, depending on what you trade, but in isolation, bottom-up analysis often leaves much to be desired because global macro beta very often dominates the performance of individual securities and currencies. For example, you can be the best RBA analyst in the world, but if China goes into recession, copper drops 40%, and the Fed hikes 100 bps in May… Your hawkish RBA call isn’t going to help you much.
You can do all the work on supply and demand in the copper market, but if 16 countries all do fiscal stimulus at the same time, your bearish “copper overcapacity thesis” isn’t going to work.
This goes to my overall philosophy which is that you need to specialize in one market but understand how other markets and variables influence your domain of expertise. If your job is to pick stocks, fine, bottom-up works. If your job is to truly understand why your market is moving, you have to study each fractal from the bottom to the top.
Top-down vs. bottom-up is usually a framework people apply to the stock market and it looks like this:
Bottom-up analysis makes more sense in equities than in other markets because those analysts are often working for firms or investors who want to buy and hold. They want the best investments and the best companies, not a long or short decision. If you’re choosing stocks for a long-only portfolio, a focus on microeconomics makes sense.
But there is a similar pyramid for every asset class. For example, this is a rough sketch of the same thing for a global macro trader looking at Australia. Say someone is bullish on Australia… They might look bottom-up or top-down like this:
Top-down obviously makes more sense on this pyramid, and in reality, most traders will do analysis that goes up down and sideways all around the pyramid as they circle toward a better and better thesis.
Why would anyone go bottom-up on that second pyramid? Perhaps because they can only trade a specific asset class. Maybe they really like the AUDUSD chart setup and that was the inspiration for a deeper dive. Maybe long AUD is a good portfolio hedge for their Chilean assets. The point here is to look at all the fractals. Nano, micro, and macro. Go into depth on all the drivers that will (or might) move your market.
If you stay too micro, you will miss the forest for the trees. If you are too macro, your security selection, structuring, and tactics will suck wind.
Dealing with Beta
A good example of the importance of macro vs. micro can be seen in the two most recent 50in50 trades: Long EWC and short XPO. In the period since I put out those two trade ideas, the S&P 500 has rallied from ~4200 to 4500.
Guess which trade is working and which one is not!? Of course, the long is working and the short is getting bamboozled. The net result of the two trades is a small profit, but close to flat. The beta (S&P 500 moves) is more important than the alpha for now.
Once you have done your top-down and bottom-up analysis, there are a few ways to implement and execute:
Find trades that work all the way down the pyramid. This is the dream scenario and where most of my good trades come from. I go down the pyramid and across the different types of analysis (technicals, positioning, narrative cycle, correlation, etc.) and find the wind blowing in the same direction on most indicators. Those are the best trades. When you have a ton of crosswinds, go find a better trade idea.
Put on relative value (RV) trades that benefit from variations in the pyramid. For example, say you are bullish the Australian dollar and bearish the US dollar (i.e., bullish AUDUSD), but you’re worried there is a bullish speculative mania in copper and a ton of new supply is about to come on. You know AUDUSD is correlated to copper. In that case, you might go long AUD and short copper. These two trades have the same directional macro drivers (primarily global growth) but have idiosyncratic drivers further down the pyramid.
Personally, I do not love RV trading. It’s hard to risk manage, and often very hard to use leverage. It’s a completely different style of trading from directional macro and requires a different set of skills. The best way to do it is to have a bunch of ideas and employ them all as a big, uncorrelated blob. Individual RV trades just make me annoyed and I tend to strip the leg that doesn't jibe with the rest of my macro view. If I think global growth is going to be strong, why not just be long AUDUSD and forget about the copper short. Hedging is for gardeners, as they say.
Macro overlay. This is a type of RV trading, but it’s way simpler and easier to risk manage and execute. Say you have two longs and one short position in the stock market, giving you net long exposure… And that was fine, because you were bullish…
But now you are bearish for whatever reason. Your bearish view is tactical and nimble, though, so you don’t want to mess around with your existing long and short stock positions which are all carefully thought out and have stop losses and take profits of their own that make sense. You might sell some S&P futures here as a macro overlay.
Wait. So how is “macro overlay” different from “hedging”?
I mean… It isn’t all that different really. The subtle difference is that hedging implies a direct offset of an existing risk, whereas macro overlay involves layering on a new risk that offers some form of diversification or protection but will still be risk-managed as a separate trade. Macro overlay is often much less precise than hedging. You are temporarily offsetting some of your risk, often by putting on a different position that you also like (maybe for different reasons) but in a way that you feel reduces some unwanted directional risk in your overall portfolio. This may sound a bit complicated but in reality, it can be done in a simplistic way. My overlays are never super complicated.
Macro overlay is not just for stonks. If you’re long AUDUSD and worried about the USD for the next few days, you might turn your AUDUSD into EURAUD for a bit. Or go short GBPUSD against it. Or sell copper. etc.
This is getting into portfolio management, kinda, but what I am discussing here is much more simplistic. You are simply adding a new trade that goes in the opposite direction of your other trades and giving that new trade its own set of parameters. I will very often do this in FX.
Since March 16th, for example, I have been long AUDUSD as discussed in my daily note, am/FX. Friday, March 25th, I started to get nervous about the USD side. At the same time, I was getting more bearish GBP as interest rate differentials moved hard against GBP and in favor of the USD. So I sold GBPUSD.
Selling GBPUSD when you are long AUDUSD is effectively short GBPAUD… But I ran them as two completely different positions with separate time horizons, take profits and stop losses. Then, on March 28th, I took off the AUDUSD long for a profit and stuck with the GBPUSD short, which is now 100 pips+ in the money. When done well, macro overlay is like an elaborate dance as you add and subtract risk according to the evolution of your views.
The more you can assign risk management parameters to every trade you do, the easier it is to manage your risk and avoid the complexity and uncertainty associated with more complicated forms of portfolio management. When individual trades remain independent, you can treat them all as separate ideas, even if they provide some diversification or hedging benefit to one another. That way, you get the benefits of a portfolio (once in a while when you want it), but you don’t need 14 engineers from RIT doing stress tests and VAR simulations on your 327 line items.
One of the best traders I ever worked with is the master of this overlay style. He would have a strong view on KRW and MYR or whatever and strap on 200 million USD of long Asia positions… Then some news would come out that was bad for Asia and he’d sell 300 million AUDUSD against his KRW and MYR. Four hours later, he’d strip the AUD at the perfect time, and then his KRW and MYR would start to perform soon after. Sometimes he’d be making money on both sides because his timing and intuition on what legs to run, strip, or hedge was so crazy bananas good.
When I first saw the guy trade, I assumed he would blow up. He had so much risk going back and forth sometimes, it was incomprehensible. But, turns out it was only incomprehensible to me, not him! He’s still going strong 15 years later.
MARKETING INTERRUPTION
You should sign up for am/FX. That’s my daily global macro note, which I have been writing since 2004. In there, I explain all my live trade ideas (lotta FX, but also other asset classes) and give you all the global macro in an easily-digestible two or three-page note.
If you like what you are reading in 50in50 so far, you will love am/FX. It also includes a spicy nonsequitur each day to stimulate your brain jelly. Thanks.
MARKETING INTERRUPTION: COMPLETE
Finally, one last way to deal with the bottom-up vs. top-down issue is to simply be a long-only investor and pick stocks. This isn’t trading and is not what this series is about, but it’s a perfectly reasonable approach and explains why many investors are mostly bottom-up. They assume US innovation and growth and stocks for the long run and then pick the companies and stocks they like best.
In prior 50in50s, I have talked about finding a thesis supported by many styles of analysis: Fundamentals, narrative, microstructure, technicals, sentiment, correlation, positioning, and so on. Here I want you to understand the idea that trades should work through most or all of those lenses and also on work on most slices of the top-down/bottom-up pyramid.
My process is all about looking for trades that tick as many boxes as humanly possible. The times when many planets are in line. But I also utilize strat #3 (macro overlay) now and then when I feel like my book is not balanced the way I want it to be vis-a-vis the USD, risky assets, rates, commodities, or whatever.
Don’t copy down those pyramid diagrams. Yours might look different, depending on what you trade. The two diagrams I included are just simplified schematics to give you an idea of what I’m talking about. If you are going deep, you might find pyramids within the pyramid. For example, you can break the “Global Growth” slice into its major components and think about US, German, Japanese and Chinese growth (for example) and how each country’s economic momentum might influence the price of your security.
I’m not saying you need to do a complete unpack of the entire global economy every time you do a trade! That’s crazy talk. But the more you can break your trade down and think about the variables that will or might impact it… The better. Simple thoughts like these can work:
Shanghai locked down last night. That’s probably a negative for Chinese growth. That doesn’t help my AUD trade.
German investor and executive sentiment have been abysmal and there is a strong Europe / China link. Not amazing for AUD.
US financial conditions are tightening faster now than they were a few weeks ago. That might underpin the dollar.
And so on. The core idea here is to analyze your market on as many dimensions as possible. Come at it from above, below, and sideways. Be creative and figure out all the variables that you think matter for the price of the asset you are trading.
The more you know at each level of zoom, the more clear your thesis will become, and the better you will understand the risks, catalysts, and drivers of the trade after you put it on.
OK! That’s today’s lesson. Now let me overlay a top-down view over these two other existing trades.
Trade 8: Sell NASDAQ Futures (NQM2)
I said at the start of 50in50 that I am not running this as a big portfolio. It’s too complicated to do so. Still, it’s impossible for me not to notice the beta of the portfolio and want to manage it.
I am slowly becoming more bearish risky assets again after a period of trading nimble/agnostic with a bullish bias. Here is the basic evolution of my views on risky assets.
November 2021 to early February: Bearish. Most of am/FX and MacroTactical Crypto was about Fed tightening and the importance of QT as it entered the narrative for the first time early in 2022. This year set up a lot like 2018 and I was surprised how complacent many were given the obvious 100mph approach of the QT train.
In February I shifted to neutral and on February 24 I turned bullish. My main view at that time was that geopolitical events are scary for markets but generally do not have a huge impact on US growth or corporate earnings and thus the market tends to overreact to them. This is generally, but not always true and this blasé view cost me before the invasion as I went short both gold and oil. So I’m not claiming to be some genius here, I am just biased against trading geopolitics from the short side. It cost me initially and then it helped me lean the right way over the last few weeks.
Now, the bad shorts put on for the Russian invasion are out. The shorts that were trading on WW3 fears are out. The bad portfolio hedges and underweights have given up on the now 1-month-old Russia story and that is what has pushed stocks from 4100 to 4500. Thing is, Russia is a red herring. The real story this year, in my opinion, is the Fed—and we are headed for a tightening in financial conditions similar to what we saw in 2018.
The market can only focus on one theme at a time. The hawkish Fed theme (bearish) cascaded into the Russia invasion theme (bearish) and there was a big puke. Now, we’ve seen a short squeeze as commodity prices rise, risk aversion subsides, and people realize the human devastation in Ukraine is unlikely to massively impact (for example) JPM or TSLA earnings.
With the shorts rinsed, we can go back to focusing on the Fed. When we do so, the view will not be pretty. We are priced for chunky 50bp hikes and demand destruction and inverted yield curves and plenty of stuff that is not great for stocks.
I’ve got EWC long and XPO short and the obvious thing I could do here is just cut the EWC. But I always much, much prefer to stick to the original plan on trades whenever I can, so another option here is to simply do a macro overlay. The question is, can I do some kind of overlay that is simple and easy to risk manage?
Yes! I can because I have been noticing over the past week that the 4585 level in SPX and the 200-day in NASDAQ (15,111) are both nearby. There also happen to be two major tops in NASDAQ at 15100 (mid-FEB) and 15260 (early FEB). So in this case, short ES or NQ (S&P futures or NASDAQ futures) are both reasonable cash trades that are easy to risk manage.
In this case, I like the NASDAQ chart better and I also believe that higher rates are ultimately more negative for tech than they are for the broad market. Tech stocks are long-duration assets while banks and oil (for example) are sectors that might be fine in a rising commodities, rising interest rate world.
Here’s a daily chart of NQ. You can see the 200-day defined the trend pretty well on the way up and we are about to kiss it.
And here’s the same chart, but hourly, back to when the Fed dumped “transitory”.
On the hourly chart, it’s pretty clear that the old broken support and early February tops around 15230/15260 are the pivots to watch. The average day’s range in NASDAQ futures has been around 200 handles so if we add two of those to 15260 we get a stop loss of 15660. That’s plenty of room on a trade like this and puts us well above the 100-day, the 200-day, and the February tops. The target is back into that choppy bottoming zone around 13k and I’ll add two day’s ranges above the bottom to come up with a target of 13344. Risking 690 to make 1626.
Finally, if you needed one more reason to be bearish the NASDAQ: Those horrendous QQQ freeze-frame ads during the NCAA Basketball are enough to make me hit a bid. The Official ETF of the NCAA®?
Bleh.
Anyway…………………… That’s it for today!
50in50 goes short NQM2 (June NASDAQ futures) at 14970 with a stop at 15660 and take profit at 13344
Note that for tracking purposes, I am using 1 contract of the micro NASDAQ future here as that’s the largest increment I can use that is under $2,000 of risk (standard risk unit of 2%). This paragraph was added the day after publication because I screwed up and forgot to write about position size in this article.
As always, I will monitor the performance and offer detailed updates as we progress. See you next week!
Thanks for reading.
Trade at your own risk. Be smart. Have fun. Call your mom.
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DISCLAIMER: Nothing in “50 Trades in 50 Weeks” is investment advice. Do your own research and consult your personal financial advisor. I’m putting out free thoughts for people who want to learn. This is an educational Substack. Trade your own view!
For anyone unfamiliar with futures don't forget the $20 multiplier on NQ futures... if you short one future you'll get stopped out with a $13.8k loss
Great read. Thanks Brent