Week 15: RV trading is hard
A lesson about alpha, beta, and dodging global macro
Welcome to Fifty Trades in Fifty Weeks!
This is Week 15: RV trading is hard
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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 on previous trades
The slingshot reversal in BTC triggered the long at 30300. It was messy in both directions. The stop loss is 24850, which is below the 2022 low (25390) and below the round number: 25000. For more crypto thoughts, check out MTC here.
The three slices of the ARKK long position are on and the stop is $29. The stock is trading around $42 right now so the trade is underwater. This is the nature of catching falling knives… You usually feel some pain.
RV trading is hard
Markets go up and down for many reasons, but very often traders and investors focus too much on their favorite investments, sectors, or asset classes, and fail to recognize the importance of global liquidity and beta. Liquidity is such an important concept, it has spawned many clichés:
A rising tide lifts all boats
Only when the tide goes out do you find out who is swimming naked
Everyone is a genius in a bull market
Don’t fight the Fed
Stan Druckenmiller, one of the most famous traders of the current era, once said: “Earnings don't move the overall market; it's the Federal Reserve Board... focus on the central banks, and focus on the movement of liquidity... most people in the market are looking for earnings and conventional measures. It's liquidity that moves markets.”
This Druckenmiller statement is an exaggeration, but it’s not far off. If you don’t get liquidity right, your world-class earnings estimates won’t matter.
Whatever product you trade, you need to figure out what is driving that market and to what extent. For example, my main market is currency trading… Any time I trade a currency, I will always know how it will be impacted by changes in:
Fed or global monetary policy
Market interest rates
Stock prices and global risk sentiment
That is global macro in five bullets and those factors drive every asset class to some extent.
If you are trading single stocks, you need to know how much of your stock’s movement comes from global macro and market beta and how much comes from idiosyncratic factors.
Before we go any further, let me define alpha and beta, because they are two terms you will see all the time in finance and you need to know what they mean. We are not concerned here with the specific mathematical definitions of alpha and beta, we just want to know what the heck the words usually mean in common discussion. If you want more precision, just Google “finance alpha definition” or “finance beta definition” and I’ll see you in 45 minutes when you get back.
Here is how I use “alpha” and “beta”.
Alpha is excess or abnormal returns. If the market is up 20% and you are up 30%, that is (theoretically) alpha of 10%. In reality, it might not be alpha but we’ll get back to that in a sec.
Beta is the amount a security generally moves when the broader market moves. A stock with a beta of 1.0 will be about as volatile as the overall market while a stock with a beta of 0.5 will be less volatile and one with a beta of 1.5 will be more volatile. Portfolios also have a measure of beta.
Beta can also refer to index-hugging returns. If you closely match market returns, a critic might argue that your fund is all beta. If you massively outperform the market, you might have generated alpha.
When is alpha not alpha? Alpha is not always actually alpha because there are other ways to generate excess return besides skillful trading or security selection. The simplest way to outperform an index is to follow it, but use leverage. If you give me $100 and I use 2X margin to buy $200 worth of S&P futures and the S&P goes up 10%, I made $20 and your return on your $100 is 20%. That’s not alpha. That’s leverage. Very often, people confuse alpha with leverage or (more dangerously) with hidden leverage. There is more to this discussion but I don’t want to go too far off track here.
The main point is: You can do all the analysis you want on a single stock, and if the stonk market tanks, your stock is probably going to tank too. You can do all the supply/demand analysis you want on the copper market, but if China shuts down, copper is probably going lower.
I discuss this today because I find many newer traders become enamored with their micro analysis in crypto, commodities, or equities, and completely ignore or forget about the macro influences that might help or hurt them. You can be a master of L1 and L2 narratives in crypto, but if you don’t know that 70% of the movement in every coin is driven by the broad ups and downs of crypto… NGMI.
I went through some of this in Trade 8: Top-down vs. Bottom-up so if you don’t know the difference between top-down analysis and bottom-up analysis, please check out that post.
How to deal with beta and global liquidity
Not everyone needs to be a global macro trader! If you want to learn global macro, that’s great (best way to learn global macro: sign up for my global macro daily, am/FX). If you are focused on your particular market, where you have an edge, that is excellent… But you still need to have global conditions in the back of your mind when you put on trades.
The big takeaway from this piece should be: You can’t just pick a thing and be bullish or bearish based on that thing’s fundamentals or technicals or correlation, etc.. You need to know what big picture factors matter and what might drive the price of your thing up and down whether or not your analysis is correct.
Obviously, if you’re a global macro trader, your whole existence is predicated on forecasting and reacting to cycles and regime shifts in various asset classes. But not everyone is supposed to trade global macro. Many traders find much more success by focusing on a particular security or asset class and developing expertise and an edge there. But those traders can often get blindsided by global macro and so the point of this piece is to help you not be that trader that gets blindsided.
Here are some ways to deal with global macro when you’re not a global macro trader:
One: Trade super short term
For short-term traders that don’t trade macroeconomic events, global macro matters the least. You need to know when the big economic events are coming so you don’t get your face ripped off through FOMC, or a Powell speech, or the USDA reports or other high-vol events… But you don’t really need to know much more than that.
Square up through the big events and trade short-term like a banshee. Be agnostic and flexible about long vs. short and trade products where you have no bias. If you are a huge Elon fan, don’t trade TSLA stock short-term or you’ll find yourself biased to the long side. Excellent short-term traders are equally happy long or short whatever they trade. If you can never be long EURUSD… Don’t trade EURUSD. In short-term trading, max flexibility and zero bias are key.
Two: Be long only
This is the simplest way to avoid ever having to care about macro but it’s also the least likely to make you a successful trader. This is more like investing than trading, but it can still work.
If you are a crypto or equity permabull, just pick the best longs and always trade from the long side. You can be long, or you can be flat. This is a low-stress way to trade in the direction of your fundamental core view and add alpha onto beta. If you are a crypto megabull and you dabble from the short side, you will notice that you always cut your shorts way too fast and white-knuckle every tiny rally because your brain is dripping with cognitive dissonance.
The problem is, during the down cycles, long only traders will face 20% to 80% drawdowns, depending on the asset class, no matter how solid the security selection. The beta will destroy the alpha. And if you’re not paying attention to the macro, you won’t really know what hit you. All your analysis of L1 vs. L2 or relative demand for your commodity or whatever isn’t going to help you if liquidity dries up or the Fed hoses down the markets with 10T of QE.
When it’s a liquidity story, it’s all the same trade and it doesn’t matter much which longs you’ve chosen. For example:
BTC, ETH, BNB, XRP, ADA, SOL, DOT, DOGE (SEP2021 to now)
Long only is mostly beta. Some alpha, if you’re good. But mostly beta.
Three: Trade RV
The simplest way to avoid the ups and downs of global markets and the falling and rising tides of global macro liquidity is to trade relative value (RV). RV trading is an entire industry and you could fill books with explanations of how to do it but in its simplest form, it works like this: You buy one thing and sell another thing. It’s a bet that the long will outperform the short.
If you do this with two stocks in the same industry (let’s say short FB, long GOOG), you eliminate a ton of macro risk such as:
Where is the broad market going to go? (doesn’t matter)
How will the bond market impact megacap technology stocks? (doesn’t matter)
What does Fed policy look like going forward? (doesn’t matter)
How will a Republican win in the midterms impact tech regulation? (doesn’t matter)
I’m saying “doesn’t matter” though it’s not 100% accurate since of course tech regulation can impact FB more than GOOG or Fed policy could impact GOOG more than FB, etc. But generally, you cancel out most macro and top-down risk when you pair two assets that operate in the same silo of the same asset class.
RV trading is much more complex than directional trading because there are a bunch of new factors to consider, especially when it comes to sizing and risk management. RV trading can be accomplished by going long one thing and short another or by doing baskets of longs and shorts. You can also (for example), go short a basket of stocks and go long index futures to hedge it.
For the purposes of this note, I am calling RV anything where you put on offsetting trades to minimize market or macro risk in an attempt to isolate the idiosyncratic risks of particular assets or securities.
Short ETH, long BTC would be RV. Or short copper and long AUD (they are correlated due to the global growth beta shared by both). Long USDJPY and long US 10-year bonds is a common RV trade, too (because USDJPY and US yields are correlated).
An industrial strength version of RV is when a fund will look at a universe of say, 100 assets and compare how they all trade relative to one another. Imagine a huge matrix of 100 assets X 100 assets and the correlation and beta of all those assets compared to each other in real-time. The machine will attempt to buy things that are cheap and sell things that are rich and continuously rebalance as assets move closer to, or further away from fair value. Some of these funds make money but it’s a tough biz and it’s very sensitive to regime shifts because correlation, volatility, and beta are not stable.
Personally, I hate RV. But many people love it and it’s a perfectly valid approach.
I almost always have a global macro view and prefer to trade in the direction of that view. When I put RV trades on, I tend to get annoyed with the risk management, the difficulty in applying leverage, and the cognitive dissonance of leaning in two directions at once.
Whenever I do an RV trade like short copper and long AUD… I always end up stripping one leg and turning it into a directional trade. If I’m bullish world, I’ll end up keeping the long AUD and somehow that pesky short copper always disappears from my blotter.
But that’s just me! It’s worth knowing how RV works. Some people love it.
Thinking about RV trades
OK so yes, RV can be complicated. But! You can also do RV in a simple way without a team of quants estimating correlation and volatility… And survive to tell about it (if you’re careful).
I’m going to provide a simple example here, but I really want to emphasize: RV trading is hard. I am going to explain a risk-averse way to do a single pair RV trade where you cannot blow up, no matter how much my idea stinks.
I’m going to pick two companies as my example today, but I have not done the deep dive on company fundamentals that you would do if you were really into this sort of thing. I’m going to make a simple observation and then see how you might trade it.
Trade 15: Short CVNA, long RBLX
We are at the stage of the tech cycle where companies either make it, or they don’t. A wave of bankruptcies will hit over the next 12 months as Powell’s firehose of unlimited, free funding has dried up and companies that cannot generate cash or quickly rightsize will burn through their remaining moneys at alarming speed.
It’s the point in the cycle where you start to guess who is going bankrupt and who is not. I’m not a CFA, and I’m not a securities analyst. I’m going to make a bunch of statements here that are theoretical so that I might describe to you how to think about an RV trade. This is not investment advice. OK, ready? Here we go.
I think Carvana is going bankrupt. They had massive negative cash flow in what should have been a dream year (2021), they overbuilt, and the recent layoffs via Zoom show poor governance and a company that is flailing.
Watch this video and tell me you don’t want to be short this company! Please open your books and turn to Chapter 11.
But… I don’t want to be straight short CVNA because it has already come off so much and the NASDAQ is already 20% off the high. A short squeeze in the NASDAQ or a change in the global macro picture (peace in Ukraine, less hawkish Fed, etc.) could take me out of my short.
On the other hand, I think Roblox is a strong brand that will survive this tech wipeout and live to fight another day. They have cash, etc. CVNA and RBLOX are not in the same industry (one is auto sales, one is video games/metaverse) but they are both beaten down COVID favorites and they move somewhat in synch because of that. RBLX has a 54% correlation to CVNA but only 28% to AAPL, for example.
Carvana just issued a huge slug of debt
Carvana debt is not trading well compared to Roblox debt
Roblox has more cash than CVNA
Do I get a free CFA for that analysis? Making Dr. Parik Patel proud.
Anyhoo. Let’s say I want to risk $3,000 on this idea, which is a bit more than usual because I think it’s going to work and that TikTok video really sends a strong doom signal to my Spidey Senses. How do I structure it?
This is the hard part with RV trades!
Again, I want to emphasize, I’m just doing tip of the iceberg stuff here. RV trading is a huge, complex field that employs zillions of smart quanty types. I’m just giving you the basics. Anyway… There are three main ways to structure and risk manage an RV trade.
ONE: You could go short CVNA stock and long RBLX and leave a stop loss on each leg, risking $1,500 per leg = $3,000. But what do you do if one leg gets stopped out? If you get stopped out of one leg, then you have directional market risk, which you didn’t want.
Also, when shorting massively beaten-down stocks, the upside gap risk is larger than usual. You could walk in tomorrow and Apple buys CVNA for a 100% premium and you’re dead. Gap risk is always something to worry about in single stocks because they close at night and on weekends, but with beaten-down stocks, the gap risk is much larger because they tend to have insane countertrend rallies, even as they asymptotically approach zero. Remember that something that is down 90% from the highs can double and it’s still down 80% from the highs! Dead stocks know how to fly.
TWO: You can size each leg using estimated volatility and stop out when the combined P&L hits -$3,000. This is how professional RV trading is normally done. You use historical or implied volatility to size each leg appropriately. That is, if one stock is more volatile than the other, you take a smaller position in that instrument. Less volatile = bigger position. This is called volatility adjustment or vol-adjusting. The big issue with vol-adjusting and then letting the two-legged position run is that you don’t have fixed P&L downside. You might lose more than $3,000.
Also, it’s a pain in the butt to monitor because you generally cannot automate this sort of risk management. You have to be watching. I always prefer automated risk management because it makes fewer mistakes and leads to more rigorous discipline.
THREE: Another way to do this RV trade is to buy options. The options on these stocks are not cheap, but I’m going to do it anyway. If you have the knowledge, you could probably sell put spreads on RBLX and sell call spreads on CVNA and that is probably a better trade but this note is getting way too long and that’s way too complicated for our purposes here. So keeping it simple, I am going to buy some long-dated options:
Buy January 20, 2023 CVNA $20 PUT for $4.70 (implied vol of around 140 lol)
Buy January 20, 2023 RBLX $40 CALL for $7
I spend $1,500 on each side. The target on CVNA stock is basically zero. RBLX is 2x current levels (~$60).
I can sleep at night because I don’t have to white-knuckle two separate stop losses or a combined P&L stop on the trade. I paid crazy high vols for those options, but I honestly believe that both options could pay off. Sometimes, buying expensive options is OK, but it’s a hard way to make a consistent living.
If you are not a global macro trader, you need to either factor in global macro, hedge it away, or explain why you are happy to ignore it. Selecting individual securities, cryptocurrencies, or commodities is great… But always consider the macro and cyclical landscape and how that might blindside you, provide a headwind, or (ideally) work as a tailwind.
That's it for today. 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!