Week 19: Weigh the Pros and Cons
Simple frameworks can help us understand complex systems (part 2)
Hi.
Welcome back to Fifty Trades in Fifty Weeks!
This is Week 19: Weigh the pros and cons
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.
If you want to learn about global macro in real time … subscribe to my daily: am/FX
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Update on previous trades
I am going to do the full .xlsx update next week as we hit Week 20, so I will keep it short here today. ARKK is on the comeback, CVNA/RBLX is doing OK, short ETHBTC is ITM, and the LLY short is stopped out.
And… Last week’s long TY trade was about as perfect as they get. It already hit the take profit. Here’s the chart:
US 10-year bond futures (hourly back to 07JUN)
One interesting aspect of this whole Fifty Trades in Fifty Weeks exercise will be to see how the different trades play out by asset class. My expertise is global macro and FX but I am avoiding FX trades in here because I don’t want my primary audience to confuse my core macro views (published in am/FX) with these more esoteric and scattershot 50in50 views where the primary purpose is instructional. A logical guess would be that whatever macro trades I do in here will outperform the micro trades (e.g., single name equities). But we shall see.
For transparency and accountability, I publish my P&L for all am/FX trades once per quarter. The most recent quarterly results are below. My P&L on the am/FX trades is mostly good-to-excellent with occasional periods of drawdown where I go ice cold for a month or two. It would make sense that since I’m a tourist in some of these 50in50 trades, I have less (or no) edge but I will be curious to see the final results. Full spreadsheet of 50in50 results to date next week. Here are the Q2 am/FX results:
Weigh the Pros and Cons
Last week’s lesson was about how to reduce extremely complex systems like the global economy into a simpler form using quadrants. The central idea was to look for heuristics or shortcuts that can help us strip out complexity and see only the most important underlying dynamics. This week, I want to look at another framework for thinking that helps me filter noise and unpack the important factors in a trade. Like the quadrants idea, it’s another super simple metacognition framework that helps me think about my thinking.
Hi Mom
When I was a kid and I had a difficult decision to make, my mom would always tell me to make a list of pros and cons. That is a simple way to get the crazy buzzing flurry of contradictory information out of your head and distill it down into something workable. I am a big believer in physically writing stuff down when it’s important. The process of writing stuff down (with a pen or pencil) has a different impact than typing something on a computer or thinking about it in your head.
Thoughts are abstract and fuzzy. Writing is solid and concrete. If you think, “I’m going to cut my AAPL short at $285”, that is completely different from writing CUT AAPL 285 on an index card and having those words stare up at you in thick black Sharpie ink as the stock rallies from $280.50 to $284.75.
The same goes for any plans or ideas you have. There is so much noise in your head, so many competing voices vying for airtime. Don’t assume you can formulate a plan in there and then execute it successfully without writing anything down. Again, this doesn’t have to mean anything more than scratching a few notes down on a piece of paper or recording some thoughts on an index card.
Research shows that when you write down a goal, you are more likely to achieve it.
When you write something down, it solidifies. It transforms from abstract into concrete. All the sludge falls away and only the important information is left. When you write something down, you have made a choice to select that particular information, goal, or action as more important than all the others. This highlights it for your brain. When you write something down, you signal to your brain “THIS IS IMPORTANT”. Your brain records it as such.
The pathways and connections developed in your brain are different when you write something down because the encoding process is different. The encoding is stronger, and more robust, and information is recalled more easily.
For years after leaving home and venturing out into the big, bad world, I forgot about the pros and cons thing. Then, one day in 2011, I was thinking about changing jobs. I have changed jobs many times in my life and it’s usually a fairly easy choice. Factors at the existing job are generating a push (I don’t like the environment, business model, management, etc.) and factors at the new job are creating a pull (money, risk appetite, business model, management, etc.) But in this particular case, I couldn’t decide. My mind froze up.
Then, I remembered my mom’s pros and cons thing and decided “what the heck I might as well try that”. It worked! Once I laid it all out, it was clear to me that the new job on offer was a suboptimal choice and I should reject it. This was a good call! I ended up getting a way better offer in a way better trading environment about three months later and soon I was an MD at Nomura.
The CIA knows
Not long after the pros and cons thing helped me with my employment decision, I was re-reading one of my favorite non-fiction books, “Psychology of Intelligence Analysis,” by CIA intelligence expert Richards H. Heuer. The book is pure gold; it is the best elucidation of good thinking I have read. The author worked for the CIA for 45 years in various roles including operations, counterintelligence, and intelligence analysis. The book explains how human bias impedes clear thinking. Much of it applies directly to trading.
Of particular relevance is “Part Two: Tools for Thinking”, especially “Chapter 8: Analysis of Competing Hypotheses”. If you want access to the full buffet of information, I suggest you read the whole book: it’s less than 200 pages and it is not boring! If you want the quick meal, at least read Chapter 8.
For now, here’s an appetizer… Heuer’s summary of Chapter 8.
Step-by-Step Outline of Analysis of Competing Hypotheses
Identify the possible hypotheses to be considered. Use a group of analysts with different perspectives to brainstorm the possibilities.
Make a list of significant evidence and arguments for and against each hypothesis.
Prepare a matrix with hypotheses across the top and evidence down the side. Analyze the “diagnosticity” of the evidence and arguments— that is, identify which items are most helpful in judging the relative likelihood of the hypotheses.
Refine the matrix. Reconsider the hypotheses and delete evidence and arguments that have no diagnostic value.
Draw tentative conclusions about the relative likelihood of each hypothesis. Proceed by trying to disprove the hypotheses rather than prove them.
Analyze how sensitive your conclusion is to a few critical items of evidence. Consider the consequences for your analysis if that evidence were wrong, misleading, or subject to a different interpretation.
Report conclusions. Discuss the relative likelihood of all the hypotheses, not just the most likely one.
Identify milestones for future observation that may indicate events are taking a different course than expected.
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I think you can use all eight of these points to help analyze trade ideas. But the simple takeaway for traders is: No matter how in love you are with your trade idea, spend time looking for disconfirming evidence. Your brain is biased to look for confirming evidence (i.e., confirmation bias). Look at alternative hypotheses with an open mind and try to figure out how and why you could be wrong. Lay out the arguments against your view and see how you feel about them. Do they make sense? Are they easily refuted?
Naturally, this process of examining alternative hypotheses reminded me of the pros and cons list. It’s basically the same thing, just a super fancy version. And usually in trading you really only have two hypotheses: Bullish or bearish.
That’s not precisely true and there are nuances around each way of thinking about the market but the point here is that if you are going to put on a trade, first do a pros and cons for it. Then go through the eight steps above as a means of clarifying your thought process. This will force you to think of what might go wrong. It will identify risks that you might have not fully taken the time to factor in.
Long GBTC
In MacroTactical Crypto 23 — 3.4% of the bitcoins are 34% off, I wrote my hypothesis explaining why I want to scale into long GBTC in five clips of 20% each day next week. Here is the intro to MTC23:
"As discussed in MTC22, liquidation is a risk for the next 10 days. Funds with gates and various rules are getting month-end, quarter-end and half-year-end redemption requests right now. I presume these requests will be large. One particularly interesting liquidation play into month end is GBTC. That is the Grayscale Bitcoin Trust. It holds spot bitcoin and currently owns 654,885 BTC or 3.4% of all the bitcoin in circulation.
Pedantic sidenote: The plural of bitcoin can be bitcoin or bitcoins. It should be one or the other. I vote bitcoin.
The problem with GBTC is that it cannot be converted or redeemed into BTC and therefore it can trade at any premium or discount to net asset value. There is no mechanism to convert GBTC into BTC or to make GBTC trade near net asset value (NAV). So, the value of GBTC is correlated to, but also completely unanchored from its NAV.
In theory, one share of GBTC is worth NAV, eventually. But since there is no way of converting GBTC into BTC, the price of GBTC reflects some combination of two things: The price of bitcoin, and the overall demand for an exchange-traded bitcoin proxy.
When crypto is hot, GBTC trades at a premium because people will pay anything to get exposure. When crypto is wintery, like now, GBTC trades at a discount because demand disappears. Here is the GBTC discount / premium to NAV over time:
GBTC premium or discount to NAV
Expect large crypto fund liquidations into month- quarter- and half-year-end. These could hit crypto and hit GBTC particularly hard because insolvent hedge fund Three Arrows Capital is the biggest holder of GBTC. As of the most recent data, they hold 39 million shares and it trades 6 million shares/day.”
A few other points to summarize the thesis:
I am bullish bitcoin and this is an interesting way to get exposure in a tax-friendly way (not investment or tax advice!).
This could work as a tactical trade (turn of the month and into a potential SEC announcement on July 6) or as a long-term investment. I see it working on both time horizons.
For the full write-up, please subscribe to MTC. It’s $199 and they say it’s totally worth it.
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Here is my pros and cons sheet for the long GBTC trade:
Once I have done this, I can actively debate the pros and cons. For example:
The “SEC YES vote super unlikely” kind of doesn’t matter because nothing is priced in. I don’t think GBTC will sell off much if the SEC rejects Grayscale’s application to become a spot BTC ETF.
The two different time horizons is an important concern and consideration. By laying this out, I force myself to make a decision: Is this a trade or an investment? This avoids the possibility of entering it as a trade, then if it goes horribly wrong, deciding… er, actually… it’s an investment.
The lack of chart support and technical support is not a problem. I had the same issue with the TY trade last week. You can simply use X number of average day’s ranges to determine the stop loss, like I did last week.
My current “mildly bullish risky assets for a summer consolidation” view is low conviction, so it doesn’t factor in as a strong “pro.”
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When all is said and done, I like the trade on both time horizons. The cons are not overly concerning. For 50in50, I will follow the short-term trade and I can also choose to do the trade in my 401k as an investment for optimal tax treatment because buying a trust at a discount like this is generally an unlimited time horizon, no stop loss kinda trade.
The parameters for the trade are: Buy 5 clips of GBTC, one at the close of each day next week (20% of $2,000 P&L risk per day so total $ at risk for the trade will be 2000). Therefore the average close for those 5 days will be my entry point.
The stop loss gets a bit complicated because you need to risk manage each clip as you get in, but for the sake of simplicity here let’s just use the average rate of the five tickets and subtract 2.5 average day’s ranges to get the stop loss. An average day’s range in GBTC since January 2021 is 5.9% so the stop loss will be at entry minus 14.6% or average price X 0.854.
Take profit on July 31 or +30%, whichever comes first.
Conclusion
Simple frameworks are excellent tools. Nothing I’m describing in here is rocket science! It’s more like 6th-grade 1/2 credit Life Skills Class type stuff. But it’s important to have processes and frameworks that help you get to the root of the problem so that you don’t get bogged down by information overload.
Use pros and cons to identify your thesis and compare it to the alternative hypothesis. This simple process can help you make better decisions.
Trading combines many fields, such as economics, behavioral science, probability, gambling, psychology, statistics, and decision theory. Incorporate literature and theories from all those fields (and others) to improve your trading. For example, if you want to learn more about decision making, check out: Thinking in Bets by Annie Duke, and Predictably Irrational by Dan Ariely.
That’s it! Thanks again for reading. I know time is the most valuable commodity in the world and I will always try to keep 50in50 as succinct as possible, without sacrificing necessary detail.
See you next week!
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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!
In your Q2 am/FX results, pos size and P&L is in $'s or another denomination? e.g. total P&L for the quarter is $790,526 ?