2

© 2016 John Netto

All Rights Reserved.
No part of this publication may be reproduced, stored in a retrieval system, or
transmitted, in any form or by any means, electronic, mechanical, photocopying, recording,
or otherwise, without the written permission of the author.
First published by Dog Ear Publishing
4011 Vincennes Road
Indianapolis, IN 46268
www.dogearpublishing.net

ISBN: 978-145753-476-8
This book is printed on acid free paper.
Printed in the United States of America

3
Editor: Michael Golik, CFA

Contributing Authors:
Foreword: Wesley Gray, PhD
Neil Azous
Cameron Crise
Joe DiNapoli
William Glenn
Todd Gordon
Patrick Hemminger
Steve Hotovec
Jessica Hoversen
Timothy Jacobson, CFA
Darrell Martin
Raoul Pal
Fotis Papatheofanous
Jason Roney
Robert Savage
Denise Shull

4
CONTENTS

Disclosure
Foreword

Chapter Introduction – John Netto

1.
Chapter The Foundation for Maximizing Return
2. Per Unit-of-Risk
Chapter Money Does Not Always Find Its Most
3. Efficient Home
PHASE I. REGIME RECOGNITION
Chapter More Risk Does Not Always Equal
4. More Return – Jason Roney
Chapter Unit-of-Risk Ratios – A New Way to
5. Assess Alpha
Chapter Identifying Inflection Points in the
6. Business Cycle – Raoul Pal
Chapter Identifying Capital Flows in Financial
7. Markets – Fotis Papatheofanous
Chapter Creating an Environment for Identifying
8. the Regime
PHASE II. STRATEGY CREATION
Chapter Chassis of the Financial Markets –
9. William Glenn
Chapter DiNapoli Leading Indicator Techniques
10. for Trading Global Markets – Joe DiNapoli
Chapter Understanding Animal Spirits Using
11. Elliott Wave Principles – Todd Gordon

5
 Chapter Using Options to Trade the Macro
12. Narrative – Neil Azous
Chapter “Dirty Arbitrage” Spread Trading Asset
13. Classes Around the World – Patrick
Hemminger
Chapter Mean Reversion Strategies – The Trend
14. Isn’t Always Your Friend
Chapter Finding the Follow-Up Trade to a
15. Catalyst Event
PHASE III. IMPLEMENTATION
Chapter Diversification Isn’t Enough – Spotting
16. the Paradigm Shift – Bob Savage
Chapter Trading the Economic Calendar: A
17. Qualitative and Quantitative Approach –
Jessica Hoversen
Chapter How to Quantify and Visualize Market
18. Positioning
Chapter Emotions Are Our Greatest Ally, Not
19. Our Biggest Enemy
Chapter The MPACT! of Automation
20.
Chapter Risk Budgets – The X Factor in
21. Investing
Chapter Paying for Returns in Context: Manager
22. Compensation Based on Return per Unit-
of-Risk
Chapter Where Do We Go From Here?
23.

Acknowledgments
Glossary Of Terms
Appendix I
Appendix II

6
DISCLOSURE
The Global Macro Edge: Maximizing Return Per Unit-of-Risk was
published for informational, educational, and entertainment purposes
only, and should not be construed as an offer to provide investment
advisory services nor to buy or sell any securities, futures, options, or
currencies. The information in this book is provided “as-is” and is not
guaranteed to be complete or current. No representation is being made
that the use of this strategy or any system or trading methodology
outlined in this book will generate profits. There is substantial risk of
loss associated with trading securities, options, and futures—a trader
may lose all or substantially all of his capital. Trading securities is not
suitable for everyone. Futures, options, and currency trading all have
large potential rewards, but they also have large potential risks. You
must be aware of the risks and be willing to accept them in order to
invest in these markets. Do not trade with money you cannot afford to
lose. The past performance of any trading system or methodology is not
necessarily indicative of future results.

7
FOREWORD
Wesley Gray PhD, CEO, Alpha Architect
The finance industry is changing. Rapidly. Information, the lifeblood of
financial markets, has been democratized via technology. Data and analytics
software are pervasive and they are cheap. No longer can Wall Street banks
and brokers pass privileged information through a byzantine network to their
best clients, leaving the scraps for retail investors. Now, technology has made
available unprecedented quantities of information, and it is providing it near-
instantaneously on an absolutely massive scope. Many of the old institutional
barriers to entry have been torn down—history may judge this period as one
that saw a greater number of opportunities made available to a more diverse
group of people than ever before.
Despite this evolution in the market’s ecosystem and the related
opportunities it creates, many still operate under old assumptions. They still
believe that the key factors to successful investing are related to a fancy
pedigree, an extremely high IQ, and access to the best hedge fund managers.
While those things can be important, the traits of the next generation of
successful investors will be no different than those of great investors of the
past: 1) a long-term horizon, 2) a disciplined approach, and 3) a keen focus
on fees and expenses. Of course, the next generation will need to apply these
winning traits in a different environment driven by “Big Data.”
Sounds easy, right?
Unfortunately, unprecedented access to information can be both a blessing
and a curse: big data liberates, yet confines; it verifies, yet misleads; it
corroborates, yet contradicts. As is the case with water, one can drown in too
much data, but with inadequate data, one cannot survive. Investors need to
find the right mix and leverage the benefits of information without drowning
in information overload.
How does one succeed in this new environment?
In the Marine Corps, we started with core principles to help us achieve our
mission. We believed in honor, courage, and commitment. In the investing
realm, core principles also drive success. Three principles come to mind:

8
education, adaptability, and discipline.
John Netto, a fellow U.S. Marine veteran, takes a similar view on the core
investment principles that will help investors succeed. John’s trading career
has focused on education, adaptability, and discipline and the results are
compelling. The Global Macro Edge embraces the journey John took as he
explored the principles of education, adaptability, and discipline in the
context of his trading career. John’s biggest contribution is to put a spotlight
on the need to focus on maximizing our return per unit-of-risk we assume.
While this sounds trivial, this simplifying focus is empowering, in a world
dominated by complexity.
Semper Fidelis,
Wesley R. Gray
CEO, Alpha Architect

9
CHAPTER
1

10
 Introduction—John Netto
“Intelligence is the ability to adapt to change.”—Stephen Hawking
Up early on a sunny Sunday morning in L.A., I was bent on getting a fast
start to the workshop hosted by one of the greatest media minds in the world,
Joel Roberts. Outside our conference room at the Intercontinental Hotel in
Century City were Landon Donovan and the rest of the US Men’s soccer
team. Just a year earlier at the 2010 World Cup Finals, the United States was
nearing the end of an exhausting scoreless match against Algeria. Then in the
final minutes of the game, when prospects seemed grim, Donovan scored and
the US won 1–0. Unbelievably, now they were standing right in front of me,
headed for the Rose Bowl to play Mexico in the Gold Cup.
Maneuvering through the men adorned in red, white, and blue got me
thinking. It invoked questions about the impact each of us has on matters
greater than our individual selves. And I asked myself, “What can I do to
make an impact, make a difference, do something bigger than myself?”
Having spent nearly nine years in the Marine Corps, with almost half of
that stationed in Japan, this was not a new thought or challenge to me.
However, since transitioning from the austere structure of military life to an
ephemeral disposition as a professional futures trader, I realize that there is
still more I can do to help people.
As the soccer team faded from view, my BlackBerry buzzed and brought
me back into the conference room. It was a message from John Wiley and
Sons wanting to publish my second book sharing new strategies on how to
invest in the markets. A range of emotions overcame me. I was thrilled with
the opportunity to push the literary envelope again, but also a little
overwhelmed because I understood just how much work goes into producing
a book that is both informative and enjoyable to read.
Still caught up in the moment, I shared the exciting news with everyone.
Not to pass up a learning opportunity for myself or the rest of the attendees,
Joel promptly inquired, “Congratulations. Now tell me… What myths do you
bust and what problems does your book solve, Mr. Netto?”
My silent response and blank facial expression was a harbinger of the
arduous work to come over the following five years.

11
The Biggest Myths on Wall Street: Why They Exist and
the Problems They Cause
Like many people, I instinctively go straight to the solution when I
attempt to show value in a process, service, or product. However, I have
learned instead to dig into, examine, internalize, and articulate the problem.
This strategy makes arriving at the right solution a far more feasible
objective. Therefore, when I embarked upon the mission of becoming a more
successful investor, I recalibrated my perspective regarding the problems I
was attempting to solve.
The Global Macro Edge will explain, through a compendium of
contributions by talented market practitioners, that the challenges facing
investors, traders, and financial advisors are the byproduct of a half-dozen
myths. Together we will examine what these myths are, why they exist,
and the problems they cause. These myths are:

1. More risk equals more return.

2. Money always finds its most efficient home.
3. Emotions are your biggest enemy.
4. Diversification is the only strategy you need.
5. Today’s markets offer fewer opportunities.
6. Compensation should be based on returns.
These are the six largest areas of misunderstanding in the market—
misunderstandings that can prevent investors from creating wealth for
themselves. By understanding how to prevent, manage, and solve the
challenges these misconceptions create, you are putting yourself in an
incredible position for success.

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Myth #1 More risk equals more return
More risk does not always equal more return; sometimes it just equals
more risk. The Global Macro Edge will show that you do not have to risk
more to make more; you have to risk smarter to make more.
Unwittingly, some investors may not be compensated fairly for the risk
they are exposing to their portfolios. The process of understanding where the
breakdown occurs happens at two key points. The first can happen during the
process of constructing a portfolio and putting in place a risk budget. The
second may occur after you have created your risk budget and the investment
strategies you have chosen are not congruent with the market environment.
As The Global Macro Edge will explain, one of the biggest risks to your
position, strategy, or portfolio is a byproduct of what regime, or environment,
the market is in currently. Strategies in one type of regime may do
exceptionally well in one type of regime while they would struggle in
another. Many investors lack the expertise to effectively evaluate what the
current market regime is and which strategies will perform the best. Failure to
identify which regime is in place and which strategies are appropriate for that
regime can lead to not being properly compensated for the risk you are
taking.
For example, in 2014, US economic data significantly outperformed their
European and Asian brethren. In the past, an uptick in US data could be
associated with a rise in treasury yields and a strengthening US dollar.
However, due largely to a powerful combination of unprecedented central
bank influence in Europe and Japan, as well as global deflation fears, there
was a huge demand for investment-grade government credit. This demand
sent yields of European and Japanese debt to record lows.
So while US economic data surged in the second half of 2014, US
Treasury yields finished 2014 near lows. The regime of disinflation and
central bank influence materially affected the risk profile of a person
positioned for a rise in US Treasury yields.
While US Treasuries were frustrating short sellers, US dollar bulls were
richly rewarded under this same regime of strengthening US economic data.
The dynamics helping to drive the rally in global Treasuries were also putting
downward pressure on both the Japanese yen and euro against the US dollar.
Therefore, while US Treasuries finished 2014 with yields at lows (reflective
of a more somber US economic environment), the US dollar was in full rally

13
mode.
Understanding the idiosyncratic aspects of a particular market regime
should be a driving factor in how you allocate your risk units. Long dollar
and short Treasuries should have traded with a much higher correlation,
given the stronger US data; however, those two trades had vastly different
risk profiles and returns.
The second key factor in why more risk does not always equal more return
is illustrated by act of constructing a risk budget around a portfolio. A risk
budget is a predetermined downside threshold where trading will cease
in order to prevent further losses. Without a risk budget, an investor is
theoretically willing to lose his entire investment.
As we saw in the period from 2009–2014, passive investment strategies
performed extremely well, both nominal and risk-adjusted basis. This
performance led some investors to be enamored with potential returns and
refrain from asking critical questions, such as:

How much risk in the portfolio is exposed?

What, if any, predetermined exit strategy exists?
Do my financial advisor or I have insight into what factors could lead to
a sharp sell-off in my portfolio’s assets?
What sort of technology is being used to regularly monitor for an
outsized move in volatility, correlation, or concentration?
Failure to sufficiently ask and answer questions like these is why some
investors end up believing they can earn a greater return by simply taking on
more risk. In reality, most investors do not have a process to either create a
risk budget or select regime-appropriate investment strategies.
Conventional investing asks, “What was my return?” The Global Macro
Edge asks, “What was my return per unit-of-risk?” The processes outlined
in this book will provide you with the tools to ask and answer both of these
questions.

14
Myth #2 Money always finds its most efficient home
Some investors can go years, if not a lifetime, before investing their
capital in the most efficient way. Multiple factors prevent many market
participants from getting the most out of their investment dollars. This occurs
at nearly every level and time horizon in the market hierarchy. Below are just
a handful of reasons:

Legacy and bureaucracy issues

Lack of technology
Central bank and political influence
Regulatory limitations
Inability to invest 401(k) money outside of select company choices
Style box constraints when allocating to managers
One of my biggest “aha” moments was when I realized the process of
allocating capital to the most talented managers and those with the best
strategies was flawed. Typical cosmetic issues like fund size, length of track
record, capacity constraints, and lack of assets under management can prove
more influential when deciding on an allocation than the robustness of a
manager or strategy.
Clearly, the foregoing issues are important and need to be factored into
any potential allocation. However, this realization about the inefficiency of
allocating capital was profound for me. It helped me understand, at the
most basic level, one of the many reasons why opportunity exists in the
market. If the system is NOT set up to place capital in the hands of its most
talented practitioners—for whatever the reason—the result is an opportunity
for the more educated, disciplined, and resourceful to benefit. Therefore,
while money may eventually find its most efficient home, the lag in that
process creates tremendous opportunity.
The hedge fund world is a great place to find alpha1 and an even better
place to overpay for beta2. There are a number of exceptionally talented,
large money managers consistently illustrating just how much opportunity
exists in the investment universe. However, most investors do not have the
in-depth understanding of market dynamics, risk-centric technology, or
infrastructure to differentiate between skill and good fortune.
In a perfect world, investors would be able to invest capital and manage
their portfolios by using ten non-correlated managers just as easily as using

15
100. The profile of the portfolio would encompass everything from high-
velocity emerging managers to well-established funds, with every move
governed by a risk budget. Yet, reality shows that the administrative burden
and lack of technology make this a challenging endeavor for most investors.
Moreover, such barriers only intensify the problem of capital not finding its
most efficient home.
Because of these limitations, some investors who seek true absolute return
strategies end up investing in more established, larger funds, thereby
experiencing “beta migration.” Beta migration is the tendency for a fund to
shift from an absolute return profile to one resembling more of a benchmark
strategy. As many funds get larger, they invariably compare themselves to a
benchmark. The problem with this is that investors are now beginning to pay
active manager fees for passive management styles.
If the process of allocation is not optimal, then investors portfolios can
develop gaps. These gaps contribute to a loss of efficiency in capital.
When investors do not have the expertise, technology, and risk measurement
tools to assess whether their portfolios are running at a peak level, the
problem tends to worsen before it gets better.
The Global Macro Edge will provide you with the insight to close those
gaps and help run your portfolio at its peak level.

16
Myth #3 Emotions are our biggest enemy
Emotions are our biggest ally and a tremendous repository of information
about the animal spirts of the market. While we are repeatedly advised never
to let our emotions guide our investment decisions, it is our emotional
intelligence which should be one of the most important aspects of when
and what to buy and sell. Many market participants believe that using their
emotions in the decision-making process can impede their success. This is
because nearly all of us have made an impulsive decision that led us to buy a
market at an extreme high, or sell it at a major low.
Painful experiences like these prejudice most investors against embracing
their impulses as a gold mine of information and a viable way to tap into
the “emotionality” of the markets. Being able to consciously identify,
compartmentalize, and integrate your emotions into the trading process can
be a tremendous source of “behavioral alpha.”
Understanding this concept is key, as the majority of efforts to enhance
performance in today’s markets target three areas.

1. Build more robust price-pattern recognition systems through a variety of

technical tools.
2. Enhance the array and depth of economic forecasting models.
3. Harness the power of market sentiment through social media.
These are all viable endeavors and an active part of the Protean Strategy
explained in the following pages of The Global Macro Edge. However, the
next wave of alpha will be to tap directly into the emotionality or animal
spirits of the market.
We are all living, breathing organisms who react in comparable ways
when the market behaves in a certain manner. Many of us, despite our
experience and pedigree, succumb to the same emotions and impulses.
Harnessing that information at an individual and collective level will be
both the greatest challenge, as well as the largest source of alpha
generation in the next 20 years! Despite the potential this area offers to
enhance risk-adjusted returns, many market participants are hesitant to
embrace it, nor do they have a process for tapping into its potential.
The Global Macro Edge will outline ways to tap into this rich source of
market information.

17
Myth #4 Diversification is the only strategy you need
Unfortunately, for most, today’s “diversification” could be tomorrow’s
“correlation.” There are no autopilots in asset management. One of the
most memorable lessons I took away from Marine Corps Recruit Training
was when my drill instructor shouted, “Recruit Netto, no plan survives the
first encounter with the enemy!” Superficially, building a portfolio of
absolute-return strategies based on past performance and “reasonable”
projections should suffice. However, the market is a dynamic, living
organism, necessitating that we stay open-minded and possess knowledge of
the variables that influence her.
One of the biggest challenges to investors, or those advising investors, is
to grasp the nuances behind the strategies to which they are exposed. Even if
they do understand the various idiosyncrasies, oftentimes they do not
possess the technology to measure the strategy on a “return per unit-of-
risk” basis in a timely manner. Such protocols can assist investors in seeing
whether the performance is deviating in a way that would require
repositioning.
Conventional methods of measuring performance focus on nominal
returns a monthly, quarterly, or even annual basis and focus on nominal
returns. In some cases, this frequency of data assessment emphasis on only
top line performance is not enough to detect events like outsized volatility
moves, position concentration issues, and overall model decay. Both
frequency and focus can make it very challenging to maintain attractive
risk/return profiles for the life of the investment.
The Global Macro Edge will illustrate multiple ways provided by an
array of experienced market practitioners to maintain true portfolio
diversification and enjoy its benefits.

18
Myth #5 Today’s markets offer fewer opportunities
For those using the right filter, there has never been more opportunity than
what exists in today’s markets. One of the biggest misconceptions The
Global Macro Edge will attempt to correct is the belief that there were more
opportunities in the past when, on the contrary, there are numerous
opportunities in today’s markets. Human psychology is such that we always
look back with fond nostalgia to the past. Unfortunately, this can inhibit an
investor from objectively assessing new opportunities. Because of our
penchant to romanticize yesteryear, many investors stop vigilantly looking
for ways to evolve and find newer, more profitable investment strategies.
There are a few factors that perpetuated this myth. First, from 2009–2014,
central banks assisted in lowering volatility by helping remove the risk in
markets through incredibly accommodative traditional and nontraditional
monetary policy measures. The second factor is the dislocation of many
liquidity providers as banks and trading desks began to reposition for
increased government oversight and regulation.
With volatility near multi-decade lows and traditional liquidity providers
leaving the market, opportunities for price discovery became scarcer. To
further compound the frustration of traders and active money managers, risk
assets went through significant appreciation from 2009–2014, or what market
historians will define as “The Golden Age of Passive Investing.”
A 50/50 combination of stocks and bonds from 2010–2014 yielded the
highest five-year Sharpe Ratio of any period since 1977 (when bond
futures could formally be tracked).3 A Sharpe Ratio measures the returns of a
stock, index, or portfolio on a volatility-adjusted basis. The higher the Sharpe
Ratio, the better the portfolio has performed on a volatility-adjusted basis.
Below is a list of the best five-year Sharpe Ratios since 1977 of a
portfolio comprised of 50 percent bonds and 50 percent stocks:
#1: 2010–2014 - 5.22
#2: 2009–2013 - 2.66
#3: 2011–2015 - 1.38
#4: 2003–2007 - 1.23
#5: 1989–1993 - 0.88
This is great for passive investors who buy and hold. However, it is less
enticing for traders who are looking to benefit from a more volatility-rich
environment.

19
 Fortunately, although not as highly publicized, the events of 2008 also led
to tremendous advances in risk-centric technology. Why is this important?
The more efficient the braking system, the faster you can drive your car.
Professional racecar drivers go north of 200 miles an hour. This is not only
due to their driving skills, but also because of an efficient braking system that
enables them to slow down just the right amount to maintain speed and
without wasting energy.
Possessing risk-centric technology is like having an efficient braking
system—it enables an investor to respond to events in a smarter way. More
than any time in history, we now have the ability to deploy our risk units in a
more robust manner, efficiently aggregate trading information, and access
global strategies and managers.
In the past, one of the biggest barriers to investing in a manager or
strategy was how to manage the risk, whether from a measurement
standpoint, liquidity, or even ongoing risk enforcement. Now, with the ability
to actively enforce risk controls across an array of managers, investors with
know-how can take on exposure in multiple non-correlated strategies from a
single account structure. This is a game-changer!
Combine risk control with the dislocation of manager talent from
traditional liquidity providers such as banks and trading desks, and there is
tremendous opportunity for those with the right account structure and
technology. As a result, achieving a superior risk-adjusted return is more
attainable than at any other time in history by a more diverse group of
investors.
Unfortunately, the majority of investors do not have the tools to efficiently
sift through the onerous amount of available information and reap the
benefits. The reality is that many are not aware of, much less proficient at,
how to merge the abundance of talent, strategies, and technology in a risk-
controlled manner. This barrier prevents them from benefiting from the next
generation of market opportunities.
The Global Macro Edge will outline strategies and structures that will
help you take advantage of these opportunities.

20
Myth #6 Compensation should be based on returns
Compensating based solely on returns entails taking a one-dimensional
view of a three-dimensional process. Compensation should be based on three
factors:

1. Overall returns
2. Returns relative to maximum adverse excursion
3. Returns relative to a predetermined risk budget
Nearly all investors determining what to pay a manager only look at
number one, without having the knowledge, much less the process, for
factoring in numbers two and three.
The decision to allocate resources to a strategy should ultimately be based
on how well it maximizes return per unit-of-risk. Despite looking for
managers and strategies that embody this statement, the vast majority of
investors do not complete the final step of the investment process. The final
ingredient is putting in place a goal-congruent compensation structure. This
structure should reward managers for maximizing return per unit-of-risk,
while not overpaying them should their results deteriorate.
Most investors follow a Draconian compensation protocol and pay a
percentage of the nominal performance, while having no provisions to either
raise or decrease the compensation based on other risk measurements of the
portfolio. This absence of a dynamic pay structure punishes both
investors and managers. The inability to incorporate a versatile and
equitable compensation structure can serve as a key obstacle for both an
investor and money manager in consummating a deal.
The solution is an incentive framework that can work retroactively. The
framework should be based on returns relative to maximum adverse
excursion and the performance relative to a predetermined risk budget.
This allows investors to reward managers for alpha, while not overpaying for
beta. The Global Macro Edge will outline how using the Netto Number
provides the solution to this challenge.
The secret to debunking these six myths and solving the problems
they cause is having the market acumen, risk-centric technology, and
unwavering discipline to pursue the one true goal: maximizing return
per unit-of-risk.
Welcome to The Global Macro Edge: Maximizing Return Per Unit-of-

21
Risk.
1 Skill in producing a superior risk-adjusted return
2 Returns that came about from being invested in the market, not necessarily one’s
investment skill
3 Source: Kevin Dressel, Bluegrass Capital Management

22
CHAPTER
2

23
The Foundation for
Maximizing Return Per Unit-
of-Risk
“Begin with the End in mind.”—Stephen Covey,
The Seven Habits of Highly Effective People

24
Overview
Whereas the previous chapter was dedicated to constructing the façade on
the castle, this one is all about laying the plumbing. The Global Macro Edge
has an extraordinary set of objectives regarding what we want the reader to
walk away with. Therefore, it is incumbent upon us to provide a roadmap for
how we plan on achieving those goals. This chapter will do so by addressing
the following points:

Inspiration, Background, and Objective of the book

Explanation of Key Terms
How the Book Is Structured
Benefits to Readers
Investing is an amazing microcosm for life. There are countless
phenomena specific to investing that are paralleled on the grander stage of
one’s everyday life (and vice versa). With both investing and life, there are
aspects controlled by nature, those controlled by nurture, and those that are
the result of a complex interplay between the two. The nature part of the
equation necessitates that one “knows thyself” and either looks to play to
one’s unique strengths, or (at the very least) not let one’s weaknesses lead to
one’s demise. The nurture part is at least equally fascinating, as it examines
how environment can influence the decision-making process and,
furthermore, how efforts to educate ourselves can improve our investment
process.
Like most of us, I am heavily influenced by my experiences, as well as the
teachings of my predecessors. When The Global Macro Edge was in its
concept phase, I was trying to create a book that would celebrate the work put
forth by my predecessors, as well as challenge readers into recalibrating how
they approach their investments. To borrow a phrase from Newton: “If I have
seen further, it is by standing on the shoulders of giants.” I am heavily
indebted to each of the influences to The Global Macro Edge named
throughout these pages (and some not—though I am equally grateful). It is
my goal to bring their insights, processed (and hopefully added to) by my
unique experiences, to the reader.
I found particular inspiration in the work done by Steven Drobny,
Sebastian Mallaby, and Jack Schwager. Drobny and Schwager’s ability to get

25
high-level macro traders to pull back the curtain on their thought process and
convey a number of rich anecdotes was invaluable. Their books served as
both indispensable learning aides and the necessary corroboration that I was
doing something right with my own trading.
Sebastian Mallaby’s More Money Than God is an incredible chronology
of the hedge fund industry, pointing out the regimes that influenced the
market through the decades. His work was exhaustively researched and
colorfully written in a way that had me, on multiple occasions, stop in the
middle of a page, look up, and say, “Now I get it!” I structured this book with
the specific intention that you, the reader, would experience multiple “Now I
get it” moments for yourself as you work your way through these pages.
The Global Macro Edge: Maximizing Return Per Unit-of-Risk is the
next iteration in the process of bringing actionable insights to readers in the
context of a group literary effort. The coauthors and I wanted a book based
on process delivered by market practitioners. The desire was a work where
the reader would not only hear our experiences and what shaped our
approach to the markets, but also clearly delineated, step-by-step processes
for how we go about accomplishing this.

26
My Perspective
Confucius asked one of his students, “Do you take me for a
man who learns and remembers many things?” When the
student answered, “Yes,” he was corrected. “No,” replied the
learned philosopher, “I link it all on a single thread.” —Book
XV of the Analects of Confucius
There are many things couched in the pages to follow: terms to remember,
strategies and best practices to consider, theories to digest, and advice to
absorb. Global markets are vast, deep, and infinitely varying oceans, and
there is very much to say about them. It is—and I will be the first to admit—
more than one person can expect to master in a lifetime. This is part of the
reason I have recruited a broad group of experienced coauthors who have
each developed expertise in different aspects of the markets.
In reading The Global Macro Edge, I invite readers to follow Confucius’
example—pick out the elements that are relevant to your own approach to
markets, those that make sense for your own trading, and work them into
your own unifying vision. This does not mean I am encouraging you to only
walk away with what you already know or believe (that would be a
confirmation bias, to be sure)—make an effort to tackle that which is strange
or conceptually difficult in this book, to honestly understand where it is
coming from, and then find how it fits into the elements of the market you are
focused upon (your “single thread”) as you see fit.
For me, the single thread that runs through this book—and through my
understanding of markets—is twoply. (To be fair, commentators see
Confucius’ single thread, or i-kuan, as two-ply as well: it emphasized the
related concepts of zhong, or loyalty, and shu, or empathy.) Personally I
emphasize the narrative of my own life and the flow of water.
Throughout these pages, readers can learn more about my personal
journey. The quantitative methods and risk-management lessons I learned
taking bets as a young (ahem) sports aficionado; the discipline and attention
to detail I picked up in the US Marine Corps; and the countless steps and
missteps, visions and revisions—each one a learning experience—I have had
in my career as a trader. The totality of these have contributed to my single
thread, the way I piece together markets. They have, I believe, led to my
continuous refinement and improvement as a trader.

27
 More than my personal journey, however, I would like to emphasize the
other element of the strand—the flow of water. Water for me is a potent
metaphor for my life, as I have flowed from one role to the next, not initially
knowing where I would end up (though I would have it no other way). Water
flows through the crevices of my life in unexpected ways, seeping in and
bubbling up when least expected. The US Marines, a component of the US
Navy, are closely identified with water. It was the Marines that brought me
overseas to Asia, where I learned to speak some Chinese, some Japanese, and
some basics of Eastern philosophy. That includes another fundamental
Chinese philosopher, Lao Tzu.
Lao Tzu, the founding father of Taoism (and someone who dedicated his
life’s work to contradicting Confucianism—but, hey, The Global Macro
Edge embraces multiple views, there is no one right way to go about the
markets or life) wrote in Chapter 8 of the Tao Te Ching that the greatest good
is like water. It flows to the points of least resistance, adapts to all
impediments and changing circumstances, keeps its rhythm steady, remains
persistent, and acts at the right time.
I believe that the greatest traders are like water, as well, as they have
embraced all of those virtues. This is why I have named my strategy
described throughout this book the “Protean Strategy.” Its namesake, Proteus,
was an ancient Greek sea god capable of changing form at will, with all the
versatility of water, and the word “protean” now means something capable of
assuming many forms. Throughout this book, the virtues of adaptability when
appropriate are expounded—a market practitioner must evolve with all the
fluidity of water when necessary. At other times, one must remain firm—but
not fragile—emulating another aspect of water (anyone who has ever done a
belly flop from a great height will know what I am talking about).
At other times still, market practitioners must think of themselves as
seamen, charting the vast oceans of global markets. There are warm, limpid
pools that are easy to navigate (but perhaps lacking depth or fish) and deep,
brackish waters with unimaginably exotic creatures below. Different climes
and different waters call for different approaches—the Caribbean schooner
needs a different skillset than the Arctic icebreaker, the sailor must know the
surface, and the submariner must master the blind depths. It is hoped that as
readers flow over the pages to follow, they will get a feel for many different
waters, some far beyond their comfort zone.

28
Why Are We Writing This Book?
The single biggest goal that I share with the contributing authors is to
recalibrate how you assess information, opportunity, and (especially)
performance in the markets. We wanted to create a blueprint for how you
may look at every aspect of not only your performance, but the performance
of any trade, strategy, portfolio, market, or third party on a return per unit-
of-risk basis.
The markets are a beautiful thing that have created wealth and abundance
for many people. However, at the time this book was published, the
establishment on Wall Street continues to be in need of some dramatic
reforms. As a global industry, the financial sector hosts some of the most
creative and talented minds on the planet. To the extent that any critiques are
leveled, it is our hope this book provides a template for dialogue toward
innovating the industry we love so dearly.
As a US Marine Corps veteran and lifelong entrepreneur, I am a strong
believer in self-empowerment. In the years leading up to the release of this
book, tremendous strides were made through regulatory efforts to bring
greater confidence to investors by putting in safeguards to improve the
transparency and integrity of the markets. An equitable marketplace—one
that rewards innovators and those with real investment skill, rather than those
relying on the ability to manipulate markets or trade on inside information
—is critical for having a fair chance at success. Likewise, it is also critical in
order to keep attracting capital, which can then be committed to productive
use (investment in the right equity leading to technological breakthrough;
investment in the right commodity incentivizing more production; lending in
the right place leading to new projects, new jobs, and new possibilities). The
market perception of equality serves as a foundation for committing long-
term resources to the process of investing. However, the single biggest
factor that compels one to earnestly commit resources, even more so
than a strong sense of fairness, is the authentic sense of opportunity. This
feeling of opportunity is fostered by educating oneself on how markets work,
developing confidence in one’s ability to interact with them successfully, and
—most importantly—a bona fide process to benefit from this knowledge
and confidence.
Some sensationalists have suggested the game is “rigged.” Some of those

29
comments have come from individuals who have minimal market expertise
and, more importantly, even less experience producing consistently positive
returns. I believe, unequivocally, thanks to appropriate regulation and
significantly expanded access to high-level market insight, the markets
have never been more balanced, more ripe for opportunity, more open to
a diverse group of participants.
For example, in the book Flash Boys, by Michael Lewis, the author takes
aim at the inefficiencies of Reg NMS, writing that only sophisticated entities
such as high-frequency trading firms and banks with dark pools are poised to
take advantage of them. I believe that the core of Lewis’s argument does
address the issue of inefficiencies in the market. However, where he and I
differ is the availability of those inefficiencies. Lewis argues that because
those specific inefficiencies are only available to a select few, the game of
investing in the market is “rigged.” It is my contention, as someone who has
generated superior risk-adjusted returns over several years (my performance
is on full display for readers in Chapter 3), the overall market is inefficient,
and the opportunities created from this state are far from exclusive. In
my experience, the primary barrier to entry is knowledge (and certainly not
access, or a starting account of unobtainable riches, or connection to insiders
willing to provide illegal-to-trade-upon information). A lack of knowledge
can always be rectified through education. This education need not come
from schools—in my lifetime, I have also been educated by mentors, books,
military deployment, news articles, conferences, idea dinners, people of all
walks of life, art, psychology, philosophy, serendipity, and rigorous
observations before/while/after actually trading.
The Global Macro Edge will outline opportunities in many different
aspects of the market. The following chapters will outline the process used to
discover and benefit from them. It is my goal by writing The Global Macro
Edge that, instead of perpetuating a sense of melancholy about some falsely
perceived lack of upward investment mobility, we empower readers to take
action and help reconfigure how they approach their investments.
I will do this by walking readers through the process that I, an individual
who has never had a job on Wall Street, used to responsibly and
incrementally utilize a risk budget of $100,000 to generate over $3 million in
profits for myself over a six-year period from 2010 through the end of 2015.
These results are verified from my brokerage statements by an established
third-party auditor in Chapter 3. All of this trading was done from my living

30
room, hotel rooms, and other places I was able to port my trading
workstation. It is my hope readers will conclude the game is inefficient and
ripe with opportunity, but far from rigged.
More importantly than just sharing my results and experiences, The
Global Macro Edge will provide detailed solutions to solving the problems
many investors are confronted with on a day-to-day basis. Some of this
includes very granular concepts such as how to understand market
positioning and how to build a dynamic compensation structure for a third-
party financial professional. Other problems we address are broader in scope,
such as the best ways to optimize a portfolio based on risk.

31
What Is The Global Macro Edge?
It is important we set the frame for key terminology. Therefore, below I
will cover key terms and phrases you will see repeatedly throughout this
book so that we, as authors, and you, as the reader, are clearly
communicating.
What is global macro investing?
The traditional definition is as follows:
Global macro investing is generally understood as the structuring of
trades based on large-scale themes tied to global economic, political,
fiscal, and monetary policy events. These themes (broad-based narratives
that explain trends and families of events occurring globally) are derived
based on forecasts, the outcome of data releases, and the interconnectivity of
global events. The themes can be used both to predict events, and as a filter
through which to understand them.
The application of global macro trades has traditionally taken place on a
large scale (one requiring such a prohibitively large amount of capital and
staying power that it was reserved for a select few individuals, such as hedge
fund legends George Soros, Paul Tudor Jones, and Lewis Bacon). These
trades were executed in a hedge fund structure, typically with billions of
dollars in assets under management (AUM). At the time, it was understood
these thematic bets may require staying power of months or even years and
could, at times, induce tremendous volatility (this was welcomed by many
institutional and high net worth investors in order to achieve the outsized
gains they so coveted).
However, as we send The Global Macro Edge to press in 2016, these
impressions of global macro are largely nostalgia. Global macro investing,
just like the markets, has evolved considerably due to a multitude of factors.
In the 1980s, 1990s, and early 2000s, the information that was driving these
trades was available only to a select group of individuals. Rapid network
collections and the democratization of financial data and research means this
information is now accessible to the masses. Globalization has created a
swath of financial news sources, social media outlets, and inexpensive
research available on the Internet. This information has created a new
balance, changing global macro investing from a long-term strategy focused
on large thematic bets, to being woven in the day-to-day price action of every

32
asset class at every price level. The markets eat, breathe, and run on global
macro themes, and price action can change significantly in the minutes after
an item of global macro significance is released—be it an economic report,
an offhand policy comment by a central banker, a trade embargo, or an all-
out act of war. The interconnectivity of the world has melded global macro
investing philosophies into all other investment philosophies to the point that
they are inseparable.
Whether it is the impact of shale oil on crude prices and commodity
currencies, the Swiss National Bank removing their bids in the EUR/CHF
currency in January 2015, a 25 percent correction in Chinese equities, or a
surprise jobs report in the US, the awareness of these events by the broader
investment community has never been higher.
Everyone, in some sense, is a global macro investor. However, some
distinction must be made: there are two types of global macro investors
in the world. The first type is the individual who takes a step back and
attempts to incorporate the narrative into their process. This type of
investor makes efforts to sense the sea and shoreline when far out at sea.
Having gotten the best lay of land and water possible, this investor charts a
course to navigate to a desired location. The second type of investor is one
who is impelled by global macro events (as all market participants are)
and is forced to respond accordingly. This investor may or may not realize
his fate and portfolio are tied to global macro events, and certainly makes no
attempt to account for them before the fact. Caught in the middle of the sea
with no land in sight, this investor seeks only to continue sailing—to keep the
ship from sinking when a sudden storm hits (instead of avoiding it), to enjoy
the bounty of the sea when he comes by chance upon a school of fish (instead
of seeking them actively), and to hope that provisions never run out before
land is stumbled upon. The Global Macro Edge is intended to teach you to
become the first type of investor.
Global macro to me is more than just attempting to incorporate
fundamental drivers into my trading. Global macro, and the title of this book,
The Global Macro Edge, encapsulate my journey from being a trader who
relied on charts and reading headlines to one who learned how to listen to a
story. I learned to listen to a story that provides insight as to how effective
certain strategies would be in certain environments. I learned to listen to a
narrative that stresses why it’s important to place more emphasis on what
others are thinking and likely to do rather than being so consumed with what

33
I thought should happen.
Ostensibly, The Global Macro Edge entails combining the underlying
macro narrative with robust trading strategies and dynamically allocating to
them based on their probability of success in the current market regime. In
actuality, The Global Macro Edge is the ability to listen…

34
What Is a Unit-of-Risk (UoR)?
Whereas the main title of this book, The Global Macro Edge, digs into
my soul as a trader, the subtitle, Maximizing Return Per Unit-of-Risk, serves
as a solid outline of my day-to-day approach and perspective on the markets.
This approach embraces the hundreds of years of collective market
experience shared by the contributing authors and myself. This approach
insists on context. Good context comes from having a framework to measure
performance. This context is the unit-of-risk.
A unit-of-risk, or UoR™, is the predetermined amount one is willing
to risk on a trade, strategy, or portfolio. Simply stated: it is your risk
budget. There are many ways to determine what an appropriate UoR should
be. This book will walk you through both quantitative and qualitative tools to
outline the process that I use to determine the UoR for any investment.
Having this ex-ante figure provides a dramatic advantage from most
conventional methods, which simply look at returns on a nominal level or ex-
post analysis that analyzes after-the-fact returns relative to after-the-fact
volatility (i.e., the Sharpe Ratio, Sortino Ratio, standard deviation analysis).
The difference is tantamount to having a game plan in advance, a set rubric
by which to measure success, a signal to others of expectations of success (as
it truly involves putting one’s money where one’s mouth is), rather than just a
new vocabulary to describe what has already happened and a continuing hope
that the past will resemble the future. The Netto Number, a proprietary
ratio I created to measure return per UoR, provides critical context that
demonstrably alters how we assess an investment and can materially
change how to evaluate investment skill.
Therefore, when I use the term “maximizing return per UoR,” I am
referring to how well an investment is performing on a volatility-adjusted
basis relative to its predetermined risk budget.

35
The UoR™ Process
One of the things ingrained in me from both trading the markets and
writing a massive tome on global macro over a five-year period is “risk
taking with process leads to success, while risk taking with impulse leads
to regret.” The more I can create and crystalize a repeatable process, while
leaving flexibility for my intuition, the greater the chance I have for success.
The UoR™ Process is the rigorous quantitative and qualitative approach
to every aspect of my investing from operations, analytics, and execution.
The UoR Process is bespoke to each individual and consistent with his or her
objectives, resources, and investment acumen. Maximizing return per unit-of-
risk is more than ascertaining what direction the market is heading. It is also
about taking nothing for granted and leaving no stone of alpha unturned on
the journey.
The UoR Process is comprised of the following:

1. An understanding of the market environment or the regime;

2. The ability to understand and choose the right strategies for that
environment/regime;
3. The ability to implement and execute these strategies with the help of
technology, best customized practices (this is not just encompassing
efficient practices, but effective practices, and ergonomic ones tailored
to individual traders), and proper infrastructure.
With that in mind, the structure of this book is designed to walk you
through these three critical phases in order for you to assimilate the UoR
Process into your own portfolio.

36
Structure of the Book
Conventional investing asks, “What was my return?” The Global Macro
Edge asks, “What was my return per unit-of-risk?” The Netto Number
provides a versatile quantitative tool for answering this question. However,
the return per UoR process does not stop at boiling things down to a single
number, as one must also understand the context of one’s return, which
entails a range of qualitative elements. Market positioning, the macro
narrative, and an array of idiosyncratic factors are also part of ascertaining
the viability of an investment on a return per UoR basis. Therefore, in order
to give you the skills to answer this question, The Global Macro Edge
centers on five aspects:

1. Performance
2. Collaboration
3. Regime Recognition
4. Strategy Creation
5. Implementation
The forthcoming excerpts in this chapter will give a brief primer on these
five aspects to set the stage for teaching the process of maximizing return per
UoR.
Lastly, as there are a number of contributing authors, the protocol for
understanding who is writing is as follows: For every chapter there is a
contributing author, the contributing authors name will be next to the title. I
will then lead off the chapter with an introduction describing my relationship
with the author and outlining how this chapter fits into the UoR process. To
mark the end of my writing and segue the contributing author, I will use
an italicized signature: John Netto.
For example, Jason Roney is the author of Chapter 4. His name appears
next to the chapter title: “More Risk Doesn’t Always Equal More Return by
Jason Roney.” I begin the chapter with some introductory comments and
finish those comments with my signature. Jason then begins from there.
On chapters without a name next to the title, I, John Netto, am the author.

37
Performance
Emphasizing the importance of maximizing return per unit-of-risk,
collaborating within a network, and incorporating “regime-appropriate”
strategies are noble. However, if you do not have the numbers to show you
have successfully translated all of that into real market gains, then your story
becomes imprisoned in its concept phase. Therefore, before the book outlines
the three-phase UoR Process of Regime Recognition, Strategy Creation, and
Implementation, Chapter 3 will break down the performance of my personal
trading from January 1, 2010 until December 31, 2015.
I hired Michael Coglianese, CPA, P.C., from an independent, third-party
auditing firm, to do an account verification of my performance and write a
report to include in The Global Macro Edge: Maximizing Return Per Unit-
of-Risk. Mike Coglianese is a well-known and highly respected alternative
investment CPA, with extensive background in the futures industry, based
out of Bloomingdale, Illinois. At the conclusion of the firm’s examination,
they issued a four-page report, which is included in Chapter 3. The report
outlines the process they used to independently verify the performance I
am representing from my personal accounts throughout the book.
The report shows that from the six years (72 months) from January 2010
to December 2015, I traded a $1 million nominal level ($1.5 million in 2015)
to generate over $3 million in profits. As Chapter 3 will show through
various institutional analytics and a sophisticated regression analysis, I
generated these profits with minimal correlation to the S&P 500.
Chapter 3 also highlights my performance on Collective2.com. This third-
party web portal serves as an aggregation tool for portfolio performance
tracking, signal generation systems, system developers, and subscribers to
systems. I created an account there and began running the “Protean System”
in February 2015. (As noted throughout this book, I call this strategy
“Protean” and myself a “Protean Trader” because my tactics and methods are
fluid and constantly adapting.) Aside from having a reputable CPA verify my
personal performance, I also wanted a way for the readers of this book to be
able to go to the site and see the actual time-stamped trades I made.
Collective2 has the technology to take the trades from an account I trade live
and, within seconds, both auto-trade and send a signal via email to
subscribers. The fills are my actual live fills. As we went to press in 2016,

38
Collective2 nominated me Strategy Developer of the Month based on the
performance of the Protean Strategy.
The Protean Strategy on Collective2.com provides a different level of
ongoing transparency that a static report cannot. It is my hope you can see the
extensive lengths I have gone to in order to be as transparent as possible
regarding my performance from multiple, independent third-party sources. It
is critical to me that you, the readers who are going to commit substantial
energy and time in absorbing the content in this book,4 have every reasonable
assurance the author driving the message has used these techniques
successfully.

39
Power of Collaboration
Whether it was my eight years in the US Marines, day-to-day sharing of
information with colleagues about the markets, or writing The Global Macro
Edge, I have always accomplished the most when working as part of a team.
Investing is a game that rewards the best hunters. Moreover, the best hunters
work in packs.
Case in point: to most people’s surprise, the true apex predator of the
ocean is not the great white shark (however formidable the Jaws movies may
have made them seem). Instead, it is the killer whale.5 There are three factors
to killer whales’ success: they are incredibly social and communicate well;
they pass on skills and knowledge to their offspring; and they hunt in packs.
This synergy, this ability to preserve and build upon intellectual capital and to
coordinate strategy contributes to the killer whales’ high return per unit-of-
risk when they hunt. Does this ring a bell when we think about the strengths
of the greatest apex predator on land?
As an aside, when killer whales do face off against sharks, they commonly
end up killing them by flipping the shark upside down. That is a very potent
metaphor when thinking about where you sit in the market food chain—
as comfortable as your positions are, as powerful as your trades have been in
the past, can your P&L be flipped? Are you a lone shark, trying to tackle the
enormity of the markets on your own, or are you part of a greater network of
distributed brainpower and analytical ability, tackling the mysteries in
tandem? Are you reinventing the wheel every day, or are you relying on the
wisdom filtered through the ages, built up by generations of traders? Are you
taking this wisdom and applying it rigidly, or are you adding to it, modifying
it as markets change? Are you versatile enough to learn from others, work
with others, and adapt when necessary?
My ability to grow as a student of the markets and amass the information
presented in this book was only possible by building a network of diversified,
innovative, collaborative, and forward-thinking individuals who were willing
to share their knowledge. Over twenty veteran traders, analysts, and portfolio
managers made material contributions to this book, collectively representing
500 years of market experience. I could have attempted to write this book on
my own, but it would not have been as rich, detailed, or instructive. I am
forever grateful for the team of market practitioners who made this literary

40
work possible.

41
Phase I – Regime Recognition
The first phase of the Unit-of-Risk Process is Regime Recognition. Being
able to understand which strategies have the best chance of success starts
with being able to identify the regime you are trading. A regime is the
technical and fundamental environment of the market. These two parts,
the fundamental and technical, provide a blueprint for what strategies and
tactics may be the most effective. On the fundamental side of the regime are
things like monetary policy, economic data, geopolitical risk, and
government policies. The key technical parts of a regime include implied and
realized volatility, correlation, volume, price momentum, and the current
return per UoR of that market.
For example, if we are in a low implied volatility technical regime and
you believe this will continue, then that is a key factor when considering
what strategies to use. Different asset classes may be going through different
technical and fundamental regimes at the same time. While at other times,
various asset classes will trade in a very congruent regime profile.
This analysis is critical because one of the biggest problems inhibiting
investors’ performance is the inability to assess which regime is in place.
Incorrect regime assessment can lead to putting in place strategies that
have a lower likelihood of success, thereby subjecting a portfolio to
unnecessary asymmetrical risks. It is critical to efficiently deploy your risk
units, and Phase I of this book will share with you a broad array of tools from
leading market practitioners to accomplish this.
The five chapters in Phase I – Regime Recognition will achieve this in
the following way:

42
Chapter 4 – Jason Roney – More Risk Does Not Always Equal More Return
Jason Roney is my trading mentor, and his thought process for
approaching the markets from a regime perspective had a powerful impact on
my trading success. Jason will walk through the process he used to run the
Global Macro Desk at a renowned Chicago prop firm and now his own CTA,
Bluegrass Capital Management. He will explain why not all risk is the same
and the process he uses to define the market regime.

43
Chapter 5 – John Netto – Unit-of-Risk Ratios—A New Way to Assess Alpha
While there are traditional technical and fundamental methods of
identifying what the market regime is, I will introduce seven proprietary
ratios I use to look at the market on a return per UoR™ basis. This gives me
deeper insight on what regime is driving things and contributes to a nuanced
approach to deploying strategies. This chapter will introduce the UoR™
Strategy Grid. This shows how I incorporate the current regime, both
qualitatively and quantitatively, into the UoR Process. Lastly, I will explain
how I created the Netto Number, its inputs, and its application in regime
assessment.

44
Chapter 6 – Raoul Pal – Identifying Inflection Points in the Business Cycle
Raoul Pal, writer of The Global Macro Investor newsletter, will outline
how he ascertains where we are and likely to head in the business cycle.
Shifts in the business cycle have a tremendous impact on asset flows and can
be a harbinger for potential changes in market regimes. Raoul will cover the
process he uses to analyze and advise his clients on the dynamic nature of
changes in the business cycle.

45
Chapter 7 – Fotis Papatheofanous – Identifying Capital Flows in Global Markets
Having the ability to spot and maneuver around capital flows in the global
markets can be tremendously beneficial in maximizing return per UoR. Fotis
Papatheofanous provides an excellent overview not only of which global
indicators best track asset flows, but how to analyze and incorporate them
into your process.

46
Chapter 8 – John Netto – Creating an Environment for Identifying the Regime
The final chapter of Phase I illustrates how I bring all of the information
discussed in the previous chapters into one integrated process. I walk through
how I use research, my Unit-of-Risk Process, desktop layout, daily routine,
and an exhaustive look at how to build a trading plan incorporating the UoR
Strategy Grid.

47
Phase II – Strategy Creation

The Protean Strategy

The Protean Strategy is the formal name for my discretionary investment
approach of dynamically allocating to strategies I feel will best maximize
return per UoR given the current market regime.
The word “protean” is an adjective meaning:

1. readily assuming different forms or characters.

2. adaptable.
3. (of an actor or actress) versatile; able to play many kinds of roles.
This single word best encapsulates the way I trade the markets. I am not
predisposed to one outcome, only willing to be open-minded about the future
market movement. The value in being highly versatile, easily adaptable, and
able to take on many shapes and forms is the cornerstone of my trading ethos.
Therefore, it would make sense that I am using multiple strategies to varying
degrees based on the fluid nature of changing market regimes.
I take a great deal of pride in the Protean Strategy being completely
discretionary. I use my experience at reading market developments in real
time to trade how I believe the market will act. I use a wide array of tools and
position structuring to do this via futures, options, Forex, synthetic spread
between products, and stocks. As I will go into great detail over the course of
this book, I combine the underlying macro narrative, market positioning,
economic and policy catalysts, and my proprietary technical indicators to
guide my buy-and-sell decisions.
My ability to assess the macro narrative and apply the right strategies for
the right environment is the determining factor in my success or failure. My
application of the strategy is not for the faint of heart and is very active.
The Protean Strategy aggregates strategies that fall into the following
three buckets:

Technical
Fundamental
Sentiment

48
Technical Trading Strategies
The single most important factor in my decision-making process is price
action. This has been the case since the days of my first book, One Shot –
One Kill Trading: Precision Trading Through the Use of Technical
Analysis, and will always be the cornerstone to how I view opportunity. As
someone whose trading roots descended from listening to the story the charts
tell us, over the years I have developed a number of technical trading
strategies to exploit these dynamics. These will be expounded upon over the
course of the book. Below are some of the technical trading strategies I use.

Fibonacci
Market Profile
Elliott Wave
Mean Reverting
Trend Following
Support and Resistance
Inflection Point
Relative Value
Options Strategies

49
Fundamental Trading Strategies
While I always incorporate and analyze the charts before putting on a
trading strategy, the incorporation of strategies driven by fundamentals is a
great complement to a solid technical trading approach. Catalyst trades that
look at events that may cause a market repricing and option positions around
certain macro regimes are just a few examples of the fundamental strategies I
commonly employ in the Protean Strategy. All of these fundamental
strategies use some aspect of the macro narrative and underlying economic
analysis to generate their signals:

Catalyst Trades
Options to Trade Macro Regimes
Central Bank Policy Decisions
Political / Fiscal Policy Events
Earnings Announcements
Special Situations

50
Sentiment Strategies
Sentiment strategies are a vital element in the Protean Strategy’s success,
as they help determine where we are in the life cycle of a trade. Sentiment
strategies harness my ability to incorporate general market feelings on
varying time scales and how those feelings are influencing positions. I have
spent a lot of time developing market positioning models, as well as
strategies that can leverage the information of those models.
Sentiment

Trading Market Positioning

Bullish/Bearish Sentiment Positioning
The final point about Strategies in Protean and a part of the UoR process
is an important one. Regardless of whether a strategy falls into the technical,
fundamental, or sentiment category, all strategies I adopt adhere to four
criteria:

Ability to operate within a risk budget

Liquid instruments that trade on an exchange
Technology can measure, monitor, and optimize them based on their
return per UoR
Takes place in a transparent structure, giving me total control of my
capital
These above criteria are self-explanatory and straightforward. The idea is
if I can’t control the risk, get out when things are going bad, measure how I
am performing in a certain regime, or have access to my account (this is
applicable to an outside allocation), then I am already relinquishing some of
my edge.
I often use leverage when I blend and execute these strategies, sometimes
at considerable levels, based on their non-correlation and probability of
success. One of the fastest things that can blow someone up is concentration
risk caused by a change in a variety of factors. Therefore, having a strategy
meet those criteria is non-negotiable.
The seven chapters of Phase II – Strategy Creation will cover the
aforementioned points in the following way:

51
Chapter 9 – Bill Glenn – Chassis of the Financial Markets
A core component of the Protean Strategy is having a keen understanding
of the US and global treasury market. Bill Glenn, my close friend and
treasury market mentor, will explain the numerous machinations, parlance,
and nuances of the treasury market, as well as his day-to-day process for
maximizing return per UoR in this asset class.

52
Chapter 10 – Joe DiNapoli – DiNapoli Leading Indicator Techniques for Trading
Global Markets
Joe DiNapoli is the godfather of Fibonacci. His book Trading with
DiNapoli Levels, first published in 1998, is a treasure and to this day is still
the foundation of my technical trading approach. Joe will walk through his
trading process for creating robust trading levels applicable in any market
landscape. These techniques provide a great framework to successfully trade
the macro markets.

53
Chapter 11 – Todd Gordon – Understanding Animal Spirits Using Elliott Wave
Principles
Todd Gordon has developed his own discipline of Elliott Wave analysis
that strongly influences what technical strategies I apply in different market
regimes. His skill set is critical in using the charts to define the size of a risk
budget before putting on a trade. Todd shares how he uses Elliott Wave
Principles to define inflection points and how this price action narrative is
used in maximizing return per UoR.

54
Chapter 12 – Neil Azous – Using Options to Trades the Macro Narrative
Neil Azous, author of the Sight Beyond Sight newsletter, is always
teaching me something new about not only the macro narrative, but also
innovative ways to take on defined risk through creative trade structuring.
One of Neil’s tools he shares with his subscribers is the use of various
options structures that judiciously incorporate technical and fundamental
factors. Neil will walk readers through the art and science of structuring
options trades around market events and the macro narrative.

55
Chapter 13 – Patrick Hemminger – Dirty Arbitrage: Spread Trading Asset Classes
Around the World
Relative value strategies—i.e., going long one market while
simultaneously shorting another market—are an active part of the Protean
Strategy from both an analytical and execution perspective. While many in
the investment public do not expansively discuss many of these strategies,
they are tremendously popular in the professional community to the point
where an entire industry is built around them. Their risk profile and potential
to be non-correlated to other strategies in the alternative investment space are
also big factors in the appeal. Patrick Hemminger, a seasoned spread trader
from Chicago and longtime colleague, will share with you his tactics.

56
Chapter 14 – John Netto – Mean Reversion Strategies – The Trend Isn’t Always Your
Friend
Mean Reversion Strategies tend to benefit from markets that are relegated
to a trading range. The penchant of these strategies to be non-correlated can
be a nice diversification tool to maximize return per UoR, particularly when
markets become range bound or whippy. Collaborating with Robb Ross, a
CTA who runs a number of Mean Reversion strategies, and Darrell Martin,
President of Apex Investing, I will walk through the inputs and process I use
when creating various mean-reverting strategies.

57
Chapter 15 – John Netto – Finding the Follow-Up Trade to a Catalyst Event
The Protean Strategy has a number of diverse and non-correlated ways of
maximizing return per UoR. In this chapter, I collaborated with a longtime
colleague who trades the second and third derivative companies after a key
event. Also known as Supply Chain Trading, this strategy will provide a
complementary and necessary bottoms-up approach to trading a top-down
macro event. This is important, as in the years leading up to the publication
of this book, large cap companies like Facebook, Amazon, Netflix, and
Google (collectively, FANG) comprised a greater portion of Large Cap
Equity Indexes. Therefore, it is critical that every macro trader develop
bottom-up analytical skills and strategies that can profit when events around
single-name stocks can reverberate through the rest of the market.

58
Phase III – Implementation
Ultimately, how much the reader gets out of this book will be determined
by what they can incorporate into their own investment process. Phase III of
the book aims to combine the skills learned in Phases I and II to integrate into
your own process focused on maximizing return per UoR.
When contemplating how to structure this phase of the book, I wanted to
focus on the things that had the greatest impact on both my market-related
and non-market-related returns. Things like how I built my network,
automated my processes, gathered data for regime analysis, measured my
intuitive and emotional states, as well as constructed a portfolio of strategies
around a risk budget.
The seven chapters that comprise Phase III – Implementation are as
follows:

59
Chapter 16 – Bob Savage – Diversification Isn’t Enough—Spotting the Paradigm
Shift
While diversifying a portfolio should theoretically be straightforward, this
is not always the case. Bob Savage, CEO of Track Research, will walk you
through an overview of building a stress test, as well as a number of
qualitative techniques to identify blind spots to even the most “diversified”
portfolios. He will share a number of real-world, actionable solutions to
better anticipate potential event shocks to your portfolio and bona fide
processes to help prevent them.

60
Chapter 17 – Jessica Hoversen – Trading the Economic Calendar: A Qualitative and
Quantitative Approach
Understanding how markets and strategies perform in different
environments is essential when deciding what strategies and the degree of
leverage to use. Jessica Hoversen will go through her process for aggregating,
analyzing, and assimilating data for event and regime studies. This ability to
draw on historical context has a huge influence on what tactics and position
concentration I use in the Protean Strategy.

61
Chapter 18 – John Netto – How to Quantify and Visualize Market Positioning
Market positioning and the macro narrative are two pillars of the Protean
Strategy. I share how I model in the Market Positioning Premium, and outline
my introspective way of connecting the dots when understanding the macro
narrative. The chapter also contains the “Cognitive Empathy Grid,” which
illustrates how one can visualize the market ecosystem and how those in it
may behave.

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Chapter 19 – John Netto – Emotions Are Our Greatest Ally, Not Our Biggest Enemy
This chapter is very special to me. I share in these pages my journey of
emotional and intuitive development, as well as its importance on my P&L. I
worked very closely with Denise Shull, author of Market Mind Games, to
combine both the latest in neuroscience research with how to apply it to real-
world trading examples. The Fear of Missing Out (FOMO) Spectrum will be
introduced as a way of understanding your profit potential based on where
your emotional balance is.
This chapter will also introduce the TAPx test that provides a takeaway
for those wanting to understand what their intuitive strengths and weaknesses
are. This is very useful for readers in both assessing their own risk profiles
and their ability to empathize with fellow market participants.

63
Chapter 20 – John Netto – The MPACT! of Automation
Automating one’s investment business can take on many forms. I will
walk you through how I, running a virtual trading desk from my living room,
used automation to improve my operations, analytics, and execution. I will
share with you how I used UoR Software to help me identify what strategies
were doing well and define my market edge. I will also walk you through the
things I learned from creating my own proprietary event risk management
execution system “MPACT!” and “MPACT! Portfolio Simulator.” This
journey cost a lot of money and was laden with numerous mistakes.
However, this tuition need not be repeated, as I will share with you the
lessons I learned and how it helped further strengthen the UoR Process.

64
Chapter 21 – John Netto – Risk Budgets – The X Factor in Investing
One of the most luminous points of The Global Macro Edge is that
investment performance should not only be taken in context to its volatility,
but the predetermined risk budget as well. The Netto Number is a proprietary
risk ratio that gives investors the tool to do this. I will walk you through how
assessing, managing, and allocating based on a risk budget and the Netto
Number may considerably improve your portfolio construction process.
Implementing these techniques is a key takeaway in the Unit-of-Risk Process.

65
Chapter 22 – John Netto – Paying for Returns in Context: Manager Compensation
Based on Return per Unit-of-Risk
The last chapter of the Implementation section addresses a problem for
many investors and money managers. For as good as it may be to use all the
tools in this book to make an allocation to a money manager based on return
per UoR, if you don’t have a compensation structure that pays them based on
this metric, then you have potentially undermined the entire process. In this
chapter, I will walk you through my Risk Factor Compensation system,
which uses the Netto Number to fairly pay a higher incentive fee to managers
who maximize return per UoR, and a lower incentive fee to those who do not.

66
How Does the Reader Benefit?
It is hoped that readers of The Global Macro Edge will benefit through
exposure to ideas, approaches, and even the nitty-gritty of daily processes
that are not given in any kind of academic finance textbook (which certainly
involve themselves with the theoretical minutiae of markets, but not with the
daily realities of trading) nor in most literature on trading. My coauthors and
I have pieced together these approaches throughout our entire careers—not
just from classroom learning, but from real-world experience, mentoring
from other experienced professionals, sharing notes with colleagues, trial and
error, and a constant commitment to thinking about how to attain a Global
Macro Edge. It is rare that you will find a book on how to structure trading
screens or a discussion of where to find alternate sources of information (and
different ways to digest that information).
The intention is that novice market practitioners will be able to jump-start
their own systems by culling from the rich assortment of processes and
approaches contained within. Experienced market practitioners will also
benefit from having the ability to compare alternate methods (useful in
thinking about how to evolve their own trading, or even just in understanding
other market practitioners), and to integrate practices described in this book
into their own systems. Collectively all readers will benefit from
incorporating techniques into their process which allow them to look at the
market through the lens of return per unit-of-risk.
There are three distinct segments of market participants for whom this
book should be helpful: investors, money managers, and advisors.
Investors (Self-Directed Individuals, Family Offices, Endowments,
Pension Funds): Investors who recalibrate their ideology and approach their
investments from a “Return per Unit-of-Risk” perspective have the potential
to receive tremendous benefit from this book. The adoption of a three-
dimensional approach to managing capital will redefine who in your
investment ecosystem is providing value, how needed their services are, and
what it is appropriate to pay them.
From reading this book, investors will acquire skills to have cogent,
confident, and informative conversations with money managers and
colleagues. After reading this book your ability to analyze the
appropriateness of a manager, strategy, or financial service professional

67
should improve considerably. Investors should have a deeper, more nuanced
sense of what things to look for when speaking with a manager or running a
strategy internally.
Money Managers (Hedge Fund Managers, Asset Managers,
Proprietary Traders): Money managers should have the tools to attract
investors by defining a more compelling value proposition. This happens by
incorporating the regime analysis tools in Phase I, enhancing your strategies
with the content in Phase II, and improving your business processes with the
implementation techniques outlined in Phase III. Managers can more easily
impress investors and win allocations by evolving their business into one that
can demonstrate a complete process for maximizing return per UoR.
Advisors (Registered Investment Advisors, Third-Party Consultants,
Financial Service Professionals, etc.): Advisors will have the ability to win
AUM by differentiating themselves from their competition through the
incorporation of the Unit-of-Risk Process into their business. By doing so,
they can gain a unique understanding into different market regimes, a deeper
knowledge of non-correlated strategies, and a better method for assessing
investment skill. Advisors will be in a better position to meet their clients’
needs. Lastly, once you advise your clients on which strategy or manager to
place capital with, you can provide your client with an innovative incentive
structure to help ensure that they are paying for alpha while not overpaying
for beta. This can help bolster your value proposition beyond its current
station and demonstrate your ability to innovate and be at the frontier of your
clients’ interests.
Fans of shattering long-held misconceptions: Even if you are not
looking to improve the returns of your portfolio, not in a position to manage
client capital more efficiently, nor to deliver innovative insights to those who
do invest, do not worry. You will enjoy the thought-provoking and
unapologetic prose in this book. With any luck, this discourse may inspire
you to think about the myths existing in your industry and a framework for
potentially solving the problems they create.
Whichever category fits you best, we sincerely hope you enjoy our
efforts!

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Summary of Key Terms
1. The Global Macro Edge – the ability to combine the underlying macro
narrative with robust trading strategies and dynamically allocate to them
based on their probability of success in the current market regime.
2. Protean Strategy – John Netto’s discretionary investment approach of
dynamically allocating to a range of technical, fundamental, and
sentiment strategies based on their probability to maximize Return Per
UoR given the current market regime. The performance of Protean is
outlined in Chapter 3.
3. Unit-of-Risk (UoR) – the predetermined amount one is willing to risk
on a trade, strategy, or portfolio. Also known as the “Risk Budget.”
4. Unit-of-Risk (UoR) Process – the rigorous quantitative and qualitative
approach to every aspect of one’s operational, analytical, and execution
methodologies in the investment process.
5. Netto Number – a three-dimensional quantification of the Return Per
UoR of a trade, strategy, portfolio, or manager. Calculated by measuring
how well an investment is performing on a volatility-adjusted basis
relative to its predetermined risk budget. The higher the Netto Number,
the better Return Per UoR. The lower the Netto Number, the worse the
Return Per UoR.
6. Regime – the technical and fundamental environment of the market.
4 I promise I have made every effort to make things as digestible as possible, but I
acknowledge that some concepts are more difficult to internalize than others.
5 http://marinesciencetoday.com/2013/11/22/oceans-toughest-predators-great-white-
shark-vs-killer-whale/

69
CHAPTER
3

70
 Money Does Not Always Find
Its Most Efficient Home
“If you want to go fast, go alone. If you want to go far, go with others.” — African
proverb

The Myth of Absolute Efficiency

Why Show Performance?
Protean Strategy Performance
Accountant’s Verification Letter
Additional Verification of the Protean Strategy Performance

71
The Myth of Absolute Efficiency
One of the stated goals of The Global Macro Edge is to debunk the
pervasive (one might say pernicious) beliefs that investment dollars are
necessarily allocated efficiently, that markets instantly adjust to new
information, and that it is impossible to ever have a true edge. These beliefs
are part and parcel with what academics call the “Efficient Market
Hypothesis” (the “EMH”)—which comes in a strong form (all information,
public and private, is already priced into the markets), a semi-strong form
(information is priced into the markets as soon as it becomes public), and a
weak form (all past trading information is priced into the market, making
technical analysis useless). In my personal experience, I have found that this
theory (or at least a belief in a total, absolute, instantaneous, all-
encompassing efficiency of markets) is lacking. The EMH fails to account for
what actually happens in practice. This is not to say that there is no market
efficiency—there is undeniably a great deal of efficiency in markets—but
there are also many sources of inefficiency that a well-prepared trader or
investor can exploit.
First, we should clear up some terminology. There is an old joke that
efficient market theorists believe that it’s impossible to find a twenty-dollar
bill on the street, as someone else would have already picked it up. This
misses the main point of the EMH, which argues that one cannot consistently
exploit markets—there always must be those lucky enough to get there first,
but the luck of the draw is random. (The joke would also be significantly less
funny if it were restated as “One cannot consistently find twenty bucks on the
street, because it would be snatched up by the first person to see it.”)
However, we can unpack the lost bill example a little more—certainly
people do find twenty-dollar (and ten-dollar, hundred-dollar, one-dollar, etc.)
bills, from time to time. They don’t necessarily find them very frequently, but
they can increase their odds (and thus their expected payout) of finding bills
if they actively look and know where to look. The EMH posits that, if
actively finding bills is a profitable endeavor, people will pile into the
business until it becomes harder and harder to find bills. At the point at which
it becomes “efficient” (that is, the expected payoff matches the cost of effort),
people stop piling in, since it is no longer profitable. If too many have begun
looking for bills (so that payoff is less than cost), then people begin to stop

72
looking for bills; if too many stop looking for bills (so that payoff is greater
than cost), people begin looking for bills again. Once this is in effect, the
EMH holds, bill-seekers are simply subject to the whims of randomness—
some will find more than average (and exceed the expected payoff) and
others will find less, but it all comes down to luck.
That, in a nutshell, is the core insight of the efficient market hypothesis—
the same kind of “efficient” thinking is applied to trading and investing. In
some senses, I have seen it play out in the real world—investors try to pile
into a “sure thing,” and this drives the price so that it is hard to make a
reliable profit. For instance, investors will pile into Treasury bonds until the
rate matches what they believe the payoff should be.
However, in many other senses, the efficient market hypothesis simply
does not hold water. Returning to the bill-seeking example, we can see a
cyclical problem. If bill-seekers pile out when there are too many in the
business, then chances are too many will pile out (it’s not like they’re
coordinating their exits). This creates periods of time when it is profitable to
bill-seek. One must just recognize roughly when these commence and when
these end. Similarly, we can look beyond bill-seeking to seeking other
commodities. While most people are likely to know that a one-dollar bill is
worth $1, fewer people are likely to know the value of a blown-out tire at the
side of the road or the value of a red streak of iron ore in a rock. Yet, there
are businesses that make a great deal of profit scavenging blown-out tires or
finding and mining metals—because of barriers to knowledge, these are
much less likely to attain the critical mass of people to obtain efficiency.
Furthermore, there are commodities lying all around for which the value has
not been realized—crude oil, for instance, was seen as a nuisance to many
landowners before its modern industrial applications were discovered. In
short, sources of market inefficiency are all around.
Throughout the course of my investing history, I have noted numerous
sources of market inefficiency. I have broken these up into Exogenous
Inefficiency, market inefficiency arising from sources outside the markets
themselves, and Endogenous Inefficiency, market inefficiency arising from
sources inside the markets.
Exogenous inefficiency can arise from numerous factors. Political
interventions into markets, and the regulations that arise from them, can skew
how investments are made. For instance, the new Dodd-Frank and BASEL-
III “high quality” capital requirements can lead to banks overinvesting in

73
ultra-safe AAA-rated assets, and underinvesting in other assets. This leads to
opportunities for other market participants not bound by these rules. To give
another example, the political process determined the 401(k) retirement plan
rules, and the limitations on 401(k) investments—another factor that skews
markets.
Similarly, intervention by central banks can contribute to inefficiency—
every time a central bank (such as the US Federal Reserve, the European
Central Bank, or the Bank of Japan) intervenes in markets. Central banks can
unbalance the situation in markets, creating new opportunities for profits until
markets can fully price in the extent of the monetary policy shift.
Exogenous efficiency can also spring from the very technologies that are
used to make markets, to provide information to investors, and to keep the
world moving. It can arise from the constraints that investors place on
themselves, ensuring that some asset classes slip under the radar (for
instance, large-scale pension funds controlling billions of dollars will totally
restrict certain asset classes).
On the other hand, endogenous efficiency is inherent in the very
functioning of the markets themselves. It can arise from a general lack of
knowledge by the investing public (after all, no one is omniscient—we all
work with the pieces of information that we have as best we can) or from
cognitive biases and emotional biases of investors (such as loss aversion,
which discourages investors from entering markets and leads investors to
hold losing securities for longer periods of time out of fear of actually
realizing a loss). For instance, investors can adopt a herd mentality,
temporarily overselling or overbuying an asset all at once.
Endogenous inefficiency can also arise from the simplified approaches
and heuristics that investors have developed to interact with markets. To give
an example—style box analysis does a very good job of grouping
complicated investments into simplified categories, but it can nonetheless
lead to inefficiency. Given the popularity of the system, its simplified
grouping can cause large swaths of investors to overlook factors not
addressed in the style. Taken in aggregate, this skews market values and
creates opportunities for others.
Together, exogenous and endogenous inefficiencies lead to a great deal of
gaps in the markets, subject to sudden price shifts or readjustments when
information shifts. It is up to skilled traders and investors to identify these
gaps, to interact with them, to figure out just how markets are inefficient in

74
any given market regime and in any particular point in time.

75
Why Show Performance?
The Global Macro Edge was written as a postmortem to my process of
solving problems that face many traders and investors. As such, I feel it is
essential to show my actual performance rather than hide behind vague
allusions to how well I have done in the markets. The goal of showing
performance is threefold:

1. Provide a further critique of the idea of absolute market efficiency by

demonstrating that, in the years leading up to the publication of this
book, I have been able to profit from the markets with a great deal of
consistency.
2. Demonstrate, through the independently verified performance of my
personal account, that I have wrangled successfully with the markets and
that the insights I present (or curate, in the case of the interviews) within
these pages come from a position of experience.
3. Begin illustrating that the process of blending together a portfolio of
non-correlated, risk-controlled strategies within a structure for enforcing
a risk budget may be a viable solution that is scalable for most investors.
Throughout these pages, as I explain the Global Macro space and I outline
my projections for the next generation of investing, it is important to me that
readers know this is what I do to support myself and my family. I live off my
own portfolio. I gain when it gains and I lose when it loses. Poring over the
array of global markets and ascertaining which direction they will move has
been my full-time job. As a result, I take trading very seriously, and must
approach it with the utmost level of discipline—it puts food on my table, a
roof over my head, and gas in my car. I am also acutely aware that the
markets can take those things back if I fail to treat the process of risk
management with all the respect that it deserves.
My goal in presenting my personal performance is not to try to reproduce
the returns I produced in my account from 2010–2015. Those are all specific
to a time and place—changing market conditions, contexts, decisions, etc.
make replicating the performance of my account very difficult. Nor is the
goal to parade out profit and loss (P&L), with no additional context, in order
to gloat over past triumphs. Instead, The Global Macro Edge advocates that
investors adopt a repeatable and scalable process of quantifying, managing,

76
and optimizing their portfolios based on return per unit-of-risk (stated simply,
how much am I risking to achieve a targeted return).
Having access to the ideas, strategies, insights, and technologies laid out
in these pages will help provide a framework for most readers to make an
informed decision about the right course of action for them. I have always
been a person who could best manage expectations if I clearly understood the
task required. As I will outline in this chapter, the creation of my investment
process was the result of brutal—often painful—experience, not necessarily
great insight. It required me to push myself out of my comfort zone, while
continually looking to evolve. I have no doubts that I still have a great deal to
learn about the market and trading. I have seen too many traders start
drinking their own Kool-Aid and then get smashed with a huge drawdown. I
speak for the group of authors involved in this book when I write that we all
feel learning about the markets is an ongoing process, which will continue for
as long as we are involved in the markets.

77
Protean Strategy Performance

Disclosure
While the book leads off with a disclosure, some things are worth
repeating:
The Global Macro Edge: Maximizing Return Per Unit-of-Risk was
published for informational, educational, and entertainment purposes only,
and should not be construed as an offer to provide investment advisory
services nor to buy or sell any securities, futures, options, or currencies. The
information in this book is provided “as-is” and is not guaranteed to be
complete or current. No representation is being made that the use of this
strategy or any system or trading methodology outlined in this book will
generate profits. Past performance is not necessarily indicative of future
results. There is substantial risk of loss associated with trading securities,
options, and futures—a trader may lose all or substantially all of his capital.
Trading securities is not suitable for everyone. Futures, options, and currency
trading all have large potential rewards, but they also have large potential
risks. You must be aware of the risks and be willing to accept them in order
to invest in these markets. Do not trade with money you cannot afford to lose.
Again, the past performance of any trading system or methodology is not
necessarily indicative of future results.

78
Verified Performance
In the lead-up to the publication of The Global Macro Edge, I have had
my trading performance from January of 2010 through December of 2015
independently verified against FCM statements by a certified public
accountant.
This was done as part of a larger audit of compliance with CFTC
Regulation 4.35—a set of rules designed by the Commodities and Futures
Trading Commission (CFTC) to ensure fair presentation of performance
information in a disclosure document, and includes such requirements as
displaying at least the past five years of performance; giving the time frame
and percentage loss of the worst peak-to-valley drawdown; and displaying a
table or bar graph of accurate rates of return. Note that I am not a
commodity pool operator (CPO) nor a commodity trading advisor
(CTA), nor am I otherwise bound by Regulation 4.35. However, I
voluntarily complied with it for the purposes of the audit to facilitate
presenting my performance in a fair, accurate, and verifiable manner.
Michael Coglianese CPA, P.C.—the firm that performed the verification
—is well-known throughout the investment space for performing NFA-
compliant audits on CTAs and other market participants. The firm was
founded nearly three decades ago by a former NFA compliance auditor, and
it is staffed by specialists who previously served as regulators or audited at
the Big 4 Accounting firms.
Below is the independently verified composite monthly performance of
the Protean Strategy, culled from several trading accounts. Performance from
the trading account for Netto Trading LLC is given from January of 2010
until May of 2010. In May of 2010, I purchased an Index and Options
Membership (IOM) Seat and became a member of the Chicago Mercantile
Exchange. This significantly reduced my fees and, from that date through the
time of publication, I have traded in this account. In August of 2013, I added
a second personal account, which I have continued to trade through the time
of publication. In January of 2015, I added a third personal trading account,
which I have also traded through the time of publication.
The recalibrated monthly nominal value from January 2010 to
December 2014 was $1 million (aggregate across all accounts). From
January 2015 through December 31, 2015, the time of publication, the new

79
monthly recalibrated nominal value was $1.5 million (aggregate across all
accounts). The starting risk budget (maximum drawdown before a
cessation of all trading in a strategy—see the discussion in Chapter 5 and
21) was initially set at $100,000 in January 2010. The percent gains in the
report confirm the starting risk budget of $100,000 netted over $3.13 million
in profits over the following six years based on the nominal investment
percentage returns. Below is a capsule of the absolute dollars made each
month.

Below are the returns presented in compliance with CFTC Rule 4.35 that
were verified in the below report.

80
Accountant’s Verification Letter

81
82
83
84
Descriptive Statistics

Figure 3.1
The above chart gives the cumulative returns of my personal portfolio
from January 1, 2010 through December 31, 2015.6 In this time period, the
portfolio returned 298.27%, for returns of 49.71% a year.7 At its worst,
portfolio drawdown based on monthly returns was 15.34% (from September
through December of 2015). This information falls into greater relief as we
examine some of the descriptive statistics applied to the daily returns.

Figure 3.2
The mean (average) return is roughly 0.19% a day. As can be seen in the
chart, even a relatively small amount of profit on average each day can add
up to quite a bit over time, if delivered consistently.
The standard deviation of about 1.18% is a measure of the volatility of my
portfolio. Had the portfolio been normally distributed (we will see in a
moment why it is not), this would have meant that roughly 68% of all daily
returns fall within one standard deviation of the mean (0.19% ± (1 * 1.18%)),

85
so they would fall between -0.99% and 1.37%. In a normal distribution,
roughly 95% of all daily returns would fall within two standard deviations of
the mean (between -2.17% and 2.55%), and roughly 99.7% of all daily
returns would fall within three standard deviations of the mean (between
-3.35% and 3.73%). Although the normal distribution assumption does not
hold, we can still use the standard deviation as a rule of thumb to assess
volatility.
Both the high kurtosis and positive skewness of the daily returns indicate
deviance from a normal distribution scenario.8 The high kurtosis of about
35.5 (anything above three is considered high) indicates a high-peaked
distribution of returns, with most returns grouped tightly around the mean but
also a relatively large amount occurring in the extreme edges of the tails (fat
tails). The positive skewness of the portfolio of about 1.47 indicates that
positive outliers tend to be farther from the mean than negative ones. Put
another way: positive skew means the big days tend to be bigger, and the
losses tend not to be as extreme. Careful risk management, as examined later
in The Global Macro Edge, is crucial in maintaining positive skew.
Taken together, what does a positive average, high kurtosis, and positive
skew mean? It indicates that the majority of daily returns are positive (since
they are clustered more tightly around a positive number). The data backs this
up, as only 498 of 1,507 trading days examined showed losses. The Protean
Strategy pursues this kind of balance—when I trade, my intention is always
to act when I feel I have better than 50-50 chances.
The capital asset pricing model (CAPM) regression against the S&P 500,
given below, yields some interesting results. This regression was
accomplished by comparing the daily returns of my portfolio (less a risk-free
rate9) to the daily returns of the S&P 500 (less the same risk-free rate). The
Alpha coefficient indicates returns independent of any relationship to the
benchmark. This means that, no matter what the S&P 500 does in any given
day, my portfolio is expected to produce 0.186% of positive return in that
day. This is at a 99% level of statistical significance (the P-value, the measure
indicating the probability that the data may be inconsistent with this alpha
reading, is extremely small, at 1.14 * 10-9). The annualized Alpha of 40.90%
indicates that the CAPM regression projects my portfolio should earn roughly
41% each year before counting for the effects of its relationship to the S&P
500. According to the efficient market hypothesis, these kinds of returns
should not be possible (or at least not reliably possible).

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 Figure 3.3
The Beta coefficient, on the other hand, indicates a -0.021 relationship
with the S&P 500—meaning that, in addition to any Alpha generated, my
portfolio should also experiences a 0.021% loss for every daily gain of 1% in
the S&P 500, and a 0.021% gain for every daily loss of 1% in the S&P. This
negative relationship is consistent with the negative correlation to the S&P
500, but note that the high P-value of about 0.49 indicates that this
relationship cannot be asserted with any level of statistical significance. In
fact, examining the rolling correlation of my strategy to the S&P, below,
shows that the relationship has been quite inconsistent over time. The Protean
Strategy puts a great premium on changing its approach when necessary—
just as the Greek god it took its name from was able to change his form at
will—so this inconsistent relationship is no great surprise.

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 Figure 3.4
Generating Alpha with negligible correlation to the S&P 500 indicates
that there could be a great deal of diversification effects from mixing my
portfolio with other investments (e.g., the S&P 500). It also reassures me that
my portfolio is defensive, in that it remains—on the whole—unrelated to
what is going on in the general equity markets. It has the potential for
positive returns even when the S&P 500 crashes significantly.
In interpreting these returns, it is worthwhile to note that monthly data is
just too slow to give a fully accurate picture. The preponderance of sub-
strategies and concentration of capital to those sub-strategies ebbs and flows,
and cannot always be represented in a matter of months. The correct period to
measure performance may literally be a matter of days or weeks. When it
comes to incorporating a new strategy into my trading account, there are
times I will take an incremental approach, slowly easing into a strategy as it
proves itself effective, while other times given the current regime and the
implied probability of its return per UoR, I will use substantial leverage.
This process of sizing is a major contributor to the performance.
Furthermore, in examining these figures—no matter how positive they
may seem—it reminds that there is never truly such a thing as “good enough”
in trading. After accounting for various operational expenses (see below),
taxes, and living expenses of a bicoastal lifestyle in NYC, Santa Monica, and
Las Vegas, the net profit falls fast. Although I averaged roughly $575k gross
profits per year from 2012 to 2015, with an average Netto Number of 5,10 I

88
am always striving to do better. Furthermore, let us also not forget I am
risking 100% of my own money. As such, I must be ever vigilant about
protecting my risk capital. After all, in business, it really is not what you
make, but what you keep. This is why the Protean Strategy is constantly
evolving, and why I am also assessing new approaches to maximizing return
per UoR.

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Expenses
As impressive as I hope these returns are, I would like to be totally
transparent in order to give the clearest possible picture of just what went into
generating them. Please keep in mind that, during the majority of the time
from 2010–2015, I was a full-time trader who spent a substantial amount of
my day either trading the markets, researching trade ideas, or curating content
for The Global Macro Edge. It is important to understand the rough annual
costs that went into creating these returns. Below is a rough estimate of those
costs:
Estimated annual expenses per year from 2012–2015

Item/Service Cost
Bloomberg Terminal $25,000
Membership Seat Leases $18,000
Third-Party Research $80,000
Book Creation $17,000
Infrastructure Investment $100,000
Accounting $10,000

Total About $275,000 per year

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Additional Verification of the Protean Strategy
Performance
It is my strong belief, as The Global Macro Edge goes to press in 2016,
that we are in the nascent stages of a democratization in the asset allocation
business. The decision to invest in a manager—usually the result of a laundry
list of style box constraints—will undergo a major transformation. Manager
talent will be sourced in much different ways in the years to come when
compared to the past. Web portals like Collective2.com, investfeed.com, and
fundseeder.com will be important third-party verification venues for trading
talent. Increasingly, market participants without a Wall Street pedigree or the
operational infrastructure critical to earning allocations have the opportunity
to display their talents on an apples-to-apples basis across all strata of their
money management brethren.
One of my most aspirational “aha” moments was when I discovered that
the process of allocating capital is rife with inefficiencies. I learned
substantial allocations by large institutions were not necessarily based on
what manager could generate the highest return per unit-of-risk, but more
about CYA11 investing protocol. Allocators were not necessarily seeking the
absolute best investment but, instead, the investment they could best justify to
their bosses and investors. If an investment in a hedge fund with a storied
history of success blows up, at least it’s defensible. However, if an
investment with a manager from a nontraditional background, a start-up, or in
a relatively obscure strategy suffers, it is easy for those in power to question
the decision to invest in the first place. There are allocators with control over
trillions of dollars in assets who figure it is better for their careers to jump off
a cliff with the crowd than invest in some newfangled, odd-looking flying
device.
This revelation was a game-changer for me. If substantial amounts of
money are not allocated in the most effective way, this helped explain to me
why certain opportunities would appear in the markets and provided the
opportunity for wealth transfer.
Let us return to our earlier discussion of the efficient market hypothesis,
which entailed looking for dollars on the street. While the majority of
institutional investors embrace selling tried-and-true methods of obtaining a
profit (like picking up bills off the asphalt), they seem to have intentionally

91
overlooked more controversial methods (like picking up blown-out tires).
This leaves many more opportunities, and more potential profit, for those
willing to embrace new methods.
So how might this change in the future? And does the current system of
harvesting manager talent present opportunities? It is my strong feeling that
third-party manager portals are a huge reason why opportunities for investors
have never been so abundant and the playing field has never been more level.
Given my prediction of a changing asset allocation landscape and my
desire to provide as much transparency as possible, I am including screen
shots of my Collective2 performance to help illustrate my point about market
inefficiency and to give readers a sense of how this paradigm shift is
unfolding.
Therefore, besides showing my account information through a letter from
a third-party CPA, I also wanted to show third-party references that someone
could verify at their own leisure. I ran a strategy on Collective2.com—an
online automated system for evaluating and backtesting various trading
strategies—throughout much of 2015 (February 11, 2015 – December 31,
2015). I also have used fundseeder.com (cofounded by well-known financial
writer Jack Schwager, a strong inspiration of mine) to track my performance
by importing trades directly from daily account statements sent by my broker.
In the case of my trading on collective2 and fundseeder.com, real trade
data from the source futures broker. To follow the Protean Strategy live or
gain more understanding, please visit this link:
https://collective2.com/details/92462952
At the time we went to press in 2016, Collective2 claimed to have 18,000
traders and 55,000 strategies, and this figure promises to keep growing.
Having to search through this much information can be both daunting and
full of opportunity. The 2010s are the decade of big data, and this is
undoubtedly the case when it comes to sorting through strategies. Those
who can best aggregate, organize, and assimilate data will ultimately be
the winners. For the readers of this book, it is my goal to empower you to
assess a strategy on a return per unit-of-risk basis, as well as understand how
the strategy fits in with the current market regime. If you can accomplish this,
you may uncover some great opportunities to find a star manager or system at
an early stage.
To help achieve this goal of finding great strategies, Collective2 offers a
feature called “the Grid.” It allows you to input specific parameters in

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searching through the vast library of strategies available. Figure 3.6 illustrates
just how robust The Protean Strategy was during this time. I ran a scan of
all the available strategies on Collective2 based on the following:

1. Sharpe Ratio above 2.5

2. Sortino Ratio above 4
3. Calmar Ratio above 5
4. Annual return greater than 20 percent
5. Max drawdown less than 20 percent
6. Minimum of 50 trades
7. Minimum of 100 days old
Of these seven parameters, four strategies emerged from the entire
database—including my own Protean strategy. Of those four strategies, as
Figure 3–6 illustrates, Protean was the only one that was “TOS” or “Trades
Own System.” It receives this designation because I trade an account at Gain
Capital, facilitated by Anthony Giacomin through his brokerage firm Stage 5
Trading. The trader interface sends my trades directly from my trading
portal to Collective2.com’s order matching system, which is configured
to route orders for any followers who are subscribing to “Protean.”
Based on those (admittedly self-assigned) parameters as of last search on
December 31, 2015, Protean was truly one of a kind.
This (Figure 3.5) is the first screen shot of the Protean Strategy which
was offered on Collective2.com in 2015. I set it up on Collective2 with an
eye toward the publication of The Global Macro Edge, as I wanted to run a
shadow strategy accessible to any person interested in getting a better
understanding of how I apply the tactics in this book. This figure grabs the
performance through the end of 2015. I regard this as another viable third-
party verification to go along with the letter from the accounting firm in the
earlier section of this book.

93
94
Figure 3.5

Figure 3.6

95
Disclosure to Collective2.com Performance
Because Collective2 utilizes simulated or hypothetical performance, even
more disclosure is necessary when displaying their results. What follows is
the Collective2.com disclosure found on the Protean Strategy’s page at
https://collective2.com/details/92462952
Past results are not necessarily indicative of future results.
These results are based on simulated or hypothetical performance results
that have certain inherent limitations. Unlike the results shown in an actual
performance record, these results do not represent actual trading. Also,
because these trades have not actually been executed, these results may have
under- or overcompensated for the impact, if any, of certain market factors,
such as lack of liquidity. Simulated or hypothetical trading programs in
general are also subject to the fact that they are designed with the benefit of
hindsight. No representation is being made that any account will or is likely
to achieve profits or losses similar to these being shown.
In addition, hypothetical trading does not involve financial risk, and no
hypothetical trading record can completely account for the impact of financial
risk in actual trading. For example, the ability to withstand losses or to adhere
to a particular trading program in spite of trading losses are material points
which can also adversely affect actual trading results. There are numerous
other factors related to the markets in general or to the implementation of any
specific trading program, which cannot be fully accounted for in the
preparation of hypothetical performance results and all of which can
adversely affect actual trading results.

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Material assumptions and methods used when calculating results
The following are material assumptions used when calculating any
hypothetical monthly results that appear on the Collective2.com website.

Profits are reinvested. We assume profits (when there are profits) are
reinvested in the trading strategy.
Starting investment size. For any trading strategy on the
Collective2.com site, hypothetical results are based on the assumption
that you invested the starting amount shown on the strategy’s
performance chart. In some cases, nominal dollar amounts on the equity
chart have been re-scaled downward to make current go-forward trading
sizes more manageable. In these cases, it may not have been possible to
trade the strategy historically at the equity levels shown on the chart, and
a higher minimum capital was required in the past.
All fees are included. When calculating cumulative returns, we try to
estimate and include all the fees a typical trader incurs when
AutoTrading using AutoTrade technology. This includes the
subscription cost of the strategy, plus any per-trade AutoTrade fees, plus
estimated broker commissions if any.
“Max Drawdown” Calculation Method. We calculate the Max
Drawdown statistic as follows. Our computer software looks at the
equity chart of the system in question and finds the largest percentage
amount that the equity chart ever declines from a local “peak” to a
subsequent point in time (thus this is formally called “Maximum Peak to
Valley Drawdown.”) While this is useful information when evaluating
trading systems, you should keep in mind that past performance does not
guarantee future results. Therefore, future drawdowns may be larger
than the historical maximum drawdowns you see here.

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Trading Is Risky
There is a substantial risk of loss in futures and forex trading. Online
trading of stocks and options is extremely risky. Assume you will lose
money. Don’t trade with money you cannot afford to lose.

98
Conclusion:
Now that we have gone to incredible lengths to be as transparent as
possible, let’s learn how to maximize return per unit-of-risk.
6 These returns are presented for informational, educational, and entertainment
purposes only, and should not be construed as an offer to provide investment advisory
services nor to buy or sell any securities, futures, options, or currencies. Neither John
Netto nor The Protean Trader, LLC is registered as an investment advisor with any
regulatory authority (including the SEC, CFTC, FINRA). The information in this book
is provided “as-is” and is not guaranteed to be complete or current. Past performance is
not necessarily indicative of future results.
7 Given that the portfolio is reweighted monthly to a nominal value ($1 million
through 2014; $1.5 million through 2015) rather than reinvested, cumulative returns are
expressed arithmetically rather than geometrically. Geometric (or compounded) returns
would have reflected a reinvestment assumption. Past performance is not necessarily
indicative of future results.
8 Although the normal distribution assumption does not hold, we can still use the
standard deviation as a rule of thumb to get a general idea of volatility.
9 In this instance, the daily yield on a ten-year U.S. Treasury bond.
10 See Chapters 5, 21 and 22 for a more in-depth discussion of Netto Numbers.
11 For the uninitiated, that’s the Cover-Your-Ass protocol.

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 PHASE I

Regime Recognition

100
CHAPTER
4

101
 More Risk Does Not Always
Equal More Return – Jason
Roney
“Simplicity is the ultimate sophistication.”—Leonardo da Vinci
With less than an hour to go before hosting a live trading
webinar for CQG, there was one final piece of preparation
vital to expelling the remaining butterflies from my stomach—
a powwow with my trading mentor, Jason Roney. “Short yen
will be the trade of 2013” rolled confidently off Jason’s
tongue. His nonchalant nature and matter-of-fact macro
analysis was the perfect pep talk before making myself so
vulnerable.
Our daily correspondences about the market, along with
the impending book deadline, necessitated a trip to the Windy
City for some face time at Jason’s office. The impersonal
nature of monochromatic off-white trading desks, proliferated
with stacks of flat panels as far as the eye can see, was a
deceptive façade for the diversity of personalities, skills, and
approaches put to work every day at The Chicago Sun Times
Building, where Jason was set up. A 20-foot radius of Roney’s
workspace could not help but leave one impressed: to his
right, a fixed-income specialist provided insight on why the
yield curve is flattening; behind him sat Tim Colby, an options
whiz trolling for more efficient ways to structure Jason’s
macro views. Prepared for sudden inspiration, a superstar
quant was perched behind him to help systemize Jason’s
ideas. Agriculture, energy, and metals ideas banter around
this cadre of traders intermixed with talk about sports, kids,
and pop culture. More subtly, but just as powerful, were the
Instant Message networks over Bloomberg, Skype, and AOL
pinging to hear Jason’s insights on the recent rally in
emerging markets.
For as forward-looking as Jason and his group of traders
may be, they are also deferential and appreciative of those

102
who have helped them through their journey. While working
on Jason’s chapter in September 2013, a convoy of us left the
trendy office digs to head crosstown to the Chicago Board of
Trade. The purpose was to see Bill McKenna, Jason’s mentor,
and arguably one of the best short-term macro traders in the
world. With the momentous appointment of Ben Bernanke’s
successor looming, as well as a decision on how the Federal
Reserve would begin to unwind their asset purchases, there
was plenty of conversational fodder.
This is what truly inspires Jason, President of Bluegrass
Capital Management (a commodity trading advisor), and it is
why his market acumen is only surpassed by his enjoyment of
seeing others succeed. For Jason Roney, the endgame is to be
around passionate and talented individuals who understand
that sharing ideas, energy, and insights can markedly improve
one’s own results. As my mentor, Jason has impressed upon
me the need to incorporate regime analytics into my trading
and shared with me a tremendous amount of information
responsible for the richness of this book.
Though he is not celebrated like other multibillion-dollar
hedge fund managers in the press, Jason Roney’s “street
cred” is nonetheless well established. He has a strong
reputation in the Chicago proprietary trading community as
someone whose methodical approach encompasses some of
the most robust aspects of fundamental, technical, and
sentiment analysis in all of the global macro space. This is
corroborated by the launch of Jason’s commodity trading
advisor firm, Bluegrass Capital Management, which began
running outside capital in the third quarter of 2014. Despite
starting with less than $5 million in AUM, the following 21
months would see AUM increase over twenty-fold to more
than $110 million by Q2 of 2016. This is an astonishing feat
considering the difficulties the majority of emerging CTAs has
in raising money. It was our good fortune that Jason was able
to write the lion’s share of this chapter before he ascended to
such prominence.
Therefore, when looking to bust the six myths outlined at

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the onset of this book, Jason Roney’s chapter is an essential
read. His “Regime” approach to the markets will be outlined
in this chapter and will, in the process, show how “not all risk
is created equal.” The material will help provide a framework
for investors and traders who are looking to employ their risk
units in the most efficient manner.
—John Netto

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Overview
Spending many years in Chicago overseeing a proprietary trading group
has helped me remain constantly aware of the biggest driver defining our
success or failure: how well my team maximizes return per unit-of-risk.
As I used to tell all of my traders, not all risk is created equal. This chapter
takes the same tack when it comes to busting the myth that more risk equals
more return. Many people take on risk in the markets without fully
understanding the fundamental, technical, and sentiment dynamics
behind the investments they are making. As such, not every unit risked is
symmetrical.
Asymmetries in the market are abundant. I will outline the tools I use in
my “Regime” approach to identify them and assess the markets on a return
per UoR basis. What I love most about trading is the cerebral gymnastics that
goes into connecting the dots. The answers are not always readily apparent,
but for those who probe enough, some great opportunities await.
Figuratively and literally, trading for me has been a journey and an
evolutionary process. My journey began as a broker in 1994, and my
evolution began when I was blessed enough to work with Bill McKenna at
Sharmac Capital. Bill is an omniscient trader. He was my mentor and
responsible for many “aha” moments throughout my career. Bill was, and
remains, dedicated to market relationships. Markets don’t move; they are
moved. Sometimes correlations are high, sometimes low, but there is always
some relationship moving markets.
In the 1990s Bill stressed the importance of watching transportation and
trading the S&P 500 futures accordingly. It worked until it didn’t—therein
lies the beauty of a marketplace that is inherently a fluid, perpetually
changing organism.
Aside from being a proponent of how markets are intertwined and the
significance of understanding relationships, McKenna was a savant at
spotting the next relationship. His intuition of both individual market
movements and their collective impact as the result of some shift in
macroeconomic policy bordered on clairvoyant. Through repeated successes
on such drivers as Internet stocks, biotechs, and European sovereign spreads,
I learned how understanding macro relationships provided an indispensable
barometer for assessing risk.

105
 When you are on top of which relationships are driving the markets, you
are in a position to define your risk in a much more granular manner. Many
market participants take on exposure unaware of which ancillary factors
impact the performance of their investment and, as a result, subject their
portfolio to unnecessary volatility. This underscores the first myth The
Global Macro Edge busts in that More Risk Equals More Return. As this
chapter will show, it is smarter risk that can equal more return.
There are four overarching factors I focus on to maximize my return per
unit-of-risk:

Top-Down Macro View

Regime Recognition
Opportunistic Trading
Event-Driven Catalysts
When you approach the market using a Unit-of-Risk (UoR) process, you
will not only understand why your risk units are making or losing money, but
also how to deploy them in a more effective manner.

106
Top-Down Macro View
Understanding why not all risk is created equal begins with a strong
foundation of what macro drivers are in the market. Trying to sort through
the abundance of information in hopes of understanding all of the nuances of
the macro universe can be daunting. As a big believer in “less is more,” I
have distilled the process down to looking at some key economic indexes.
Some of these indexes are widely available and others are ones I have custom
made. Both of these factors help form my quantitative view.
My first read on the macro landscape always starts with the numbers, or
my quantitative analysis. As this part of my analysis provides statistical
context, I use some very straightforward indicators to assess the global and
regional economic landscape.
My qualitative macro analysis focuses on what headlines will move the
market and potentially change the perception about the trajectory of the
economy. These two approaches combine to form the salt and pepper to all of
my trading meals.

107
Quantitative Macro Approach
Two factors go into my quantitative macro approach. The first is a general
assessment of current conditions. The second is the recent trend of data. If
both current conditions and data trends are positive, then I am looking for
openings—technical spots to play these markets long. If both current
conditions and data trend are weak, then I am looking for spots to get short
those markets.
As a person who gets a great deal from global fixed income and currency
markets, one of the first things I assess is where real yields are for each
country. Another key quantitative fundamental input is the set of current
economic conditions. Real yields and economic conditions can be a great
starting point for understanding how real money may be positioned. For
example, if real yields are lower than the S&P 500 dividend yield, asset
allocators as a function of balancing portfolios will probably be bidding for
equities in this environment.
As such, I have a current conditions dashboard that goes into defining my
overall regime. I put employment, retail sales, GDP, CPI, and inventories on
commodities. If a market has positive current conditions and positive trend,
then managers are likely buying and vice versa.
For example, the biggest backdrop in 2013–2014 was that the real yield
on the Dow stocks was much higher than real yields on a number of assets.
The BOJ and ECB helped compound this problem.

108
 Figure 4.1 – Eco Results
The second factor I use to get a sense of the data trend is the set of
surprise indexes. This helps contextualize how a market may react to any
given news flow. The market may be at -20 on the surprise index irrespective
of whether the unemployment rate is at 10 percent or 5 percent. These
surprise indexes do a great job showing the recent trend of market surprises
or disappointments.
Specifically, I use the set of Citigroup surprise indexes to track this second
component, which one can get for different regions of the world (US, Europe,
Asia, South America). One of the reasons I use these particular metrics can
be seen if you overlay a very basic three-period moving average and ten-
period moving average on any of these charts. When the shorter term three-
period moving average is above the ten-period moving average, it’s a pretty
safe bet that most money managers will have to be long those markets.
However, this is obviously not an end-all-be-all strategy—when economic
times are good, it is very hard for managers to not justify being fully
invested.
The Citi Surprise Indexes in and of themselves, are not something I can
trade as a standalone indicator. However, they do a good job of providing a
framework to understand the trend of any given region. They reflect how an
economy is performing relative to expectations, where a positive reading
means data releases have been stronger than expected, and vice versa.

On Bloomberg, you can type:

Name Identifier Command
Citigroup Economic Surprise Index – United CESIUSD <INDEX>
States <GO>
Citigroup Economic Surprise Index – Eurozone CESIEUR <INDEX>
<GO>
Citigroup Economic Surprise Index – Asia CESIAPAC <INDEX>
Pacific <GO>
Citigroup Economic Surprise Index – World CESILTAM <INDEX>
<GO>

109
 Figure 4.2 – Citi Economic Surprise Index with 3-Period & 10-Period Simple
Moving Average
Along with the Citi Surprise Index charts, which illustrate the current data
trend, I also create a custom chart that includes the top three to four data
points in each country (see Figure 4.3). This chart illustrates the current
economic conditions. The idea is that if global economies are expanding,
money managers will be forced to allocate their capital. Conversely, if the
economies are exhibiting secular weakness, then money managers will likely
be more tight with their capital.

110
 Figure 4.3 – Custom Chart of Initial Jobless Claims, Durable Goods, Retail
Sales, and ISM Manufacturing Overlaid on Top of S&P 500
The last quantitative factor I look at is how short-term rates are trading
relative to dividend yields of major market indexes. Like the Citi Surprise
Index, this is not meant to be a standalone indicator but it does give some
context of how allocation metrics may be playing out. If the dividend yield of
a respective market is higher than the underlying short-term government debt,
this is something that can be supportive as we saw from 2010 to 2015. The
chase for yield helped keep a structural bid in the S&P 500.

111
Qualitative Macro Approach
Having a strong macro view is the right blend of art and science. Whereas
my quantitative macro approach is more reactive to empirical evidence, my
qualitative approach is more anticipatory. In other words, whereas the basis
of my quantitative macro view relies upon numbers from indexes which have
posted data that is already known, my qualitative process anticipates how
markets will react. This qualitative process is where a lot of the robustness in
my trading process exists and helps me maximize return per unit-of-risk.
While I am not looking to build a long-term position that can last for
months at a time, knowing what events can shift sentiment can create the
opportunity to earn outsized gains as the market can move in a non-linear
way in the short term. Because I can usually identify which relationships are
and are not moving the markets, I can apply some basic technicals for entry
and exit.
Analyzing qualitative macro relationships is no surefire way to
maximizing return per UoR. The mistake of many traders who trade
perceived market relationships is their propensity to get married to the idea a
macro relationship will persist. This can be a challenge for a lot of relative-
value strategies, which traded based off of a historical correlation only to see
the introduction of a new driver that materially alters things. Therefore,
deference to price is always the prime consideration when both initiating
and managing risk.
While there are individuals who do extremely well at specializing in a
single market, for my trading style, I have found that the more markets I
follow, the more relationships I can identify. From there, once I understand
what is moving markets, I feel very confident in trading with that edge.
Understanding relationships demands you have a firm grasp of the key
macro drivers and how sentiment influences both today’s trade and future
trades. There are many ways to accomplish this, and here are some of the
methods I use.

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Third-Party Research
Like many market participants, I gather research from multiple sources.
However, 80 percent of the stuff I read comes from only a handful of places.
The reason for this is straightforward, as I have found I am most effective
when focused on just a few things. Therefore, consolidation is an integral part
of maintaining that focus.
The research that best complements my process appreciates the present
with an eye towards the future. As a money manager, I am always trying to
be proactive. Therefore, research needs to strengthen that anticipatory
disposition. Whereas much of the mainstream financial media and
editorializing on Wall Street is about rationalizing what just happened, I
am preparing for what is about to happen. To accomplish this and stay in
sync with the macro narrative, I look for research to do three things:

Provide specific ideas with a clear plan of action

Show a pathway of how large money managers are viewing the
economy
Keep me apprised of economic data and its significance on market
perspective
While these three things can be cherry-picked from various places,
Pantheon Macroeconomics, run by Ian Shepherdson, is my go-to source to
find them all. Pantheon’s U.S. Economic Monitor is a daily newsletter and the
keystone to my entire research process. Ian Shepherdson’s economic analysis
and forecasts are used as inputs in many of my trading models that
incorporate fundamentals. I have integrated Ian’s rigorous process, unbiased
analysis, and clairvoyant economic predictions into technical trading systems
that benefit from having a quantitative macro overlay. I have the confidence
in both the independence of Ian’s opinions and his economic acumen to place
such importance on his numbers.
He has earned such high regard because for years Mr. Shepherdson has
aggregated, distilled, and explained an array of arcane economic information
to myself and a close niche of institutional clients. He takes the abundance of
economic information and drills it down into a concise format that I can read
and assimilate in under ten minutes a day. Whether I was heading the global
macro group at a prominent Chicago proprietary trading firm or running a

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CTA, Pantheon Macroeconomics has been a great ROI on my research
dollars.
Here is an example highlighting how Pantheon provides me with all three
of the things I am looking for in a research product. Irrespective of what a
policymaker, central banker, or Wall Street analyst says about the economy,
Ian Shepherdson goes to exhaustive lengths to size up the actual data. This
reliance on empirical analysis underscores Ian’s perspective that is
encapsulated in the famous quote from renowned statistician William
Edwards Deming, “In God we Trust, all others bring data.”
For example, despite Janet Yellen and the US Federal Reserve coming out
with very dovish rhetoric in late January 2016, suggesting it would be hard
for the economy to hit its inflation targets, Ian applied his thorough analysis
and explained to his subscribers over many weeks why the Fed was
underestimating the potential of hotter numbers. This served as an excellent
backdrop to provide liquidity in February 2016 to a market that was pricing
in a higher risk of recession. Ian argued his case with ample graphs, charts,
and economic analogues that gave me the confidence to position myself for a
mispricing in the US Treasury market.
During this time, the January and February US Consumer Price Index
(CPI) showed Core CPI was running at 0.3% in back-to-back months for the
first time in 15 months. Ian dissected the CPI components and explained why
the parts of CPI causing the uptick were likely to persist and that the Fed and
OIS market was potentially behind the curve. This level of detail is important,
as the CPI has numerous inputs with a myriad of interpretations. If the CPI
was hot but the inputs causing the rise were perceived as transitory, this
reverberates much differently through the market than if the strength in those
components are likely to persist.
Therefore, immediately following important economic releases and policy
decisions, it is critical to understand as quickly as possible what part of the
data was strong or weak. And Ian is the best I have seen at contextualizing
the high-frequency economic data. My team then updates our models with
this context to stay fluid with the most recent information. Ian does this over
Bloomberg Chat and via email within minutes of any major release.
It has taken years for me to understand how to spot research that provides
an edge and even longer to integrate that research into a repeatable and
scalable process. At the center of that process is Ian Shepherdson and his
team at Pantheon Macroeconomics.

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Networking
Along with third-party research, I use my personal network to connect the
dots. As a result, I can better define the real risk to my positions, have a
deeper understanding of what is moving the markets, and comprehend how
the animal spirits of the market are behaving. Understanding both the verbal
and nonverbal aspects of communicating with various sources is a practice
that can yield tremendous dividends.
For example, understanding who in your network is in the flow of the
market, who is stuck in a position, who is drinking too much of their own
Kool-Aid, and who specializes in certain market conditions is critical.
Sometimes the pace at which a person IMs me can help me understand their
relative excitement compared to the pace of how they may normally
communicate a message. If a person IMs me six single-line comments in
rapid-fire succession, this is a different level of excitement compared to the
same message in only one IM in a paragraph. Being able to pay attention to
the subtle clues of your network can provide tremendous value. These are all
factors helping me further contextualize and create a robust qualitative
assessment of the macro landscape.
A good network encompasses three tiers. The first tier consists of the
handful of people you talk to almost every day. This group of three to five
individuals is your base and fully integrated into your system. It is important
to keep it at this level because you need to manage information and keep
things simple. In my case, I have most of these people sitting around me to
share ideas during the day. I also communicate regularly with John Netto,
who specializes in trading around major economic and policy events. I want
to see how he is positioned, where he thinks the market will move, and which
products may present some opportunity.
The second tier of my network consists of people I correspond with at
least once every two weeks, usually via an IM or email. The information
exchange is certainly less than with my first tier, but still important to help
form context. An example of this person may be someone from Wall Street
who helps me execute or a hedge fund colleague with a unique perspective on
a market move.
The third and final tier of my network consists of the rest of my contacts. I
may go months without correspondence but may come upon an event where I

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either want to share something or vice versa. This can help when certain
geopolitical risk comes to a specific region, or I need to understand
something more esoteric.
We as humans are meant to hunt in packs, and my network is an
essential component to maximize return per unit-of-risk.

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Regime Recognition
The word “regime” is one of the most important key terms cropping up
throughout The Global Macro Edge, but I am aware everyone has their own
definition. I define “regime” as the total market environment
encapsulating all pertinent fundamental, technical, and sentiment data
for a particular market or asset class. The ability to recognize which
regime is in place is arguably the most important part of my process and the
primary cause for why a majority of strategies underperform.
Multiple problems can arise from not accurately identifying which regime
is in place. The biggest of these is having a profit-and-loss profile that has
you risking more to make less because the tactics you are using are not
appropriate. This asymmetrical position exposure, or not being fairly
compensated for the risk you are taking, is a material factor for why more
risk does not always equal more return. Investors may be playing the
wrong markets in the wrong regimes and, as a result, could be risking more
absolute dollars for lower implied returns.
For example, the macro regime in place in the United States from 2009 to
2014 was one of incredible central bank accommodation. This period will be
viewed in history as the golden age of passive investing. This was an
environment where those looking to deploy capital in strategies benefitting
from volatility had a completely different risk profile than a portfolio that
combined trend following, mean reversion, and option-selling strategies.
From 2015 to early 2016, the market entered a regime that has more rapid
regime shifts as a function of central bank communication that previously did
not exist. The ECB, Fed, BOE, and BOJ all increased their communication
frequency, altering the market pricing mechanism. The bottom line is using
the same positioning tactics in the latter regime that were used in the former
regime could account for a dramatically different return profile.
In order to get the most out of every unit of risk, I implement “regime-
congruent” strategies that are both uncorrelated to each other and consistent
with the underlying regime. This has given me a huge edge with my risk units
compared to a market participant who does not have a strong understanding
of what regime is driving the market.
The four major factors that go into assessing a regime are as follows:

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 Price Momentum: Are price changes accelerating (high momentum) or
decelerating (low)?
Correlation: Are correlations between asset classes high or low?
Volatility / Gamma: Is volatility of prices high or low?
Volume / Open Interest: Is volume high or low?
The following questions are also asked:

Is a market trending or mean reverting?

Are fundamentals or technical driving trades?

Figure 4.4 – Regime Grid

In the end, no single factor defines a market’s behavior. Therefore, I use
multiple factors that help define the overall regime for a market or asset class.
Once I have identified which regime is in place, I can effectively assign a
skew to the probability of a set of trade types. From this point, I can
allocate more time and risk to the upper skew as determined by which regime
I believe the market is currently trading. I will do any trade type, but what my
team and I do best is understand what our core trade type is and find asset
classes that are exhibiting these characteristics.

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Money Flows
The first tool I use to evaluate the four major factors comes as a result of
spotting major money flows. As Chapter 5 on Unit-of-Risk Ratios will
outline, having a snapshot of the risk-adjusted performance of several
hundred markets gives precious insight such as:

Where money is moving;

How much is moving; and
Whether flows will continue.
Being able to evaluate this dashboard quickly is key in keeping things
simple and robust. As the figures in the section on the Risk-Adjusted
Dashboard illustrate, the message on both a short-term and longer-term basis
goes a long way to answering the four points outlined above.
John Netto and I have worked extensively on using these metrics to guide
the process of assessing which markets are exhibiting extraordinary strength
or weakness. Incorporating this gives me a more granular perspective of how
my risk units are performing.

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Opportunistic Trading
After taking the “Top-Down Macro View” and “Regime Recognition”
parts of my approach into account, the third component to better maximizing
return per UoR is defined as “Opportunistic Trading.” Opportunistic trading
is a byproduct of the day-to-day machinations that come about due to a
variety of short-term factors. Identifying these opportunities is aided by
having a strong top-down macro view and a keen understanding of which
regime is controlling the landscape. Those two factors will help dictate a
number of these idiosyncratic opportunities.
These opportunities typically work around the following drivers:
(1) Calendar events;
(2) Expiration week tendencies;
(3) Market positions into key events;
(4) Relative value spread extremes;
(5) Policy changes; and
(6) Inefficiency of overnight price movements.
Why is understanding the impact of these events so important? It is very
challenging to quantify with any statistical relevance the impact of the
foregoing variables. If these are hard to quantify with traditional measures,
then there is a greater likelihood that, by developing a keen qualitative
understanding of them, facilitating intuitive insight, you can maximize return
per unit-of-risk at a much greater level. It also means if you are not aware
of these opportunistic situations, you could be on the other side of them
and subjugating your portfolio to unnecessary risk.
Although these are just a handful of examples, there is tremendous profit
potential from opportunistic trading. These asymmetries are unique unto
themselves, and are associated with opportunities that may appear on a
regular basis to the trained eye.

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Event-Driven Catalysts
The final piece of my four-part approach in maximizing return per UoR is
working positions around “Event-Driven Catalysts.” Whereas opportunistic
trading would look to benefit from market idiosyncrasies, event-driven
catalyst trading is predicated upon our analysis of the importance of a
particular key event. These events have not only shown a propensity to move
the market the moment they occur, but they also create the opportunity for
further price discovery in the hours and days that follow. Some of the events
worth focusing on include:

1. Central Bank Announcements;

2. Key Economic Releases;
3. Geopolitical Conflict;
4. China PMI;12
5. Earnings; and
6. Elections.
When looking for large market-moving events, it is critical to handicap
the market’s position both INTO and AFTER the events. Whenever possible,
it is important to have your own outcome factored along with what the street
is anticipating.
As many readers of The Global Macro Edge may already know, events
causing a seminal change in perception or catch the market improperly
positioned offer opportunities to maximize return per unit-of-risk. With any
event-driven strategy, the key ultimately comes down to assessing how much
of the repricing is sufficient in reflecting the new information. Ascertaining
this ultimately comes down to a real-time exercise incorporating all four of
the factors in my approach.

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Application
The first goal of my execution methods is to strive to put market
asymmetries in my favor. This is the cornerstone of this chapter and my
trading methodology of why not all risk is created equal. Therefore, it is
the application of this information that determines my success or failure. The
cornerstone of this is my classification system.
The classification system I use designates trades as either Core, Bias, or
Tactical, taking into account which execution strategy, time frame, and risk
the trade will have. This structure allows me to incorporate my discretionary
trading skills on top of a quantitative framework. The below figure provides a
snapshot of how I merge my approach in assessing the market with how I
apply that knowledge to the market. The remainder of this section will
provide more color on the columns in this grid not already covered to this
point.

Figure 4.5 – Classification System

Within each trade classification, I have defined the approach, assessment
frequency, average time frame, execution strategy, and max risk per trade.
These are all factors in more effectively deploying my risk units.
Core:
The approach on the Core strategy plays largely on what global macro
theme is controlling the market. I reclassify my thoughts on this about every
two weeks. (Obviously, if there is a huge outlier event, then I will adjust
accordingly after it occurs.) The positions within this classification typically

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last between five to twenty days. The max risk I take on for trades in this
category is 50 basis points (bps), or 4 percent of my risk budget.
Whether it be Core, Bias, or Tactical, I have four different execution
strategies to enter the market. In the case of my Core trades, I rely on three of
those four strategies to play this: Breakout, Trend Participation, and
Optionality.
Bias:
In moving from Core to Bias, I am lowering my time horizon as well.
Historically this has been my professional sweet spot. I incorporate three
different approaches: Regime Recognition, Event-Driven Catalyst, and
Relative Value.
My assessment frequency to see when the market is changing is done on a
weekly basis. As a result, my holding period can last between one to ten days.
These trades can oftentimes blend with both my core positions and tactical
ones given the flexibility in the holding period.
This is incredibly flexible, incorporating all four of my execution
strategies: Breakout, Trend Participation, Mean Reversion, and Optionality.
Whereas the max risk for a Core strategy is 50 basis points (bps), the max
risk I will put on any trade with a “bias” classification is 25 basis points, or 2
percent of the risk budget.
Tactical:
The most fluid and highest velocity of my trade classifications are
“tactical” ones. My approach to this falls under three categories: Risk-
Adjusted Return, Real Flow Participation, and Relative Value.
As the name tactical would suggest, I am reassessing the viability of these
trades on a daily and intraday basis. Consistent with this, my average interval
for holding these trades is intraday up to three days, and the max risk is 15
bps.
The majority of my trades classified as Tactical use two execution
strategies: Trend Participation and Mean Reversion.
Execution Strategies
I utilize three technical approaches for entering the market and another
approach with options. The fact is, from a price action standpoint, the
markets can only do one of three things: break out, pull back as part of an
underlying trend, or mean revert. Whether I am trading spreads, relative-
value arbitrage, outright longs, or momentum trades, the style itself factually
fits into one of those three execution categories. As a result, I have defined

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and tested strategies inside each of these categories.
By defining a rule-based structure in both short- and long-term trades, one
can select from those strategies to execute based on what regime is in place.
Now you have further drilled down on how to allocate your risk units in the
most efficient manner.
Optionality is the fourth category only because there is a volatility
component to it. However, in the end the execution techniques will be using
volatility pricing to trade options within one of those three trade setups as
well, (i.e., breakout, trend pullback, or mean reversion).
Breakout Strategy:
A breakout strategy refers to a market that has moved above a key
technical resistance point and acts as technical confirmation of a move
higher. As shown in the figure above, I will use the breakout strategy on trade
classifications with a longer time frame, such as Core and Bias.
Trend Participation:
This refers to using a contra move on a shorter period to get into a good
spot that matches up with a longer-term trend. For example, the daily trend
for the S&P 500 may be strong; however, the 60-minute chart is now
showing technical weakness. I may use this weakness on the 60-minute chart
to build a long position for a daily move that is trending higher. I use this
execution technique for all three types of trade classifications.
Mean Reversion:
This is an execution strategy which entails selling markets at what I
believe are extreme technical highs or buying at extreme technical lows.
Couple this with an overarching regime that doesn’t support a sustained move
higher or lower, and by using mean reverting trading entries at historically
extreme levels, I am attempting to benefit from the perceived asymmetries.
Another benefit to this is I serve the role of liquidity provider. I use mean
reversion execution techniques for trades classified as Bias and Tactical. It is
not in my profile to get into a mean reversion trade at the Core classification
level.
Optionality:
Optionality provides a few different benefits from the aforementioned
execution strategies. The first is during times of a regime change, the market
usually cannot price volatility in a way that reflects the changing regime. It
also allows me to take on exposure from a long side that defines the portfolio
risk with certainty. While I apply the Optionality execution strategy mainly to

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Core and Bias trades, I would also consider it for an Opportunistic trading
situation as well.
Below is an example of a bimonthly report I send to my investors. The
report encapsulates the techniques I have shared to this point. It illustrates the
markets I trade via futures, how I categorize those markets, and how I
provide a core view on what regimes are in place.

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Figure 4.6 – Bimonthly Report

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Roney Ratio Dashboard
Understanding how the market is performing on a risk-adjusted basis can
be very illuminating. Measuring the performance of a product by comparing
it to its own historical volatility can completely change the story on how one
perceives what markets are driving the trade.
Those products performing the best under this measurement are usually
the recipients of large money flows and warrant closer examination.
Conversely, those at the bottom of the dashboard can be a sign of where
money is leaving and can further corroborate the short-term macro narrative
that is playing out.
One of the most important aspects of the dashboard below is it allows me
to incorporate “look-backs” into my quantitative analysis. A look-back is
simply something comparing the recent price action of a product with the
longer-term price action of a product. I can apply this look-back methodology
on any time frame. I can use it on hourly, daily, weekly, and monthly charts
to see what message the market is sending.
I am particularly interested in situations, where a market has traded in a
specific range over a prolonged period and now is up or down that same
range in the current bar. This may be a strong signal about a major move
because it is instructive to see a market is now up a full risk multiple relative
to its previous trading range.
Contextualizing recent performance is not only something I do on major
products, but on relative-value trades as well. For example, using the Roney
Ratio dashboard below, I can compare how the S&P futures / DAX futures
spread is performing compared to its usual price action. Identifying other
opportunities such as this is another key in deploying my risk units
effectively.
Figure 4.7 below is a capture of a set of currencies I follow on a given
day. The same approach I use to follow this currency dashboard also applies
to the other asset classes outlined in Figure 4.6 (Bimonthly Cross Asset
Report). Each of these currencies has its own fundamental story, but
comparing them with each other in this dashboard allows one to look at risk
and the markets in a whole new light.
The Roney Ratio dashboard has two look-backs. The first one is
comparing the short-term performance of the market against a set of days. I

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am routinely changing the parameters that go into this measure. I simply use
the sort button in CQG to visually display from highest to lowest.
The second figure below (Figure 4.8) uses the same interval of the first
figure but computes the net change over a longer period. On this day, the
short-term story was focusing on how many commodity currencies were
strong versus the yen. ZAR, CAD, AUD, and MXN were all at the top of the
board. While yen weakness against commodity currencies trade was key for
the day, on a longer-term basis, dollar strength was a more prominent theme.
The Dollar Index (DXE), USDKRW, and USDCHF were all at the top of the
dashboard, having the highest Roney Ratios, and EURUSD was at the bottom
for the longer term, Figure 4.8.

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Figure 4.7 – Roney Ratio Dashboard Short Term

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Figure 4.8 – Roney Ratio Dashboard Longer Term

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The above dashboard is the first part of the equation.

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Tracking Market Performance in Segments
Maximizing return per UoR requires more than just analyzing the net
daily performance of the market. I measure how my risk units are performing
on a deeper level to identify if there is more risk to my positions at certain
times of the day. As a result, I divide the trading day into three parts, or
segments: Asia, Europe, and US. The Asia segment takes place from 7 PM
Eastern Time to 3 AM Eastern. The European segment is from 3 AM Eastern
to 8:30 AM, and the US segment is from 8:30 AM Eastern to 5 PM Eastern.13
I also compare performance in the Globex night session versus the Globex
day session.
I apply both quantitative and qualitative analysis to how those markets
perform during each segment. By measuring how the market behaves in each
segment, it’s possible to see where a market may be earning most of its
performance, volatility, and correlation. I combine the market’s performance
in segments with the information on the Risk-Adjusted Dashboard and can
form a very strong narrative for what macro drivers are moving the market.
For example, beginning October 1, 2012 through November 15, 2012, the
S&P futures were up 4.6 percent during the Globex night session (6 PM
Eastern to 9:15 AM Eastern) and down 2.6 percent during Globex regular
trading hours. I run specialized performance metrics showing how markets
have performed alone and collectively in both overnight and regular trading
sessions. This one relationship in the market was coupled with Asian equities
outperforming US. This was a very strong message that real money funds
began taking longer-term carry positions forced by the Fed and central banks
around the world, forcing fund managers out the curve to seek yield. Markets
are very cyclical and, at different times, offer opportunities for price
discovery. Therefore, tracking over 50 global markets’ performance in
segments and on a risk-adjusted basis helps keeps me objective in terms of
what I think should happen versus what is actually happening. With that in
mind, what can be just as telling, and particularly prominent in parts of
2014, was what relationships were not driving the markets. It can be just
as exciting when traditional relationships break down, as there can be
huge opportunities for great low-risk trade setups.
Being aware of the how markets are performing at different times of the
day may reveal opportunities to better allocate your risk units. Performance,

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correlation, and volatility at different times of the global trading day can
either confirm or refute the macro narrative.

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Four Types of Trading Days
Irrespective of the period one may be looking to hold a position, many of
us are short-term traders when taking on exposure in our portfolio. As with
every part of my trading methodology, it ultimately circles back to how I can
maximize return per unit-of-risk. As you have learned from the previous
sections in this chapter, I have my overall approach, strategies for executing,
my Risk-Adjusted Performance Dashboard with the Roney Ratio, and my
assessment of the market performance in their respective segments. The
foregoing all play a role in the final key piece of the puzzle: what type of
trading day we are involved in.
I categorize the trading day into four types. Understanding which trading
day the market is showing provides a framework for more detailed risk
management. As a result, I can enter, manage, and exit positions based on
what the market is giving me. This is important in providing another way to
get the most out of my risk units.
Of the four trading days, one is a pure trend day, two are range days with
an underlying bias, and the fourth is a pure range day with no bias. They are
as follows:

1. Trend day – This is a trading day where the market moves only in one
direction, up or down. The retracements and pullbacks are incredibly
shallow as either the buyers or the sellers are in complete control. Key
technical levels to the upside or downside do not abate the trend of the
day. Based on my definition of a trend day, they occur approximately 12
percent of the time.
2. Range day with an upward bias – This is a trading day where the
market is moving higher on a net basis but retracements of 38-62
percent are typical. The market closes up but had opportunities for both
bulls and bears to make money.
3. Range day with a downward bias – This is a trading day where the
market is moving in a downward direction. However, like the range day
with an upward bias, it is common to see the market ebb and flow.
4. Range day with no bias – This is a day where the market will move in
both directions in a meaningful way. There is incredible respect shown
to key technical levels on both the upside and the downside. There is

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 very little to no follow-through, and the market has made very little
ground from its opening price. There is almost a perfect bell curve, and
the symmetry of price action above and below the opening range is
nearly identical.
Having an understanding of the four different trading days incorporated
with the other aspects of my approach gives you a mathematical framework
to maximize return per unit-of-risk. When you overlay this on top of macro
drivers and can assess a probability and likelihood of what type of trading
day it is, then you can allocate capital based on the most appropriate
execution strategy.

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Evolving with the Trading Day’s Opening Range
One of the biggest tools for me in determining the type of trading day is
how the market performs in the opening ten to twenty minutes. This time
frame can be incredibly valuable in assessing the type of trading day. As
such, I usually prefer to watch it and not trade it. Even in the electronic
world, the width of the opening range and the bias it gives can be very
instructive about the day to come.
In reality, approximately one out of every eight days is a trend day in any
given market. So essentially you are in the business of trying to handicap
based on what type of day it will be. From there, use the opening range to
confirm or refute that—or at least as additional information to update the
probabilities. I will already have a leaning based upon market positions, daily
sentiment, and the macro backdrop. These factors can either increase or
decrease the probability of seeing a range day. Furthermore, those factors can
determine what type of range day may occur.
Understanding the type of trading day can be particularly lucrative for
swing traders. For example, on trend days it is more advantageous to enter at
the beginning of the day if your position is in the direction of the trend.
However, if your position is against the direction of the trend, waiting until
the end of the day to initiate a position can do wonders for your cost basis.
Conversely, if it is a range day, then it may be wiser to take an
incremental approach to building your position. Either way, you are
employing a process that may further help maximize your return per unit-of-
risk

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Review Process—How to Monetize Your Own Trade
Analytics
“Markets change and people don’t.”
Evolving as a manager should be everyone’s goal. I am constantly looking
to refine every aspect of the investment process. This only comes from
holding yourself accountable to a robust review protocol. The cornerstone for
any trader seeking a more protean approach and successfully adapting to
changing market conditions requires this final level of commitment.
I use proprietary software to provide extra granularity in aggregating and
assessing my P&L attribution. Reviews take place at both a qualitative and
quantitative level with my trading team. The fact is, if you are sticking to a
process, then handicapping your success or failure is usually straightforward.
If you are seeing success in trade or specific trade types, then clearly the edge
from your process is working. However, if you experience prolonged
difficulty, then you must step back and assess why.
While reviewing the data from my trades during a time when I am
underperforming, I ask myself what some of the factors behind this are. It
normally comes down to a few things: I am probably not seeing the
relationships or real drivers. I am being too reactive and not proactive
enough. Or I am trying to deploy a strategy in a regime that has been
handicapped improperly.
Not all trades work, but there is a lot of information in both winning
and losing periods. After aggregating the haves from the have-nots, I lean on
my network to uncover nuggets of alpha. There is no silver bullet or secret
sauce to answer any of the market’s riddles. I am not naïve enough to think I
know it all, and therefore I ask many questions. Questions that will illustrate
where the breakdown in the process may be occurring and more importantly,
what the right path is to fix it.
As I look back through my journals, a recurring theme is that I tended to
struggle the most when a very large move was about to take place across a set
of markets. This is intuitive, as the cyclical nature of the market is taking
over, and the pendulum between greed and fear, rich and cheap, and
bullish and bearish is beginning to shift. My profit and loss can be a great
harbinger of this phenomenon.
Another key takeaway from reviewing my trades is that, when I have the

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largest drawdowns, this has often been a sign the markets have reached a
significant turning point. Yet another takeaway is that I tend to be
consistently profitable but not reaching outsized gains when the market is
very orderly.
All of this ties back to our theme throughout this chapter that not all risk is
created equal. By having the technology and process to review data on a
regular basis, I can spot where my risk units are performing well and
underperforming. I can see if this matches up with the macro narrative and
make the necessary adjustments.
It is my goal to take the most methodical approach possible. I want to
create a clockwork-like process. This process gets somewhat easier at the end
of the week or month when analyzing trades, signals, or indicators for a given
market. This does not only have to apply to traders analyzing their own trades
but for investors, advisors, or institutions looking to invest in outside
strategies. A manager’s review process can be very instructive in making
an investment decision. Below are some situations I pulled from my
trading journal from 2014 and 2015.
Situation 1 – Dollar Market Strength in August 2014
Despite the dollar being bullish for much of 2014, when it
began to move strongly in August of that year, I
underperformed relative to my thematic call. This happened
because I applied the wrong tactics to a market that was
trending strongly. I tried to buy pullbacks when a momentum
strategy was more appropriate.
Situation 2 – Oil Market Went from Trend Following to
Mean Reversion in Late 2014
In January 2015, following a precipitous move lower, the
oil market became a market more conducive to applying
relative-value and mean-reversion strategies than playing for
momentum. My review process caught this changing dynamic,
and I adjusted my strategies and regime scoring accordingly.
The aforementioned factors are why P&L can be a powerful harbinger of
regime change.
Below are some of the questions I use to analyze my trading performance:

Is my P&L consistent with my assessment of what regime is in place?

Are my profits coming from trades that I have added to winners or

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 added to losers?
Am I more profitable in a given trading segment or day of the week?
Am I performing better or worse after weeks of large wins or large
losses?
Is there an analog for this behavior either in my P&L or in the market
itself that may tip me off to another trade?
The reality is that analyzing your trade results should tell you as much, if
not more, about potential cycle changes in the market than most standard
technical trading analytics.

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Conclusion
Not all risk is created equal, and the process of getting the most out of
your risk units is not a static endeavor. The Unit-of-Risk Process requires
work, commitment, discipline, and a dynamic approach that is congruent with
your personality and investment objectives. This chapter, along with the rest
of The Global Macro Edge, provides a framework for each reader to
understand that more risk just equals more risk, but smarter risk is what
equals more returns.
12 It cannot be underestimated how much China now moves global macro markets,
and is also keyed into global markets as a trade powerhouse.
13 Appendix II in the back of this book gives a more detailed breakdown of all the
key market times.

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CHAPTER
5

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 Unit-of-Risk Ratios – A New
Way to Assess Alpha
The ultimate goal of the Protean Strategy and of every investor should be
to maximize return per Unit-of-Risk™ (UoR). Doing this necessitates the
right combination of art and science. The art of maneuvering through the
market is something that comes from years of experience, developing one’s
intuition, and gaining a deeper understanding of market psychology. The
science requires that one has a rubric to objectively assess what trades are
driving the market and what strategies will maximize return per UoR. The
single most important set of tools that allows me to bridge the gap between
art and science are the Unit-of-Risk Ratios. Analyzing market performance
on a true risk-adjusted basis is the first step in the Protean Strategy to
objectively assess a trade, market, or investment on a return per UoR basis.
Unit-of-Risk Ratios are a proprietary set of ratios, measurements, and
formulas used to assess how well an asset, strategy, or portfolio is
maximizing return per UoR. This is critical in both corroborating the macro
narrative and assessing which regime is in place. I may have a theory of how
markets should be trading given a certain headline; however, if my UoR
Ratios aren’t corroborating it, then I need to reassess the real drivers that are
requiring my attention.
UoR Ratios are versatile and adaptable. They can function as a standalone
tool as well as provide great comparative analysis. In this chapter, I will show
how I use seven of my favorite UoR Ratios to assess performance on a true
risk-adjusted basis. I will also explain how I use certain UoR Ratios on an ex-
ante basis to estimate the expected return of different strategies and thus to
guide my risk allocation levels.
Two UoR Ratios have already been referenced in earlier chapters. The
Netto Number™ was explained as part of the overview in Chapter 2, while
Jason Roney introduced the Roney Ratio as part of his regime assessment
process in Chapter 4. I will go into greater detail on those specific ratios and
introduce five others to further build on the robustness of this framework.
This chapter will illustrate my journey of discovering, developing, and
implementing these indicators into my UoR Process. I will do this by
covering the following points:

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 Challenges Using Nominal Returns
Gaining a Three-Dimensional Perspective
The Seven UoR Ratios
UoR Dashboards
Integrating Information from UoR Dashboards into the Protean Strategy
The most important ratio in the UoR Process is the Netto Number.
The Netto Number is the driver behind the Risk Factor Compensation System
I created and explain in Chapter 22, the penultimate chapter of this book. By
understanding the concept behind the Netto Number, it will be easy for you
to transition this framework towards compensating a money manager on their
return per UoR. When you pay a money manager based on this metric, you
will likely have in place a more goal-congruent compensation structure as a
result.

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Challenges Using Nominal Returns
My journey to incorporate a more robust analytical framework began in
classic fashion: by attempting to solve a problem. My issue was not being
able to get the right performance context simply by looking at my portfolio
P&L for the day, week, month, or year. I needed to know more in order to
make the most informed allocation and risk management decisions and,
without the right context, making the right decisions is very difficult. This
problem exists because many in the markets work purely on an outcome or
end result mind-set. When you turn on the media or ask someone how the
market is doing, in most cases the only thing you can find out is the net
change in prices, with no attention paid to the process, path dependency, or
other factors that led to that outcome.
Hearing that the Dow Jones Industrial Average is up 80 points on the day
is still instructive—I learn it is up, and that is in and of itself useful
information. However, I am missing a great deal of context. I do not know
what that 80 points represents in terms of the Dow’s average daily range. I do
not know if the Dow was down 100 points at one point in the day. I am not
sure if the Dow was up 200 points at one point, nor how it performed in the
last week or month.
These same problems exist in the world of trading and money
management. When asked about how they are doing in the market, most
traders and PMs respond in a similar way by providing their results in
percentage terms with no context. It is wonderful if you made 15 percent last
year, but if you were down 30 percent at one point or were willing to risk 100
percent of your portfolio to get that gain, that is a much different matter.
Being up 15 percent with a Netto Number of 0.3 is much less desirable than
being up 8 percent with a Netto Number of 2.0.
This issue exists in the markets when preparing to trade or forecasting
performance, just as much as it does when assessing performance after the
fact. Many (but by no means all) professional money managers have risk
budgets or stop loss/drawdown limits. It can therefore be difficult to compare
the eventual results of managers facing no constraints with those of risk
takers who must manage the path dependency of avoiding a drawdown level
that might result in the closure of their portfolio.
In a perfect world, I would turn on a financial channel or market website

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and see that the Dow has a Netto Number of 1.6 on the day, 2 on the week,
and 3 year-to-date. I would see the same for each asset class and individual
stock and, within moments, I would be poised to make an informed
investment decision. Alternatively, when discussing the performance of a
strategy with someone in my network, they could respond with its Netto
Number. If others held this tack, the dialogue between market participants
would be more meaningful and the investment decisions people made would
be better informed.
However, we can only achieve the right answers if we are asking the right
questions. As noted throughout this book, the right question is not “What are
your returns?” but rather, “What are your returns per unit-of-risk?” All of
these details are lacking when only viewing performance in nominal terms.
The seven UoR Ratios given below offer a much broader perspective.

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Gaining a Three-Dimensional Perspective
Now that we understand the inherent limitations of only utilizing nominal
performance in our investment process, the next step is to develop a three-
dimensional approach to assess performance and solve this problem. An
approach that will allow you to confidently ask and answer one of the most
important questions you can ask about a strategy, portfolio, or instrument:
“What was the return per UoR?”
My journey along these three dimensions took many years and provides
insight as to how the UoR ratios were developed to measure true risk-
adjusted performance. By taking a unique, multi-faceted approach to
measuring performance, we can put ourselves in a great position to employ
better strategies, allocate to stronger managers, and build a more robust
process.
After reading The Global Macro Edge, you will have the tools and
expertise to look at the market in all three dimensions we outline.

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First Dimension – Nominal Performance
As discussed in the previous section, this is a straightforward number that
starts with the most basic questions we all learned to ask as market
participants: “How did the market do today?” or “How much did you make
last year?”
Nominal performance is the default analytic used by the majority of
market commentators and investment marketing documentation. If you look
at most investment literature from a mutual fund, it will show its performance
in percentage terms. These firms will usually only compare their percent
gains with their peers or benchmarks when showing how they stack up.
The problem with this style of assessment is that it lacks context. The fault
is not necessarily the media’s or the financial services community’s. We, as
consumers of financial products, need to demand more descriptive numbers;
we must request a broader array of data points and voice our displeasure
when we don’t get it. This first dimension plays to our “results mentality”
society, where a potentially random outcome is often deemed more
significant than a robust, repeatable process.

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Second Dimension – Nominal Performance Relative to
Realized Volatility
The second dimension of performance assessment is a marked
improvement on the first one. It takes performance of a market, strategy,
portfolio, or money manager and compares it relative to its actual volatility
over time. Instead of asking how much a strategy made, one might ask, “How
much did you make relative to your realized volatility?”
This question is standard amongst institutional allocators, financial service
professionals, and professional money managers. Many in the professional
community have some component of their process that measures performance
with the filter of realized volatility.
In short, this measure shows what returns look like in relation to the
moves of the market, strategy, portfolio, fund, or whatever you’re looking at.
If you have realized 20 percent returns in a market over a year, but the
annualized standard deviation in the market is 50 percent, it would only take
a 0.4 standard deviation move (20 percent divided by 50 percent) to wipe out
those returns—that’s not necessarily all that good, considering how volatile
the market is (you would have failed to capitalize on much of it) and
considering how much risk there is that your position could be wiped out.
However, if you have 50 percent returns with 20 percent volatility, it would
take a 2.5 standard deviation move (50 percent divided by 20 percent) to
wipe out your profits (this should happen less than 1 percent of the time,
given normal statistical assumptions). It also indicates you squeezed
relatively lower volatility for higher profits, riding the uptrends and getting
out of the downtrends.
The Sharpe Ratio is the most common tool used by financial professionals
to assess a measure of performance relative to realized volatility, or the
annualized standard deviation of returns. The Sharpe Ratio, which was
touched on in Chapter 1, provides insight when assessing the risk-adjusted
performance of a stock, market, or portfolio. Other ratios such as the Sortino
and Calmar are also useful tools in this measurement process. When you get
literature from many hedge funds, these ratios will be alongside their nominal
performance to help give the prospective investor a sense of what risk was
endured in pursuit of those returns in the form of realized volatility.
It would be nice to have financial media outlets show any of these ratios

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alongside market performance. It is my belief once viewers became familiar
with how the Sharpe, Sortino, and Calmar Ratios work, they would consider
them a vital addition to nominal performance. As viewers learned the
importance of these metrics, they would welcome them displayed on a daily,
weekly, or monthly basis to showcase the market’s return relative to realized
volatility.
One note about these ratios is that many in the industry commonly refer to
them as measuring “risk-adjusted performance.” In my strong opinion, this is
badly misnamed. These ratios work on an ex-post basis and simply measure
historical volatility-adjusted performance. This label is understandable given
that many construe risk and volatility as synonymous terms.
My takeaway from this subtle, yet material difference is that in order
to understand what real risk-adjusted returns are, you will need to
incorporate ex-ante analysis. In other words, you will have to assess your
risks before the fact, instead of just looking at measures of how extreme
past moves were. To do this you will need to add another dimension to
your process. This third dimension is encompassed by the Netto Number.

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Third Dimension – Nominal Performance Relative to
Realized Volatility and a Predetermined Risk Budget
The last and most important dimension in assessing performance comes
by asking how a market, strategy, portfolio, or manager performed relative to
both realized volatility and a predetermined risk budget. This third
dimension of performance assessment incorporates a critical before-the-fact
component that is not part of the process used by the majority of financial
professionals, money managers, or third-party advisors. The small niche of
market professionals who do have something comparable in place would be
at proprietary trading firms or certain types of multi-PM hedge funds. These
firms generally leverage their balance sheets and the capital efficiency of
futures to allocate based on risk, with nominal account size being a somewhat
ephemeral concept. The primary question these types of firms ask is where
traders’ equity curves are in relation to their risk budgets.
In the case of measuring the performance of an individual market, the risk
budget would be the stop loss of a trade. For example, if I was long the S&P
500 coming into the week, I would derive the value of the risk budget for my
analysis by understanding where the logical stop loss in that position would
be located. If that predetermined level is 20 points away, then by analyzing
that long position relative to its 20 point stop loss along with its realized
volatility, I can really make some headway in understanding how well or
poorly something has performed. The rest of the chapter and book will
elaborate on this.
The key component here is that third dimension analysis is done on a
predetermined basis. For instance, the risk budget used in the Netto Number
should be arrived at in advance, and stuck to for the entire relevant period—it
must reflect a trader or analyst’s assumptions in advance of a risk period, and
remain unaltered; otherwise, the measure can grow arbitrary and gameable.
The challenge with the performance ratios shared in second-dimension
analysis is they are all done ex-post with no risk budget component. In fact,
the vast majority of retail and many professional investors do not invest with
a risk budget. Why is this important? There is a tremendous difference in the
performance of a trader who has $1 million and a $200k risk budget and one
with $1 million to trade and no risk budget. Similarly, a hedge fund PM with
4 percent stop loss must operate completely differently from one with a 12

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percent stop loss, and so their returns must be judged accordingly.
(Unfortunately, sometimes PMs think that they are operating with a 12
percent stop only to find that it was actually 4 percent when they hit that
threshold!)
Managers with generous or no risk budgets need not concern themselves
with the path of their performance (for instance, whether P&L dips
significantly down before spiking way up) and, as such, can be expected to
have different return profiles from those operating on tight risk budgets. One
needs to account for this when evaluating a manager’s skill, rather than
simply assuming that the PM with higher returns is better. Similarly, a
passive index investment with no risk budget should have a completely
different return profile than a strategy that actively trades the market with
predetermined risk parameters. Simply measuring nominal returns does not
take this dynamic into account.

Figure 5.1 – The Three Dimensions

As The Global Macro Edge goes to press in 2016, there is no commonly
used, ex-ante analysis input based on a risk budget for measuring manager or
market performance. If you allocate to a manager with a 10 percent volatility
target and he returns 3 percent with a Sharpe Ratio of 1.0—meaning his

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excess return (3 percent minus the risk-free rate) was the same as historical
volatility, and decidedly less than 10 percent—has he done a good job or not?
That 3 percent return looks good relative to his after-the-fact, or ex-post
realized volatility, but decidedly mediocre in relation to the volatility that he
was mandated to generate. Chapter 22 will specifically show how a Netto
Number for a manager can help evaluate this specific situation and determine
what incentive fee to pay the manager.
For managers who do not target volatility or use portfolio-level stop
losses, probably the most accurate way to define before-the-fact, or ex-ante
risk is to assume that when you place an allocation with a manager, you are
genuinely willing to lose it all. However, the vast majority of allocations do
not work in this manner; when placements get to some undefined loss
threshold and people hit an emotional breaking point, they exit and move on
to the next investment. One can only imagine how much wealth destruction
takes place each year by investment dollars that are misallocated,
mismanaged, and lost as a result of not having a bona fide risk budget
framework.
The Global Macro Edge details how three-dimensional performance
assessment is straightforward and easy to implement. The seven UoR ratios
will show you how.

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Seven Unit-of-Risk Ratios
The seven key unit-of-risk ratios I use to measure the risk-adjusted
performance of the markets are as follows:

1. The Roney Ratio (shown in Chapter 4)

2. Agony-to-Ecstasy Ratio (total upticks from opening price vs.
downticks)
3. Return-Over-Max-Drawdown (amount market is up or down
relative to max peak or trough)
4. Opportunity Ratio (measures trading opportunities within a
market)
5. MPACT! Ratio (score given to an economic/news event and
potential price impact on market)
6. Netto Number (discussed extensively in Chapter 22, measures alpha
generated relative to size of predetermined risk threshold and
negative volatility)
7. Regime Profitability Factor (likelihood a certain strategy will do
well given certain regime)
In this section each of the seven ratios will be covered in the following
way:

Description
Inputs - nomenclature of the ratio
How the ratio is used - what it may illustrate about the market
Example

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Unit-of-Risk Ratio #1 – Roney Ratio

Description
The Roney Ratio is the patriarch of all UoR Ratios. While it was
introduced in the previous chapter written by Jason Roney, we’ll expand
upon it here and show how to compute it. It is the first ratio I used to solve
the problem of trying to compare the performance of multiple products on an
apples-to-apples basis. Jason Roney, my mentor, created this powerful
formula that allows someone to look at hundreds of markets and within
seconds understand which assets are up or down the most “risk multiples”
over any given period.
A risk multiple compares the nominal performance of a market with
the risk parameter of a predefined lookback period for that same asset.
For example, if the average risk parameter of your lookback period for the
Dow Jones is 100 points and the Dow is up 100 points on the day, this would
equate to being up one risk multiple on the day. Conversely, if the Dow was
down 100 points on the day, it would be down one risk multiple.
The Roney Ratio applies to any asset class, index, or individual product.
Therefore, one can compare the number of risk multiples a tech stock is
up versus the number of risk multiples a currency is down on an apples-
to-apples basis. This gives a much more granular perspective of performance
than simply looking at nominal returns.
Inputs – net change as the numerator, a measure of historical volatility
(average true range) as the denominator.
The inputs are static in concept but dynamic in application. The Roney
Ratio is not a standalone analytical tool. The measurement windows for both
the net change and the historical volatility measure can be altered, depending
on whether you want to get a flavor for performance per UoR on an intraday
or long-term basis…or anything in between.

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How to Use
Below are three examples that illustrate how to use the Roney Ratio in
different situations on different asset classes.

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EXAMPLE 1
Let’s start with a vanilla example of how to construct a Roney Ratio for
S&P 500 futures. Let’s assume we want to measure the daily Roney Ratio,
and S&P 500 futures are up ten points on the day. Therefore, we’ll use ten as
the numerator.
To arrive at a value for the denominator, we take the average true range
(ATR) over the last 30 days of the S&P 500. The average true range of any
market is the average daily range, adjusted for gaps from the previous day’s
close, over the lookback period. In our example let’s say that this value is 30
points, meaning the S&P 500 averaged 30 points between its high price and
low price over those 30 days.
In this case, the Roney Ratio for the day would be 0.33.

Figure 5.2 – The Roney Ratio

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EXAMPLE 2
Let’s look at a shorter-term example for a market that is negative. In this
case we’ll say that gold is trading down $3 over the last hour and has a 24-
hour ATR of $4. To calculate the Roney Ratio, we divide -3 by 4 to get a
figure of -0.75.

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EXAMPLE 3
Finally, let’s look at a somewhat longer-term example. Imagine that over
the last six months, the monthly ATR of the USD/JPY was 90 pips, and over
the last month it has rallied by 270 pips. In this case, we can say that, based
on these parameters, the Roney Ratio is 3 (270/90). Say we wish to compare
it to the Nikkei, which is usually highly correlated to USD/JPY, to see which
has been the better trade. If the one-month change in the Nikkei has been 450
points with a monthly ATR of 300, that would yield a Roney Ratio of 1.5. In
this case, USD/JPY has delivered a superior return per UoR.
It should be evident that using different time parameters will tend to yield
different Roney Ratio results. Comparing a ten-day return with the 30-day
ATR will yield Roney Ratios with a higher absolute value than looking at
one-day returns, for example. It’s important to spend the time to become
comfortable with interpreting Roney Ratios across the time horizons that
you’re most interested in. An example of how I score the Roney Ratio for
one-day moves is set out below.

Figure 5.3 – Interpreting the Roney Ratio

Without Jason sharing his insights with me, my trading would not be as
profitable. My ability to quickly ascertain what asset classes are up and down
significant risk multiples keeps me on the right side of money flows and in
touch with the message of the market.

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Unit-of-Risk Ratio #2 – Agony/Ecstasy Ratio
Description – The agony/ecstasy ratio provides color on the nature of
trading in a given market by comparing the peak price reached over a
specified period of time relative to its open, with its trough price, also relative
to the open. The agony/ecstasy ratio does not use net change as a factor. It
is focused solely on the max upside compared to the max downside over a
given period.
From the open of the trading day, if the Dow was down 120 points at its
lows, this would be the “agony” component, whereas if the high of the day
was up 40 points, this would be the “ecstasy” component. I generally prefer
to express this in terms of the bigger directional move; in this case, we would
say that the Dow has a 3:1 agony/ecstasy ratio.
This is important from a UoR standpoint when assessing markets, trading
systems, and asset classes. It’s very easy to look at the net change one day
and think “Oh, the market did this.” However, the path dependency of daily
trading can significantly influence the behavior of market participants. While
it’s generally easy to carry positions that are profitable from the word go, it
can be quite difficult to hold trades that spend most of their time in the red,
perhaps significantly so. By observing how markets trade during a given
holding period, we can better understand market psychology and spot
potential setups or opportunities that go beyond a simple macro narrative.
Inputs – Maximum favorable excursion (MFE) from a specified time,
maximum adverse excursion (MAE) over the same period.
Maximum favorable excursion (MFE) is a term most commonly used by
trading system developers when describing how much a trade went in one’s
favor after entry. If a trade was up by 50 ticks at its peak, then this is the level
that will be referenced irrespective of where one exits the trade (win, lose, or
draw).
Maximum adverse excursion (MAE) is the opposite of MFE, describing
the maximum drawdown from trade entry until the time that it is closed. If a
trade was 20 points against a trader at the lowest point during the trade,
regardless if one got out (down five points, up five points, or break even), the
MAE would be recorded as 20.

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 Figure 5.4 below shows an example of where the MFE and MAE would exist
on a chart. Point A shows the point to identify the MAE for this period while
Point B illustrates where the MFE is located.
Ideally, your trades will have a much higher aggregate MFE than
MAE.

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How It Is Used
In measuring return per UoR, I always want to know a lot more than just
the net change of a market or trading system. I want to see how much heat or
joy was part of the ride, and I do this by tracking each market’s MFE and
MAE from its open to its close. This tells me many things.
The MFE/MAE comparison can be very instructive, as it gives me a sense
of whether what I am seeing in top line performance is corroborated by the
price action. For example, if a market was up 30 basis points on the day, this
is a superficially positive result. However, if the MAE that same day was 70
basis points, and its MFE was only 35 basis points, it may have been a day
when being short was actually a better position for short-term traders. (In this
sense, those familiar with basic technical analysis can see how MFE and
MAE analysis is a cousin of open-high-low-close analysis.) If we combine
this with the Roney Ratio and see that this market was underperforming its
peers or other sectors on an apples-to-apples basis, then we may have
identified a bona fide laggard that makes a potential short candidate for the
next market downturn.
Most people attempt to determine which sectors are leading and lagging
based on their nominal performance. UoR Ratios give you the tools to take a
true three-dimensional approach to confirm which stocks, sectors, and risk
assets are truly leading and lagging.
As one of the key UoR Ratios, I have a dashboard for the agony/ecstasy
ratio that tracks the number of total ticks of the MFE in one column and the
total number of ticks in the MAE in another column. From there, they are
filtered to alert me which ones have the greatest disparity.
For example, if the SPX has ten points MFE and one point MAE, that
creates a pretty significant MFE to MAE ratio, which is something I want to
know about. Conversely, if the NASDAQ only has a 5 MFE and 40 MAE,
this is also something I want to see. I can screen all of the parameters I care
about and be alerted when my criteria are met.
Note that the information contained in the agony/ecstasy ratio is similar to
that contained in candlestick or bar charts, albeit without the net change on
day. By creating a dashboard, I can synthesize this information for multiple
markets at once, rather than scrutinizing charts on an ad hoc basis to pick out
the same information for markets one by one. I use multiple lookback periods
in this regard, tracking the agony/ecstasy ratio for the last hour, last day, last

161
week or month. They all tell a different story about which markets are
performing well and poorly on a return per UoR basis.
There is also utility in employing the agony/ecstasy ratio to test the
viability of a system or performance of a third-party manager. A simple
example would be to compare two managers or systems with the same
nominal performance side by side. The first system was up 10 percent with
an MFE of 20 percent and an MAE of 5 percent. The next system was also up
10 percent but had an MFE of 12 percent with an MAE of 11 percent. They
both are up 10 percent, but the return per UoR profile is dramatically
different.
It is interesting to see if a certain asset class is playing with a lead or
having to come from behind a lot. I compare my total MFE to total MAE
when looking at systems, even before I look at the net results. Having this
information might save you from falling in love with a potential time bomb
about to explode in your portfolio.

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Unit-of-Risk Ratio #3 – Return Over Maximum
Adverse Excursion/Max Favorable Excursion
Description – Return over MAE or MFE is a ratio I use to further
contextualize how a market is performing over a specified period. This is an
adjunct to UoR Ratio #2 in that I want to see how much agony or ecstasy I
would have to take if positioned in a market. If the market is higher, I will
measure it relative to its MAE, and if it’s lower on the day, then I’ll measure
it relative to its MFE.
Just like the preceding UoR Ratios, I can adjust the time frame to capture
the window that most interests me, measuring it over an hour, six hours, a
day, a week, or since a major market event. This is another metric that gives
me a very quick snapshot of which markets are performing well and poorly.
As with every UoR Ratio being introduced in this chapter, please don’t
assume that the time frames and other specifications presented in the
examples represent some sort of ideal setting. Every trader or portfolio
manager views the world through a different prism, and as an author my main
concern is to provide an analytical framework with which the reader can
build out his own investment process. In truth, I could write an entire book on
just these seven ratios, exploring different scenarios and analytical examples.
What you should take from this chapter is that there are multiple ways to
assess how something is performing.
Inputs – The numerator of this ratio is the net change in price, and the
denominator is the maximum excursion in the opposite direction of the net
change
For example, if EUR/USD opens at 1.1350, trades down to 1.1325, and
then rallies back to 1.1360, it would be up 10 pips on the day but would have
had 25 pips of “agony” or MAE. Therefore, the return/ MAE score for
EUR/USD on the day would be 10/25, or 0.40.
The same process applies for markets to the downside. Say the euro opens
the day at 1.1350 and trades up to 1.1375 before immediately reversing and
trading down to 1.1300. In this case the net change on day is a loss of 50
pips, whereas the MFE was a rally of 25 pips. The return/MFE ratio is
therefore 50/25, or 2.0.

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How It Is Used
Although similar to the agony/ecstasy ratio, return/MAE adds another
layer of context with which to assess price action. The more UoR Ratios that
a market scores favorably/unfavorably in, the stronger the signal becomes
with regards to the opportunity embedded in trading it. A market may trade in
a tight range but still register a high agony/ecstasy ratio if most of the price
action is skewed towards one side of the distribution. Return/MAE is
therefore useful to get insights into the magnitude of the daily change, as the
Roney Ratio is to put it into some sort of historical context.

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Unit-of-Risk Ratio #4 – Opportunity Ratio
Description – The opportunity ratio provides context on how much price
movement there was within a given trading range. Most derivative traders
measure realized and implied volatility to value and trade options. The
opportunity ratio helps measure the “realized gamma” that a market delivers
over a period of time, providing an insight to the benefit or cost of delta
hedging on a relatively high-frequency basis. This is an important distinction
from looking at a simple close-to-close realized volatility, or even intraday
ranges. A market that traverses a 1 percent intraday range once offers a
different opportunity set from one that has an identical high and low but
travels between them several times over the course of the trading day.
Understanding this distinction enables to me select option trades that
capitalize on the realized gamma of the market.
Most interpretations of option volatility focus on the implied range that
the market is pricing. The opportunity ratio shifts the focus from a simple
snapshot of the trading range to the market’s volatility within this range.
Understanding the path of the market and frequency of movement within that
range can lead to some tremendous opportunities.
Inputs – While the specific inputs of the opportunity ratio are proprietary,
the important thing is for readers to understand what it is measuring—
namely, the composition of the movement within a trading range. Armed
with this knowledge and a decent data source, readers should be able to
construct their own versions of an opportunity ratio to guide their trading.

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How It Is Used
As an active options trader, it is important to understand what the market
is telling you about anticipated price action. Implied volatility of an option
price is an important part of how I assess potential movement in a market. As
an active trader, I tend to dynamically hedge my deltas as the market moves,
buying low and selling high when I am long gamma and doing the opposite
when I am short. Either way, the opportunity ratio helps me understand how
much hedging I would need to do to remain delta neutral over the course of
the day. If there was a lot of delta hedging, then this is likely a market I want
to be trading from the long side, as more gamma-scalping opportunities
equals more profits. If there was very little delta hedging, then this tells me
something different about the market, and a short gamma position may make
more sense. Either way, this is information that few macro generalists track.

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EXAMPLE 1 – SPX WEEKLY OPTIONS
Let’s look at SPX weekly options first. We’ll assume that the at-the-
money straddle is pricing movement of 21 points per day. Obviously if you
are long these straddles or otherwise benefit from a high degree of volatility,
you are hoping for a lot of price movement. Conversely, if you are someone
who sells options or tends to benefit from more mean-reversion and market-
making strategies, then you are best served if the market falls short of the
implied range with very few big moves.
Either way, the opportunity ratio tells me how much gamma is delivering
alongside the net change in the market. If the realized gamma is high, then I
will apply one type of strategy, while if the gamma is low, then I can take a
different tack.
The bottom line is that the path for those 21 points has a material impact
on your profitability if you are trading options. If the market opens, trades
lower, and then gingerly moves from the lower part of that range to the highs,
you’re less likely to make money being long options than if the underlying
moves 15 points per hour.

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EXAMPLE 2 – EURO FX FUTURES
Let’s take a look at EUR/USD on September 4, 2015, the date of the
August nonfarm payroll report. Prior to the release of the data, the IMM
1.1150 (i.e., at-the-money) straddle expiring at the close of business that day
was priced at 90 pips. On a hold-to-maturity basis, therefore, the breakevens
on the straddle were at 1.1060 and 1.1240.
Following the release of the data, the euro traded up about 40 pips to
1.1190, at which point it turned around and dropped 100 pips to 1.1090. After
a failed rally to 1.1140, it retraced back towards the lows before ripping 80
pips back towards the highs. While the net change on the day was only a
small fraction of the straddle price, it is quite possible that the owner of these
options could have cleared a tidy profit by dynamically hedging his deltas.
On the other hand, someone short the straddle may have found himself flat or
even down on the day through anti-scalping himself, even though the net
change on the day was very modest.
This is one example of how looking beyond the nominal change of the
market can really benefit someone by illustrating some appealing
opportunities well before the rest of the market is aware of them. The
opportunity ratio highlights markets that may be underpriced or overpriced
relative to how much gamma costs.

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 Figure 5.5
A lot of options traders look to build a more robust way to price volatility.
I feel strongly that a real exploitable edge can come from building a
better model to price gamma, or the price path. The opportunity ratio
helps me price that path and has been a meaningful part of my P&L profile
illustrated in Chapter 3.

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Unit-of-Risk Ratio #5 – MPACT! Ratio
Description – The Market Price ACTion Ratio, or MPACT! Ratio, is
a ratio I created to measure where certain asset classes may trade based on the
outcome of economic news, central bank policy decisions, and other one-off
events on an ex-ante basis. The MPACT! Ratio does this by forecasting how
many “risk multiples,” as defined by the Roney Ratio, a market may move
based on the outcome of the event.
For example, if the European Central Bank delivers a policy decision that
is more dovish than the market expects, EUR/USD may get an MPACT!
Ratio of -1.5, meaning the euro could move 1.5 risk multiples lower over a
specified period of time. The Dow Jones Euro Stoxx index, a likely
beneficiary of easier monetary conditions in Europe, may get an MPACT!
Ratio of 2.0, while the S&P 500 may get an MPACT! Ratio of 0.8. The S&P
would have a lower score to reflect that ECB policy may only tangentially
impact monetary conditions in the US, as an improvement in global liquidity
could be offset by a strengthening dollar.
Specific MPACT! Ratios are bespoke to each market and require a lot of
ongoing research, preparation, and maintenance. However, in the heat of the
battle when the market is going through its process of price discovery, having
the MPACT! Ratio ready during an event can help me act quickly and
decisively, particularly if there is a surprise.
The idea of measuring how an event affects a market is nothing unique.
However, where I think the MPACT! Ratio provides a lot of value is
formalizing a process to assess event risk and anticipate market price
action before it occurs. Much of the success in this game is about being
ready when opportunity calls, and an investment process using the MPACT!
Ratio has helped me generate the returns discussed in Chapter 3.
While the previous four UoR Ratios are based on quantitative inputs,
thereby potentially changing on every tick, the MPACT! Ratio has a lower
frequency of updates.
Figure 5.6 below illustrates some common events to which I apply an
MPACT! score. Which events I track is a fluid process, so this is merely a
snapshot, as the market sensitivity to these events can ebb and flow.

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 Figure 5.6 – List of Events for MPACT! Ratio
Figure 5.7 below is a list of the markets where an MPACT! Ratio is
applied. I also grade parts of the yield curve and relative-value spreads.
Going through this process makes it very difficult for me to get blindsided by
an event. While occasionally losing money is all part and parcel of
trading financial markets, it is just anathema to me to lose because I was
unprepared for a scheduled event.

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 Figure 5.7 – List of Asset Classes for MPACT! Ratio
Even when markets do not move along the lines envisaged by the
MPACT! Ratio, I can still make use of the information contained therein.
Keeping a proprietary database of events, predictions, and outcomes has
helped tremendously in fine-tuning the process, particularly as it has a lot of
qualitative inputs. This database has become a valuable aid in assessing
opportunities and more vigilantly managing risk.
Inputs – While the exact inputs of the MPACT! Ratio are proprietary,
nearly all of the clues needed to create your own MPACT! Ratio are covered
somewhere in this book. Things like the surprise indices outlined in Chapter
4, the data analysis techniques in Chapter 17 and Chapter 18’s lessons on
interpreting market positioning provide a great framework for your research.
The MPACT! Ratio has both qualitatively and quantitatively derived inputs,
with initial preparation before the week starts and fine-tuning the day before
the event itself. It is this ratio that drove me to automate my position and risk
management as discussed in Chapter 20, The MPACT! of Automation.

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How It Is Used
The MPACT! Ratio is a critical part of both predicting and managing
event risk in the market. By incorporating the MPACT! Ratio, I am able to
assess both quantitatively and qualitatively where the market may trade. This
then gets combined with key technical levels in the market, a regime
profitability factor (RPF) score (UoR Ratio #7), and a qualitative input from
my network of market contacts. There are approximately six asset classes and
30 markets I focus on.
So if the Fed comes out more hawkish, more dovish, or in line, the
MPACT! Ratio projects how many risk multiples the modelled markets will
move. This ex-ante analysis can be archived and used for future reference to
complement other strategies. This information also gets integrated into the
regime profitability factor, which I’ll discuss in more detail later in the
chapter.
Looking at an example using the MPACT! Ratio on a Fed policy
announcement from September 17, 2015, I can illustrate how this process
works. Fed decisions take more time to construct given their qualitative
nature when compared to other events such as economic data. At the same
time, the somewhat ambiguous nature of the release can also provide more
opportunity. This basic example in figure 5.8 covers five scenarios.
Using the MPACT! Portfolio Simulator™,14 I can project how many risk
multiples the five-year Treasury security may move based on the outcome of
the announcement. In this case, the MPACT! Ratio projected that a very
dovish outcome from the Fed would cause a rally of two risk multiples in the
next 24 hours, while a moderately dovish would project a rise of 0.4 risk
multiples. An extremely hawkish surprise, meanwhile, would suggest a sell-
off of 1.8 risk multiples. If one risk multiple were 32 ticks, then an extremely
dovish outcome would project a rally in the five-year note of 64 ticks—two
full points.

Figure 5.8 – MPACT! Ratio on five-year Treasury for FOMC Decision

showing how many risk multiples it is projected to move
It should be easy to see how using the MPACT! Ratio could help manage
risks and generate returns for your portfolio, particularly over event risks. For
me, the MPACT! Ratio Dashboard accomplishes this by aggregating all of

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the markets I trade and projecting their expected risk multiples in this way.
The result is heat map identifying which asset classes to focus on based on
the projections made by the MPACT! Ratio.

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Unit-of-Risk Ratio #6 – The Netto Number™
Description – A three-dimensional quantification of the return per UoR of
a trade, strategy, portfolio, or manager. Calculated by measuring how well an
investment performs on a volatility-adjusted basis relative to its
predetermined risk budget. While institutional risk ratios like the Sharpe,
Sortino, and Calmar all provide great ex-post analysis of performance relative
to realized volatility, the Netto Number delivers a barometer of performance
based on ex-ante risk tolerance.
The Netto Number is also the key input in the Risk Factor Compensation
model outlined in Chapter 22. It is my belief that the Netto Number not only
tells you how much skill a manager has, but is also an important input into
determining how he should be compensated for his performance. This is all
part of our Risk Factor Compensation model.
Inputs – The Netto Number blends elements of the Roney Ratio, the
agony/ecstasy ratio, and return over max adverse/favorable excursion.
Numerator: Net change for the designated period.
Denominator: The Risk Factor = Average of Maximum Adverse
Excursion (when net change is positive) or Maximum Favorable Excursion
(when net change is negative) and the risk budget. Typically, I identify the
risk budget as the amount of capital at risk as defined by an actual or
hypothetical stop loss. Alternatively, I may also define it as a rolling average
range when looking at longer-term trends. Either way, I sum the risk budget
and the MAE/MFE and divide by two.

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176
How It Is Used
The Netto Number is part of nearly every aspect of the UoR process and
Protean Strategy. I use it to assess how markets are performing on a return
per UoR basis. In Chapter 22, I’ll cover how to use the Netto Number to
measure how well a manager maximizes return per unit-of-risk. Here, I’ll
focus on how to apply the Netto Number when trading the market.
There are two key aspects that make the Netto Number such a vital
component of my investment process. The first is context and the second is
comparability. It is the ability to contextualize and compare markets in a
matter of seconds that makes this metric so integral to my trading.
The Netto Number is contextually robust because I am able to look at any
market, asset class, or strategy with the understanding of how it is performing
relative to its predetermined risk budget, (i.e., its hypothetical stop-loss
point), as well as the negative volatility that it has endured. The ex-ante risk
budget component helps me understand, in a more pragmatic way, just how
good the performance is. Without the risk budget component, a key level of
granularity is absent. For example, if you are long the euro coming into the
trading day, what is the appropriate stop loss for that long position? Is it 40
pips, 80 pips, 120 pips? There are many ways to arrive at this level, but once
you have it, you can then contextualize how the trade is actually doing
relative to that stop loss.
Now let’s assume that EUR/USD opens at its lows and closes up 60 pips
on the day. This is a different profile from it dropping 30 pips from the open
before rallying to close up 60 pips on the day. We can see these two price
paths respectively calculated, assuming a risk budget of 80 pips, as in
Scenario 1 and Scenario 2 below.

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Scenario 1:
EUR/USD opens at the low, has 0 MAE, and closes up 60 pips on a risk
budget of 80 pips.

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Scenario 2:
Assume profits on the euro were still 60 pips, the risk budget was still 80
pips, but MAE was instead 30 pips.

In Scenario 1, the Netto Number is 1.5; in Scenario 2, meanwhile, the

Netto Number will be lower at 1.09. This reflects the fact that while the net
change and risk budget in this trade were identical, there was also an adverse
excursion of 30 pips, thus incurring greater real-time risk (and consequently
lowering the return per UoR). This distinction illustrates why my goal is to
help persuade people to talk about the markets in return per UoR terms rather
than nominal terms.
The second factor that makes the Netto Number so practical is the
versatility that allows me to look at multiple asset classes, strategies, or
markets on an apples-to-apples basis. I can import the Netto Number into a
dashboard and, without ever turning on a news channel, know exactly what is
driving the trading narrative for the day. The ability to compare the
performance of Apple stock, USD/JPY, and a synthetic basket of European
equities is a game-changer in terms of knowing where to allocate risk. The
UoR dashboard section of this chapter will elaborate further on how I
implement these ratios in my trading.

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Mathematical Application of Netto Number on AAPL and USD/JPY
Say that I want to compare the performance of AAPL and USD/JPY based
on return per UoR. I look at cross-asset relationships like this every day when
assessing the macro landscape using the Netto Number. In this case, I want to
make a comparison of longer-term returns per UoR, say for the calendar year
2013. For each asset’s risk budget, I’m going to use the rolling three-year
average range. It’s important to recognize that the risk budget input in the
Netto Number is dynamic, and the factors I use to calculate it change
with the regime. However, in the absence of a predefined stop loss, taking a
simple average range should suffice for the majority of analytical needs.
Let’s look at the yearly Netto Number of AAPL and the USD/JPY in
2013.
Metrics to Compute Netto Number:

2013 Nominal Performance

2013 Maximum Adverse Excursion
Risk Budget or UoR = Average Yearly Range (rolling 3 years)
USD/JPY
Year-over-Year Performance = close of 86.75 in 2012, close of 105.31 in
2013, up 1856 pips
Maximum Adverse Excursion = 2012 closing price – 2013 low price = 22
pips
Average Yearly Range (rolling 3 years) = 1190 pips, which is our risk
budget

The Annual Netto Number of USD/JPY in 2013 is 3.06.

AAPL
2013 Nominal Performance = close 76.02 in 2012, close 80.14 in 2013, up
4.12
Maximum Adverse Excursion = 2012 closing price – 2013 low price =
21.01
Average yearly range (rolling 3 years) = $26.13

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 The Annual Netto Number for APPL in 2013 is 0.17.
Although the performance of USD/JPY was clearly better than that of
AAPL in 2013 (21.4 percent vs. 5.4 percent), this undersells the discrepancy
in the return profiles. While the nominal return of USD/JPY was four times
better than that of AAPL, its Netto Number was nearly 18 times better, which
is a more accurate reflection of its return per UoR (and your utility from
being long).
I’m an optimist and would like to think that most institutions and
professional investors would like to improve their ability to contextualize the
performance of a market relative to its volatility. The Netto Number can help
them do so. Simply looking at nominal performance or even volatility-
adjusted performance without knowing the size of the risk budget is a
material factor in why many investors and allocators end up disappointed
with the performance that they receive.

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Unit-of-Risk Ratio #7 – Regime Profitability Factor
(RPF)
Description – Input used to ascertain implied profitability of a strategy
based on market, asset class, and regime. Input is multiplied by factor of 50
with the result appearing in the UoR Strategy Grid.
The UoR Strategy Grid is a proprietary interface that aggregates multiple
strategies into one dashboard. The dashboard dynamically updates based on
the Regime Probability Factor (RPF) and serves as the command and control
center of the Protean Strategy.
The scores are graded on a scale of 1 to 100, with the higher the score, the
better the implied Netto Number for that strategy and market. Each market
vector receives an initial score of 50, which is then adjusted by applying the
proprietary RPF to generate an ex-ante estimate of the opportunity set from
trading a particular strategy and asset class. This enables me to focus on those
sectors of the market that my research suggests will offer the highest return
per UoR. I’ll elaborate further on the UoR Strategy Grid in Trading Journal
section of Chapter 8.
Inputs – The inputs are proprietary. However, much like the opportunity
ratio, I want to share the concept with you so you can think about how you
might construct something to meet your own needs. Consider some of the
return per UoR Ratios discussed earlier as signposts that can help point the
way towards which types of strategies may work in a given market
environment.

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How It Is Used
Figure 5.10 below illustrates a simple Strategy Grid before any of the
RPFs are applied. As you can see, the reading for each market segment is a
neutral 50.

Figure 5.10 – UoR Strategy Grid before factoring in the RPF

The RPFs are calibrated to estimate the Netto Number generated by
applying a particular strategy to a specific market segment or asset class. The
final scoring is done along the lines of the following rubric:
Score of
0-25 equals Netto Number from -1 to 0
26-50 equals Netto Number from 0-.5
51-75 equals Netto Number from .6 to 1.5
76-100 equals Netto Number from 1.6 to 5
Once I apply the RPFs, the Strategy Grid will look something like this:

Figure 5.11 – UoR Strategy Grid after factoring in the RPF

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 I now have a heat map indicating where to allocate my investment risk.
Over time, allocation to strategies should be as dynamic as their implied
profitability. The amount of capital at risk in a given strategy/market should
correlate with its implied probability. The Regime Profitability Factor is what
helps me ascertain the appropriate concentration level. As I do an extensive
amount of preparation before each market day, I am equipped with a game
plan for how to allocate my capital. As the ideal deployment of investment
risk changes, the UoR Strategy Grid helps me track where to focus my
trading.
As you can see from the figure above, different asset classes go through
different trading regimes, and while one market sees a repricing, another may
be less inspired to perform. G7 currencies may be a better market for my
trend-following system than emerging market currencies, or European
equities could be better mean-reversion candidates than US equities. The RPF
has fundamental, technical, and sentiment inputs. After reading this entire
book, you should be able to construct an RPF model of your own and feed it
into your own dashboard.

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UoR Dashboards
The Unit-of-Risk dashboards are a distillation mechanism for providing a
one-stop snapshot of which markets are delivering tradeable opportunities for
the Protean Strategy. They display a number of the UoR ratios outlined in
this chapter, and I use them to visually contextualize several hundred asset
prices in a matter of moments. Seeing which assets are performing most and
least strongly on a risk-adjusted basis is very instructive and is a highly
efficient way to keep my finger on the pulse of the market.
The concept of the dashboard, like many things in this book, was the
byproduct of great teamwork and cross-pollination. I approached Thom
Hartle of CQG with the idea, sharing with him the concepts of the Protean
Strategy and Netto Number formula. It went through a number of iterations
before we arrived at the current version, which Thom programmed in Visual
Basic and I can run in Excel. The end product is a testament to the benefits of
high-level collaboration.
An example of my UoR dashboard is displayed below. Observe how I can
tell, with just a glance, how different markets are performing on a UoR basis.
The top section ranks the top and bottom five asset prices in my investment
universe according to both their short- (left side) and long-term (right side)
Netto Number. In Figure 5.13, I have an ordinal ranking of my equity index
and sector universe by short- and long-term Netto Numbers. The dashboard
also provides a small graphic to illustrate where each market is trading
relative to its short- or long-term range.

185
186
 Figure 5.13 – UoR Dashboard
I have a number of different UoR dashboards that I utilize throughout the
trading day. I have a one-stop shop that summarizes the most important
market developments of the day, but I also have regional dashboards that
focus on the most important asset markets within each time zone. Below is a
brief summary of what I look at in some of my dashboards:
Macro – The macro spreadsheet is my one-stop shop and contains a
summary of the most important market developments occurring all over the
world. I start my day by synthesizing the information contained in this
dashboard, including:

Top and bottom five Unit-of-Risk Ratios

Global equity index futures
Global fixed income futures
Commodity futures
FX rates
Bellwether single name stocks
Asia – During the evening and overnight session (US time), I monitor:

Global FX rates
Key global fixed income and equity markets
Fixed income, equity index, and sector developments in Japan, China,
Korea, Hong Kong, and India
Europe – Markets can be very active during the European morning. When
I need to know what’s going on, I wake up and look at:

Global FX rates
Sovereign bond markets in roughly ten European countries
Commodities
All the major European equity indices and sectors
Local listing prices for bellwether European stocks
US – After digesting global developments on my macro dashboard, over
the course of the US trading day, I generally switch to a dashboard more
focused on that time zone:

Global FX rates
US equity indices and key sectors

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 US fixed income
Commodities
Obviously, in some cases the same markets appear on multiple
dashboards, which makes sense. After all, EUR/USD trades 24 hours a day
and is an important market to trade, so I want to keep tabs on it regardless of
the time of day.

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Integrating Information from UoR Dashboards into the
Protean Strategy
The UoR dashboards are powerful tools that enable me to quickly assess
market developments and to spot incipient trends and divergences (that might
signal the end of a trend).
For example, on January 29, 2016, the Bank of Japan surprised markets
by introducing a negative interest rate regime. Coming on the heels of what
had been a very weak January for many risky assets, this surprise easing was
greeted enthusiastically by most markets. When I checked my UoR
dashboards that morning, I saw high Netto Numbers for a large number of
assets, including USD/JPY, the Nikkei, S&P futures, and EURO STOXX.
However, my screen actually showed a negative Netto Number for
Japanese banks, which was a notable divergence. Not only had banks been
star performers after previous BOJ easings under Kuroda, but they had
generally been leading indicators for USD/JPY and the Nikkei as well.
That Japanese banks failed to participate in the rally despite leading to the
upside was a clear warning that the BOJ decision to move to negative interest
rates was not an unalloyed positive.

189
 Sure enough, the initial reaction to the BOJ decision reversed over
subsequent days, with USD/JPY, the Nikkei, and bank stocks everywhere
moving sharply lower. Being able to quickly spot the divergent message from
Japanese banks created an opportunity to take profits on longs in other
markets and to set shorts at attractive levels.

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 It is this type of analysis that makes the UoR dashboards so powerful.
Moreover, by integrating the seven UoR ratios into my investment process, I
can maximize my efficiency in leveraging the information from the
dashboards to deploy risk in the market.

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Conclusion
It is one of my personal goals for The Global Macro Edge to help shift
the dialogue in financial commentary from performance assessment based on
nominal returns to performance based on return per unit-of-risk. While the
terminology or calculation of these ratios may seem confusing and
esoteric, the advantages to understanding and incorporating them into
your investment process could be substantial. The philosophy explained
in this chapter can confer an array of benefits to a broad range of
market participants:

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Investors
Unit-of-Risk Ratios give you a unique way to look at your portfolio and
identify trouble or opportunity. The process of analyzing your trades and
investments within this context can be very powerful. Moreover, if you invest
in external funds, then evaluating them on the basis of their return per UoR
can assist you in judging the managers’ level of skill and thus whether they
merit your ongoing trust and investment.

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Money Managers
Amongst global macro funds in particular, the years before we went to
press have seen a heavy emphasis placed on risk management and loss
avoidance. Unfortunately, many of the tools used to evaluate trading
strategies tend to be blunt and focus on ex-post nominal returns rather than
returns per UoR. At the same time, for individual portfolio managers, sizing
trades and deciding how to deploy risk in the market within this context can
be a real challenge. The toolkit that we’ve explored in this chapter can
significantly enhance your investment process by providing you with
appropriate metrics for identifying market opportunities and assessing their
performance once a trade is established. In time, this should help you
maximize your return per unit-of-risk employed.

194
Advisors
Advisors pride themselves on being a conduit between top manager talent
and the investors they represent. While most allocators can get comfortable
with the numbers and strategy narrative from a fund’s tear sheet without a
problem, understanding how the UoR ratios work can provide unique insights
into which managers may succeed or not. Integrating the UoR ratios,
particularly the Netto Number, into the vetting process can further
differentiate an advisor’s value proposition in a field where many of the
offerings look very much the same. Demonstrating to your investors that you
employ a set of metrics beyond the industry boilerplates to evaluate managers
and maximize returns per unit-of-risk can help you stand out from the crowd.
14 The MPACT! Portfolio Simulator™ will be discussed in Chapter 20.

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CHAPTER
6

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 Identifying Inflection Points in
the Business Cycle – Raoul Pal
One of the hardest things, even for the most seasoned
economists is to say with certainty where we are in the
business cycle. It is for good reason so many obsess over this:
once you have confidently determined the present point in the
business cycle, your ability to target the specific asset classes
best positioned to maximize return per unit-of-risk increases
dramatically.
The process to determine not only where we are, but also
where we are heading, can entail a wide array of
methodologies. Some include econometric models, consumer
surveys, liquidity measures, or simply seeing how crowded a
local restaurant is on a Friday night.
While it is not feasible for many of us to get a PhD in
economics or statistics, this does not prevent us from
developing an understanding of why the business cycle is
important and what we can do to determine the market’s
perception of it. It is often at inflection points in business
cycles that tremendous asymmetrical investment
opportunities present themselves. These inflection points
determine what the next leg in market movements and market
pricing will be. Consequently, market participants who were
not properly positioned for the shift will need to adjust their
exposure. These adjustments, taken as a whole, are explosive
in redefining the new market regime.
As I have mentioned repeatedly, these regime shifts can
lead to tremendous repricing in the market. Inflection points
are generally agnostic to old market sentiment and blind to
trends, taking no mercy on strategies that may have been
profitable in the prior regime, but are rendered ineffective in
the present. Phase I of The Global Macro Edge is about
regime recognition, and the business cycle is a crucial element
of any regime. While regime shifts can occur in response to a
technical level breaking, a sudden change in sentiment, or a

197
 key piece of economic data being released, it does not always
happen. An inflection in the business cycle, on the other hand,
is almost certain to precipitate some sort of regime shift (in
fact, the other elements—shifts in data and sentiment—can
themselves serve as indicia of an inflection in the cycle).
This chapter is going to give you an overview on how
Raoul Pal, Co-Founder of RealVision and Writer of The
Global Macro Investor, assesses and identifies inflection
points in the business cycle and accordingly advises his
clients. The Global Macro Investor is an internationally
renowned and highly successful monthly global macro
advisory publication with occasional intra-monthly updates
for time-critical analysis or recommendations. It is read by
many of the world’s largest and most successful hedge funds,
pension funds, sovereign wealth funds, and family offices.
Raoul Pal has demonstrated tremendous advisory acumen
through the pages of this newsletter, which is imbued by his
ability to help clients navigate their way through tumultuous
markets.
—John Netto
Facts tell and stories sell. When it comes to understanding what shaped
and influenced my perspective, events from my time running the hedge fund
sales team in equities and equity derivatives at Goldman Sachs left an
indelible imprint on how I would forever approach the markets.
The first occurred during the Asian crisis in the late ’90s, as I was
fortunate to follow an extremely famous macro manager implement his trades
for a global slowdown. I would sit in the office in the evening and try to piece
together what his team was doing and why. They held short positions in
currencies, short positions in equity indices, long positions in bond markets,
short positions in economically sensitive sectors of the global equity markets,
and short positions in copper and oil.
It was at that point I came to realize how all asset classes reflect the
economic cycle and that understanding the economic or business cycle
was the key to making money in the macro world.

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The Business Cycle
Business cycles are the direct result of cyclical economic fluctuations,
which can occur over a span of several months to a number of years. The
importance of the business cycle is that it tracks the changes in the rates of
economic growth and determines the returns available in stock markets as a
whole and the sectors within these markets.
It can therefore be used by investors to understand the progression of the
investment environment between recession and economic boom, as well as
the prospects of individual sectors relative to the broader market.
In order to recognize the different phases of a business cycle, there are
three key indicators which underlie these fluctuations and inform investors of
the state of play throughout the economic cycle.
These indicators are known as the corporate profit cycle, the credit
cycle, and the inventory cycle. Alongside changes in other important
variables, such as levels of employment and monetary policy, these indicators
can tell us where we are in the business cycle at any given time. During the
life of the business cycle, the indicators will provide information on which
stage the cycle has reached from a division of four typical stages: the early
stage, the mid-stage, the late stage, and recession.
The early stage is typified by fast-growing profits, with credit beginning
to grow and also low inventories with high sales. Emerging from the
recession stage, this first part of the cycle is where monetary policy is relaxed
in the form of low interest rates, allowing for access to credit and a positive
environment for fast growth in order to boost the economy. Historically, this
phase of the business cycle is the most robust, with growth figures for the
broader stock market since 1962 indicating that this phase is responsible for
over 20 percent returns. During this phase, the economy is still being
stimulated, increasing sales and ensuring that inventories are low as demand
for these products rises sharply.
The mid-stage includes profit growth peaking, credit growing strongly,
and inventories swelling to equal sales. This phase is usually the longest and
is characterized by positive growth, albeit at a slower rate than experienced
during the early stage. Economic performance is healthy and steadily
growing, and the increase in credit is also strong during this stage.
Inventories will also have had time to catch up to sales as investment causes

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these to grow and eventually reach equilibrium with sales. The monetary
environment accommodates growth at this stage but becomes increasingly
neutral and is no longer stimulating the economy as in the early stage.
The late stage finds a cooling of profit, credit tightening, and growing
inventories as sales die out. This stage is commonly described as the
economy “overheating,” with inflation preventing further growth as central
banks tighten monetary policy and interest rates rise. This phase is typical of
an economy that begins to experience profit warnings and a slowdown in
sales growth. For the first time in the cycle, inventories become considerably
larger than sales as access to credit tightens.
Finally, a recession sees credit dry up, profits fall, and both inventories
and sales falling. This stage completes the business cycle, with economic
growth contracting and access to credit becoming scarce for everyone.
Corporate profits fall, and slow sales eventually bring inventories back down.
Monetary policy gradually becomes more relaxed during this stage in order to
stimulate the economy and begin the cycle again. For investors, opportunities
exist across the spectrum of the business cycle.

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Building the Framework

Defining the Time Frame

I came from a hedge fund background. I’ve been in and involved with
hedge funds for over 22 years. And one thing I’ve noticed from the early days
of hedge funds is that investors didn’t have monthly mark-to-market; they
had trade horizons. And their trade horizons matched with their investment
horizons. For example, in the early days, Soros may have held a trade for
several months or even up to a year, but currently in the world of monthly
NAV, people are being forced down to a two-week trade horizon. And that
has left an enormous opportunity for people like me who look at the medium
term, which I view as 2 months to 18 months. That horizon has the least
competition in it and is the easiest to predict. It is also the most trending. So I
tend to do little trading under that two-week time horizon. Some people can
do that well, but overall, the market has lowered its returns by focusing on
shorter terms.
It’s much easier to learn the medium-term time horizon or understand the
probabilities involved in that and the investment opportunities. Traders in
short-term horizons must generally deal with smaller price movements and
noisy market fluctuations obscuring the trend, so the emphasis shifts to how
well one can get a fill-in order to maximize every basis point of profit. This is
an increasingly difficult prospect, given the proliferation of high-speed
trading algorithms specifically designed to take a small bite out of every
market order placed. In the midterm, the noise of short-term swings tends to
fall away and the emphasis shifts to whether the logic behind a trader was
correct. So that’s what I do in my monthly publication—I look at that time
horizon, and that has generally given me much better returns than most other
people in the industry.
Versatility is critical to me as I follow general guidelines and pride myself
on not being a slave to hard and fast rules. Again you look at the texture—for
example, if I am currently looking at what’s happening within the China
sphere, I will also be looking at Australia, Indonesia, Taiwan, South Korea,
Japan, and the US. I will examine, among other things, their trade balance
with China. I like to group data into three- or four-month blocks. This time

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frame provides the right balance between temporal and trend.
For example, if we start to see Asian exports to China pick up over a few
months, then it may be the start of something meaningful. It may get us to
positive territory so you can say, “Okay, something is happening. I need to
look at this and figure out if this is a short-term move or the start of another
expansionary phase.”

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Understanding the Big Picture
My approach is different than that of many other people. The first thing I
do is build my long-term macro framework. I ask questions such as: Are we
in a secular bull market or a secular bear market? Is the economy in the
inflationary/expansionary or contractionary/deflationary phase?
“Contractionary” means lowering the trend of average GDP growth, and I get
to those by looking at the really big macro drivers. These drivers include
demographics and maturity of population, where we are in the credit super
cycle. Those kinds of things make a very big difference. How high is debt-to-
GDP, household savings, the global balance sheets, or top-down balance
sheets? What do economies look like? So what that does is moves probability
in the direction of various outcomes.
I then look across all asset classes and try to understand where we are in
the secular bull or bear market in those asset classes. Doing that is what got
me interested in soft commodities back in 2006, because soft commodities
were massively undervalued relative to their asset prices. Equities on the
other hand were massively overvalued, even after the bear market of 2003,
using various measures including market cap to GDP, P/E ratios, and debt-to-
equity.
By extension, I look at global economies in the same kind of way. Where
are they in their cycle? Where do they fit in the global macro framework? If
we have an aging population and high indebtedness in the West, then we
have the inverse of that elsewhere—the young population with relatively high
savings and no debt in the so-called “monsoon countries.” Those are the
countries around the Indian Ocean; they tend to be Islamic countries that took
on the religion through a process of world trade (as, for example, the Arab
traders brought Islam to the spice-exporting Indonesian islands). They are
trading nations that have been long forgotten by most people because of
various investment biases. They become more interesting to me because they
have the wind in the sails behind them (key economic expansion like GDP,
money supply, ISMs improving, increased tax revenues, etc. (See Figures 6.1
and 6.2), as opposed to the doldrums of the West.

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Figure 6.1

Figure 6.2

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Understanding Cyclicality in the Markets
The most important question to investors in understanding a business
cycle is not where we are but where we are going. The market is a
discounting mechanism, and you must understand the probabilistic
outcomes that may be realized in the future and extrapolate backward to
present day.
This is how I start looking at the big picture. I focus most of my time on
understanding where we are in the cycle. But once you’ve built a big picture,
you have to understand where we are in that, and the most important
investable thing is what I term the business cycle.
Now, it differs a little bit from what the Austrian economists and people
like Schumpeter call the business cycle. I essentially look at the expansion
and contraction of GDP, and I use the ISM because the data goes back to
1947. And, additionally, you can bolt on some further ISM numbers that
we’ve done in-house so we can get it back to about the 1890s. And that gives
us an idea of how long the business cycle lasts, how far it goes, when it goes,
and what it does.

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The Secular Cycle
We first have to start with the secular cycle to give us the historical
understanding of where we are and where we are going, from a very top-
down perspective. In this analysis I am using the US secular cycle because it
is the key influence on much of the developed world, as well as much of
Southeast Asia, where demographics are similar.

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Demographics
Firstly, with regards to demographics, we need to understand at the
simplest level what the population structure looks like. In the Western world,
the population is aging rapidly and in some countries it is already shrinking.
An aging population, with the demographic bulge close to retirement age,
causes a drag on the economy as saving versus spending patterns shift. It will
also create a shift from investment to divestment in due course, dragging on
asset classes.
In Bloomberg, you can type in WPU <GO>, to get to the population
demographics screen in Figure 6.3

Figure 6.3
Choose the US and drag and drop it into another window. Then type GPU
<GO> to see a graph of the US population over the age of 65.

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Figure 6.4

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Long-term Equity Market Cycles
A ten-year moving average of the year-over-year percent rate of change of
equities is highly cyclical. It is the manifestation of the secular cycle and
illustrates it well. This is calculated by taking the year-over-year percentage
change for decades of equity market growth. For instance, if the S&P 500
ended one year at 1000, and ended the next at 1100, then the year-over-year
percentage growth would be 10 percent [(1100-1000)/1000 = 0.10 = 10
percent]. After getting all this data, the ten-year moving average for any
given year would be the average of the last ten years’ percentage changes (for
instance, the average in 2015 would be the average of the ten annual
percentage changes from 2006 to 2015; the average in 2016 would be the
average of the ten annual percentage changes from 2007 to 2016). Taking this
longer-term sample smooths out the noise from any given year (for instance,
the massive drop in the S&P 500 in 2008 would have less of an effect) while
still indicating whether the moving average is above trend (as it would be
when the business cycle has been expanding in recent years) or below trend
(as when the cycle is contracting).
Studying the rate of change movement can be an important tool to help
traders and market analysts gauge the momentum of a trend and identify
levels where a market may be temporarily overbought or oversold.

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 Figure 6.5
You can see from the above chart that this measure of the secular cycle
gives a good idea of when the investment cycle and the US economy are not
performing well. The drop below the 5 percent mark is when things are really
bad.
The key point is that this is cyclical; thus when the cycle rolls over, we
can forecast the future within a framework. As an example, at the time of
writing this chapter in 2016, we notice a higher probability risk for a 1933–
1936 style event, where the cycle rolled over giving a secondary fall and a
reduced return on assets and low economic performance.

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The Commodity Cycle
We can then add the Commodity Super Cycle to the secular framework.
Commodity prices are indicative of global investment levels and global
growth. In boom periods, overinvestment accumulates, leading to
overproduction and oversupply. In the bust periods, that overinvestment is
cleaned out; the supply overhang persists; and underinvestment often takes
place, sowing the seeds for the next boom when supply is squeezed and/or
demand rises again.

Figure 6.6
As you can see, the Commodity Super Cycle is heading much lower and
will eventually cross zero. This is a clear sign that the secular cycle is
pointing lower.

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The Debt Cycle
Finally, we add in the long-term debt cycle. We need to understand
whether the debt impetus is rising (which is expansionary) or falling (which
is contractionary). As we all know, the peak in the debt cycle sows the seeds
for the bust that eventually follows.

Figure 6.7
The debt cycle is clearly in the debt deflation zone, where total debt is
extremely high but the rate of change of debt has reached the tipping point
and can no longer expand at a fast rate due to the excessive debt burden. This
is a big drag on the economy.

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Secular Contraction
For the purpose of understanding my methods in this chapter, my key
indicators are still firmly pointing to the contractionary phase of the secular
cycle. Thus the busts are generally worse than the booms, and the overall
pace of the economy is sluggish and downside risks are prevalent.

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Analyzing the Business Cycle Itself
The next and single most important thing we need to understand is the
business cycle itself. This is THE key driver of asset prices and the direction
of the overall economy. The idealized version of a business cycle would see
consistent ups and downs and would be perfectly measurable.

Figure 6.8
In reality, the business cycle differs from this as some cycles are shorter in
length and some are longer, some are deeper and some are shallower.
Normally people might suggest it is random and therefore useless, but it is far
from that. It is one of the most powerful tools for economic and asset price
predictions that exists anywhere. All you need to do is understand that, when
the cycle peaks, it will move toward a trough (a recession). You can then
assess the probabilities of how long it will take to reach the trough, based on
any and all factors you deem relevant, and it will stop you from
overestimating the upside or downside.

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Figure 6.9

215
Blending the Business Cycle with the Macro Narrative.
While using the right key, like everything else you will read in this book,
in most cases it comes back to two factors. The first of those is the macro
narrative and the second is market positioning.
For example, assume we identify that we are in a negative phase of the
cycle, a period of low growth. Therefore, I’ll attempt to spend more time
looking for tops in those markets or points where we see bond yields fall. I
look for the negative turning points in the cycle because that’s where the bulk
of the returns lie.
The business cycle drives returns. You can overlay the year-over-year
change in the S&P and it is a facsimile of the ISM PMI (adjusted so that 50 in
the PMI corresponds with 0). Therefore, if you can forecast the business
cycle, you should do very well forecasting asset price returns. And that to
me is the crux of what most people miss in their analysis.
My experience has taught me that predicting the business cycle over the
medium and longer terms is easier than over the short term. But I know when
a shift is coming and, when it arrives, I know what’s going to happen to asset
prices because it’s happened almost every time at that point in the cycle. So,
again, the game for me is to look for probabilities based on the business cycle
and project what that does to asset prices.
Questions I always ask myself are:

Is current market sentiment in step with the business cycle or is it

pricing in a different scenario? For instance, is data starting to weaken
materially but the market is still positioned for growth, or are people too
defensive and things are starting to turn positive?
Are there exogenous political or economic factors (monetary policy,
government shutdown, technology, legislation, etc.) that can make this
cycle path different?
Now let us assume that we know the cycle is turning over. Let’s make the
assumption that we know the big macro backdrop and it’s negative. Then we
can understand that there are returns to be had playing the negative side of
the equation, by being long bond yields or short equities at this point in the
cycle. So how I look at that is down to the next element.
If you can forecast the business cycle, you are then able to forecast asset

216
price patterns. Utilizing the monthly guide of the business cycle, we can look
at almost every asset. Note that agriculture is mostly independent of the
business cycle, as demand for certain food crops is inelastic (people need to
eat in good and bad times) and supply shocks are often due to weather.
However, other assets like copper, industrial metals, equities, oil, bonds,
emerging market returns, and emerging market currencies are all related to
the business cycle. A comparison to the ISM PMI will show you they are
highly coordinated.

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Practically Trading the Cycle

ISM Is the Business Cycle

Cyclical effects have to be understood in the context of the attributes of
the economies they affect. For example, some economies—and thus their
currencies—have a bias toward manufacturing, while other are service-
oriented and less susceptible to the fluctuations of an economic cycle.
Correlations between economies are subject to change as factors including
industry, monetary policy, and domestic circumstances are in a constant state
of flux.
Professional traders, managers, and investors have a few pieces of data
that are key to their decision-making process. After GDP, one of the most
important, is PMI (otherwise known as a Purchasing Managers’ Index). A
PMI is sometimes referred to as a “headline” factor, as it gives early warning
of advances or declines in an individual country’s economic health.
A PMI is the result of a survey of a broad swath of purchasing managers
(those responsible for buying goods and services for a company) on whether
they believe activity across business domains will expand or contract. The
result is scaled to the number 50—if the majority of respondents feel business
activity will expand, then the number is above 50; if the majority feel it will
contract, then the number is below 50. A trend moving from 42 to 50 on the
monthly chart shows the economy’s expansion is “normalizing” the faster on
a monthly reading, the more optimistic the outlook. Sinking below 50 is a
major warning sign and below 42 is recessionary.
The ISM PMI—the most commonly used PMI for the United States—was
previously mentioned in this chapter and deserves to be explained further.
This index is a PMI published by the Institute of Supply Management on a
monthly basis. The ISM PMI is a key statistic in assessing economic health
or lack of it. It measures manufacturing output by surveying new orders,
factory output, employment, suppliers’ delivery time, and stocks of
purchases. It is computed in five separate subcategories and weighted
according to importance, with new orders receiving the greatest weight.
The comprehensive nature of the ISM survey produces data that can move
the market with the interpretations and directional clues it offers. It comprises

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data on new orders, production, employment supplier deliveries, and
inventories. These are five components of the business report, which includes
a total of 11 indices as follows:

New orders
Inventories
Production
Deliveries
Employment (manufacturing)
Customer inventories
Exports
Imports
Price index
Managers index
Backlogs
Additionally, ISM publishes a semi-annual economic forecast. The data
from the Institute demands global respect from economists’ dependent on
their data-driven forecasting. This is not mere conjecture.
A PMI has a number of uses in an interpretative sense, predicting
contraction and expansion in the economic cycle with, as we have seen, a
level of accuracy that can provide a basis for forecasting. The manufacturing
sector is the place where a recession begins and the place where signs of
recovery begin, even though the industry is not necessarily a major part of
GDP anymore.
PMI results can also give the first clues of advancing inflation by
indicating which way purchasing managers have seen prices going. (Of
course if your central bank is operating in a region not worried about
controlling inflation but, rather, with increasing it—such as the Eurozone and
Japan at the time this book was published—then the analysis changes quite a
bit and the monthly graphs become critical.)
ISM started collating PMI data regularly in 1948, and its reliable release
on the first business day of every month certainly added to its use as a
predictive tool. That’s just one of its strengths. So, too, is the fact that
historical data goes back to just after WWII. Another benefit is that the
information collated represents both the supply side (customer confidence)
and the demand as the amount of a manager’s reported purchases expands or

219
diminishes. With the index centered around 50, the critical extremes—as with
all PMI indexes—are 42 on the down side and 57 on the positive. When
extremes are close and troughs and peaks can be detected, the “cycle” may be
ready to retrace. One of the with this sort of analysis difficulties is that it does
not necessarily need an extreme to turn.
Once again, the monthly comparisons are important as they develop a
trend, or establish a low or high, and the signals they give can be advanced
warnings. Thus a shrinking manufacturing number can be an indication that
the contraction has begun long before it starts to show itself in other areas.
So, how I do create this voodoo business cycle I refer to? Simple. It’s the
smoothed ISM. The ISM itself is the best indicator in existence of the
business cycle. When it crosses 46 to the downside, the chance of a recession
is almost certain, and, when it slips below 50 (see Figure 6.10), there is a
large probability for a recession.

Figure 6.10
Just to emphasize the point, here is the chart of the ISM versus US GDP
(see Figure 6.11).

220
 Figure 6.11
I don’t use the ISM just to predict US GDP; I use it as my guide to the
global business cycle. To the extent that the US economy is highly correlated
to the global economy, it does an even better job at forecasting World GDP
(see Figure 6.12).

221
 Figure 6.12
And just to prove that it’s not just about the US weighting in World GDP,
here is the chart of ISM versus South Korean GDP (Figure 6.13).

222
 Figure 6.13
Now, nothing is perfect and everything requires nuanced understanding
and contextualization. The job of the ISM as our proxy for the business cycle
is to help us understand where the global economy is going and thus the
return on assets that we can expect going forward. The year-over-year
percentage rate of change of the S&P 500 is highly correlated to the ISM. If
the ISM breaks below 50, we can expect the S&P 500 to show year-over-year
negative returns, and if it breaks 50 to the upside, we can expect positive
year-over-year returns. Easy. What follows is the chart of the ISM (and the
Treasury Survey that preceded it) vs. the year-over-year S&P 500 going back
to 1886 (see Figure 6.14).

223
 Figure 6.14
And here is the chart since 1999 showing exactly how good a fit this is:

Figure 6.15
As can be seen, the ISM forecasts equity returns too! We can even
extrapolate (roughly) where the S&P 500 should be at any one time. Again, it

224
is not perfect but the best guide that exists. For example, in 2015, noting that
the ISM was in its down phase and extrapolating the speed of the decline, I
could forecast with a higher degree of certainty than most other analysts that
the S&P 500 would not have a very positive year last year. The ISM helped
me get that bet right.
The S&P 500 fits the ISM because corporate earnings are obviously
correlated to the overall growth of the economy:

Figure 6.16
But the magic of the business cycle doesn’t stop there—the ISM is
especially good at forecasting commodity prices.
We can forecast lumber prices:

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 Figure 6.17
Copper prices:

226
 Figure 6.18
And crude oil prices:

Figure 6.19
It is also the key factor for Global Equities, Global Bond Yields, and even
Credit Spreads:

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 Figure 6.20
Figure out the direction of ISM and you’ll know the direction of all assets.
Thus, if you can formulate a view on where the ISM is going, you have a
better chance of predicting asset prices than pretty much anyone on Wall
Street, with their model-based assessment. Understanding the business cycle
helps you get it right more consistently than anything else. Add in a bit of
technical analysis for entry and exit levels and a sprinkling of risk
management et voilà! You will have the best asset-pricing model in the
world.

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Overlay All Cycles
It should be stated again that nothing is perfect, even a match as well fit as
the ISM PMI. There are always a few false signals, a few longer cycles or
shorter cycles, and that is where the hard work lies. To gain a better
understanding, we need to overlay the secular cycle. Knowing that the secular
cycle was down helped me to forecast that economic growth in the US would
be lower than most people forecast since 2009. Then noting the direction of
the ISM and plotting that against the average length of a business cycle gives
me greater ability to predict when key risks or opportunities may occur in the
future. Finally, we need to figure out the movements in the ISM as it winds
its way from peak to trough to peak again. For that, I use the Citi Economic
Surprise Index (CESI).

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The Short-Term Cycle
The CESI, (Figure 6.21) like the ISM, is highly cyclical and, unlike the
ISM, these cycles are very consistent within a time range. This helps us
understand when the economic data is going to disappoint or when it is likely
to exceed expectations.

Figure 6.21
The recent turn lower in the CESI cycle was forecastable two or three
years ago (due to the relative predictability of the cycle lengths) and, when
taken in context with the ISM structure and direction, afforded me the ability
to predict some two and a half years ago that the US would likely be flirting
with recession in Q4 2015. The chart above illustrates this analysis.

230
Finding Qualitative Alpha
Identifying sources of qualitative alpha is the magic; it’s the hardest thing
to do. You have to understand what you are looking at, the context of it, and
what that means for probabilities of events. Ultimately, all we care about are
probabilities, as we trade and invest based on what is likely to happen. I have
an implicit understanding of what the probabilities of a trade working and not
working are.
Another aspect of synthesizing all of this involves understanding things
such as market positioning. It is not the most important factor to me, but I
like to understand if I see a great opportunity for a trade—for example, prior
to publication, I’ve been seeing a great opportunity in being short the euro,
but the euro has been rallying. I can see that the market had the position on, it
got overextended, and it’s been forced to close the position over time. I can
see that the market is now looking for excuses for why the euro hasn’t gone
down, with analysts’ reports touting any number of reasons, which are then
picked up by the financial press.
If I then put that into my framework and my technical analysis and look at
what’s going on in the broader concepts of Europe, that gives me the
opportunity to enter my trade. If the market has gone up, positions have been
closed, and people who shorted too early are getting blown out of the trade,
then the opportunity will present itself.
That’s certainly counterintuitive, and it’s a very difficult thing to learn. It
comes from experience and understanding how markets function, how the
various participants function, and also learning to filter news flow. Filtering
the news flow is probably the single most important thing. Most people take
too much news flow at its face value and don’t do enough homework
themselves. The real thing is you need to build your own view and not listen
to everybody else. And then read around to question your own view or to
support your own view. Many people trade based on somebody else’s bit of
research they’ve just read and it kind of makes sense to them today.
However, by tomorrow they’ve forgotten about it and are doing something
else.
To put probabilities further in my favor, I like to look across all asset
classes for confirmation. If I’m looking at a big global macro picture, I look
across all asset classes to see if there is any supporting evidence. If I’m

231
looking for the cycle to roll over, like in the US, I’d like to see the evidence
of that in the currency markets, the commodities markets, in fixed income
markets, and in the equity markets. And I’d like to see it not only in US
equity markets but also in the other global equity markets. So I’d like to put
the whole lot together, and that’s a real art. It’s very difficult to do because
you have to have a very broad framework and an understanding of countless
different things. Still, it’s not impossible to learn—it just takes time.
And really learning how to filter is what gets you there!

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Conclusion
Identification of the business cycle is critical in properly assessing the
market regime and the potential profitability of certain strategies. This
chapter has walked you through some of my process for extrapolating future
asset price movement using the tools I favor for identifying where we are in
the business cycle and where we are likely headed. That process is a key
component in the pursuit of maximizing return per unit-of-risk.

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CHAPTER
7

234
 Identifying Capital Flows in
Financial Markets – Fotis
Papatheofanous
Measuring capital flows and gauging what is driving those
flows are two critical approaches I used to create the Regime
Profitability Factor (RPF), the multiplier that projects how a
given strategy will perform in a given asset class. The
influence of capital flows is a critical input in computing the
RPF and consequently, how much capital I should allocate to
a certain strategy on any given day. Fotis Papatheofanous, a
professional portfolio manager with a strong global macro
bias and the managing director of the Fotis Trading Academy,
is a close friend and colleague who provides institutional-level
analysis for me on this subject. Along with a weekly macro
newsletter and analysis that Fotis prepares, we regularly
compare notes about the macro landscape and where capital
flows are going for the day. I overlay his capital flow analysis
with the UoR ratios outlined in Chapter 5. Fotis, due to his
situation in Europe, traveling between London and Greece,
has become my Mediterranean mojo. He is one of the first
people I speak to when I get up in the morning. He shares with
me information about what is driving the macro narrative,
which in turn outlines how capital flows moved the markets
while I was asleep.
Capital flows, as will be described in more detail in this
chapter, are the path that money is taking around the world—
to which countries and which asset classes money is flowing.
Simply put, if money is flowing into a specific asset, its value
will increase with the increased demand (conversely, if money
is flowing out, its value will decrease). Taking capital flows
into account, we can build on the old dictum of “buy low, sell
high” to say “buy before future capital inflows increase the
value, sell before future capital outflows decrease the value.”
This admittedly takes a lot more verbiage, but the extra verbal

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 effort is worth it. Understanding capital flows, knowing why
they occur, being able to analyze them, and—most importantly
—predicting future capital flows before they happen are all
key elements of global macro trading.
Perhaps it is the longstanding Greek nautical tradition, but
Fotis navigates the complex waters of capital flows like an
experienced seaman, charting their currents and projecting
their destination. At the same time, he is able to express his
process so simply that it should be accessible to even the
novice trader.
—John Netto
One of the key “ingredients” that contributes heavily toward your success
in global macro analysis is being able to ask the right questions. It is
important, occasionally, to look back in time, study history, and identify the
lessons the past can teach us regarding investing and investors’ behavior.
One of the greatest traders and investors who ever lived was Jesse
Livermore. After the crash of the stock market in 1929, he was worth around
$100 million. That’s roughly $1.4 billion in today’s terms, after adjusting for
inflation!
He started his career at the age of 14, trading at “bucket shops,” and he
eventually became so successful that the owners of these establishments
would not allow him to trade with them. Today, we would describe him as a
“day trader” or a “scalper,” paying attention to momentum and breakout of
ranges, especially in his early years of trading.
Now, you might ask yourself why this is important and relevant, in a book
focusing on global macro and maximizing return per unit-of-risk.
The answer is simple and the message from studying the past is clear: as
Jesse Livermore grew up and wished to trade in a more professional manner,
entering bigger transactions and trying to capture larger trends, he realized
that he must start paying attention to the overall status of the economy and
identifying the big picture first, rather than focusing exclusively on the short-
term trend of the markets.
The lesson learned is that we should begin our analysis and investment
process with a top-down approach, trying initially to identify the “big
picture” in the financial markets. It is important to begin our process by
asking the right questions that will enhance our understanding. It will
enormously help our investment process by trying at first to understand the

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bigger context in which we operate. We must initially be able to answer
questions such as:
What is the bigger picture among macro themes that we should be careful
not to neglect? Which phase of the business cycle are we in the moment? Is
there a divergence between actual economic indicators and the expectations
of the public regarding future developments? Which catalysts or macro
themes are driving prices at the moment?
So the very first step of our process should be to identify the status of the
economy, the position on the business cycle, and current market sentiment.
To provide an example of this, we can look to one of the most famous
currency trades in recent history. George Soros became very popular after the
collapse of the British pound in 1992. His famous speculative position was a
macro trade based on the fundamentals of the UK economy at the time. The
UK government was engaged in an expansionary fiscal policy of taxing and
spending, while high inflation and the UK’s involvement in the Exchange
Rate Mechanism15 were seen to provide the perfect macro storm for George
Soros. Even when the UK government raised the interest rates above 10
percent to try to stem borrowing and bolster the value of the pound, the
downward spiral continued and a heavily leveraged $10 billion trade by
Soros earned $1 billion in just a few days.
Studying the macroeconomy at the first stage of your analysis provides
you with a distinctive edge since you are paying attention to the actual forces
that move the markets, and you are focusing on the forces and catalysts that
drive prices. This can give you a significant advantage because of the
potential to use these factors as leading indicators.

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 Figure 7.1
As you can see in Figure 7.1 above, as the macroeconomic environment
changes (macroeconomic indicators change) and this causes the economic
cycle to change too, it affects the response from central banks and
governments, as they adjust their monetary and fiscal policies accordingly.
For example, if inflation is seriously moving lower, threatening the economy,
then the central bank needs to intervene and most likely decrease interest
rates in order to stimulate the economy and avoid deflation. In May 2009, the
European Central Bank announced a broad Quantitative Easing (QE)
program in which it would start buying covered bonds worth about $60
billion in order to avoid further deflation. In January 2015, they announced
that they would expand the program in order to reflate the eurozone area.
But this action affected financial markets, and certain asset classes reacted
in a very specific way. The lower yield environment in the eurozone caused
the euro currency to depreciate significantly; equities, on the other hand,
benefited and moved higher.
But, you see, financial markets also impact real economic activity. For
instance, a low currency value affects a nation’s exports in a positive way
but, on a global level, this will also bring a reaction from another country
seeking to compete on the international trade. Based on our example above,
regarding the QE in eurozone and the depreciation of the euro currency, what
would be the reaction of other central banks? Can Japan or USA tolerate very

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low values of the euro? How is this affecting THEIR exports and overall
competitiveness? You can understand that they will have to adjust their
policies accordingly and therefore another cycle begins! In fact, in the years
following May 2009, both the Bank of Japan and the US Federal Reserve
adopted expansionary monetary policy by engaging in their own broad-based
QE programs.
Once we have identified the “big picture” and how macroeconomic
indicators and central bank policy interact with each other, we should start
paying attention to capital flows because this will help us understand if our
investment thesis is valid or not. Simple as that. We might believe that the
stock market will crash due to any number of reasons, but if the flows
indicate an increased appetite for risk and there are strong flows into riskier
assets, then we need to re-examine our original proposition.
Back in 2007, the chairman of the US Federal Reserve, Ben Bernanke,
made the following statement:
“…given the fundamental factors in place that should support the
demand for housing, we believe the effect of the troubles in the subprime
sector on the broader housing market will likely be limited, and we do not
expect significant spillovers from the subprime market to the rest of the
economy or to the financial system.”
–May 17, 2007 Remarks of Ben Bernanke at Federal
Reserve Bank of Chicago’s 43rd Annual Conference on Bank
Structure and Competition, Chicago, Illinois
Not long after he said that we had seen the beginning of the Great
Recession, a crisis that threatened not only the US economy but the global
financial system as well. We can’t predict the future, but paying attention to
the overall conditions and identifying capital flows correctly may not only
warn us about the financial risks ahead but also can be vital in choosing the
right asset class to focus on.
In the next sections, we will discuss capital flows extensively and how
you can benefit practically from this process.

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Capital Flows
Let us begin with a definition of capital flows.
Capital flows measure the net amount of a currency that is being
purchased or sold due to capital investments.
In order to understand this better, suppose that the Australian economy is
growing very strong. Meanwhile, in the eurozone, an anemic and weak
economy is creating a shortage of investment opportunities. In such a case,
the logical result would be for eurozone investors to sell their euros and buy
Aussie dollars so they can participate in the booming Australian economy.
This would result in outflow of capital from the EU and inflow of capital to
Australia. From an exchange rate perspective, this would cause a fall in the
EUR currency and a rise in the AUD as investors are willing to sell their
EUR positions, driving excess supply higher but simultaneously demand for
the AUD increases.
Capital flows can be divided into two broader categories:

Physical Flows and Portfolio Flows

– Physical Flows: This includes actual foreign direct investments into the
country, such as real estate, manufacturing, local acquisitions, and others.
– Portfolio Flows: We can identify portfolio flows in the equities and
fixed income markets.
Equity Market: Theoretically the stronger the performance
of a country’s market, the stronger the capital flows, since
everyone would like to take part in a bull market.
Fixed Income: In times of global uncertainty, fixed income
investments are becoming more popular because of the
demand for “safer assets.” As a result, economies offering the
most valuable fixed income opportunities will be capable of
attracting more foreign investments.
In the following pages, I will share with you my methods for identifying
portfolio flows across different financial markets. This will greatly help in
finding trades with an appealing return per unit-of-risk.

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How to Identify Portfolio Flows
a) Carry Trade and the Inverse Carry Trade Strategy
If we understand the mechanics of the carry trade and the inverse carry
trade strategies, it will help us to further understand the current financial
environment, evaluate the regime that exists in the markets, and identify
where capital is flowing in the global financial system.
The carry trade is a long-term strategy that is used mainly by investment
banks and large macro hedge funds. The carry trade can be implemented
using both currencies and bonds.
If an investor prefers to use currencies, then this strategy would be
implemented by borrowing and selling the lowest yielding currency, while
buying and lending (often by depositing in an interest-bearing account) the
highest yielding currency. Not only does the investor pocket the difference in
interest rates but, while the carry trade holds (that is to say, while the market
is not rushing to unwind the transaction), the investor also experiences profit
from appreciation in the purchased higher-rate currency (since traders are
buying) and depreciation in the lower-rate currency. In the years leading up
to publication of The Global Macro Edge, the most commonly used currency
pairs for carry trades have been:

AUD/JPY, NZD/JPY, GBP/JPY, CAD/JPY, EUR/JPY, and

USD/TRY
To minimize overall risks and volatility in their portfolio, investors will
generally buy a basket of these currencies, instead of just one pair. Although
the carry trade strategy has made billions of dollars for many hedge funds, it
does not offer guaranteed outcomes and there are significant risks involved.
The carry trade exists when speculators borrow a currency with a low
interest rate and purchase bonds in a country with a higher interest rate. The
difference in the amount that the trader has to pay in interest and the amount
earned from the bond yield becomes profit if the borrowed currency remains
more or less the same. This is known as a “positive carry” and allows heavily
leveraged currency trades to become hugely profitable over time.

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 Figure 7.2
Figure 7.2 shows you an example of a very popular carry trade: the GBP
vs. the JPY, back in 2005–2006. At the beginning of 2005, the yield on the
GBP was between 4.50 to 5.00 percent, while the yield on the JPY was
between 0.00 and 0.25 percent. Therefore, if an investor bought one contract
of the GBP and sold the JPY, he would be earning $22.35 in interest on a
daily basis. The profits at the end of the year would be close to $8,150 from
the interest rate differential alone, besides the appreciation of the GBP against
the JPY.
But what information do we receive regarding capital flows and the
sentiment of traders during the period where the carry trade was popular? By

242
understanding sentiment, we can further understand the behavior of investors,
and this will lead us to identify where capital is flowing. Continuing with the
example above and as you can see in Figure 7.3, investors had an increased
appetite for risk, willing to chase higher-yield, “riskier” investments. As
such, assets such as higher yielding currencies, equities, commodities, and
real estate moved higher. On the opposite side, bond prices moved lower as
there was less demand for “safe haven” assets.

Figure 7.3
Due to the sheer size of the carry trade market, any indication of a change
in circumstances can result in an unwinding of positions, which can wipe out
smaller traders very quickly. An example of this occurred during the Asian

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financial crisis in 1997, where, as result of unwinding of carry trades of high-
yielding bonds, huge flows of money out of a country or region created a
global crash. In the case of the yen carry trade, an indication of a rise in
interest rates from the Bank of Japan would wipe out billions of the carry
trade profit.
While the bond markets of emerging market economies are often seen as
good vehicles of the carry trade, they are also considered as highly risky.
Bond markets have high yields relative to the risk of the financial health of a
nation. Where there is a risk that the country will not be able to finance the
debt it creates from its borrowing, the yield is higher. Since the value of carry
trades in these high-yielding emerging markets is estimated to be around 2
trillion US dollars, all it would take is for one of these countries to be unable
to finance its debt and these markets would unwind, causing financial chaos
and widespread economic repercussions.
The inverse carry trade (also called “reverse carry trade”) attempts to
profit from the unwinding of carry trade positions and the subsequent sharp
negative movements in the value of the high-yielding currencies as a result.
When global macroeconomic events cause a flight to quality, the high-
yielding currencies are considered to be risky investments and experience
volatility and sharp devaluations against other safer currencies. The events
are self-fulfilling, as nervous investors dump their large carry trades, and any
losses attached to these, in favor of the security of safe haven investments
such as the US dollar.
The resulting flow of funds out of the high-yielding markets can have
serious implications for the financial system, with traders taking short
positions to further push the currency lower in a secondary movement
following the reduction in risk tolerance.
Take a look, for example, in Figure 7.4 what happened in January 2016
due to fears surrounding the health of the Chinese economy and global
deflation pressures.

244
 Figure 7.4
An important downtrend in FXI, the iShares China Large Cap Index
caused the carry trade to unfold, resulting in the strengthening of the Japanese
yen against all major currencies and strong flows away from “riskier” assets
and toward “safe haven” investment, such as sovereign bonds.
If the early signs of decreasing risk tolerance can be spotted by traders,
they can provide very good opportunities for a profitable trade. In a globally
connected economy, there can be multiple signals that could give rise to
negativity in investors. Another example is the financial crisis of 2008. As
the scale of the banks’ exposure to toxic mortgages in the US market became
apparent, traders began to scale back their risky investments, especially carry
trades (which were seen as potentially the riskiest of all).
b) Using Equity Markets to Identify Capital Flows and Sentiment
We can specifically use equity indices to understand current market
sentiment and monitor capital flows.
The best way to illustrate this is by using a practical example that
happened in January 2016. Sentiment was very negative due to concerns
about global growth and the Chinese economy, as well a big drop in
commodity prices, particularly crude oil.
Investors were pulling out of global equity indices due to the increased
risk aversion, and this can be better illustrated in the iShares MSCI World
Index. You can observe in Figure 7.5 a strong, distinctive downtrend, as
capital was flowing away from equities and into bonds since they are
considered a safer investment.
It is extremely important to establish the nature of the current regime in
the markets and understand sentiment amongst market participants, as this
will greatly assist you in identifying which way the capital flows are moving.

245
 Figure 7.5
Hence, based on the example above, due to negative sentiment as well as
concerns about the economy and global growth, there were capital outflows
away from equity markets.
Instead, there were capital flows into safe haven assets such as bonds.
Figure 7.6 below shows you the BND ETF that tracks the total bond market.

246
 Figure 7.6
You will notice that just as there were flows away from equities, there
were comparable flows into bonds.
c) Using Fixed Income to Identify Capital Flows and Sentiment
A good gauge of capital flows are the short- and long-term yields of
international government bonds. It is important to monitor the yield between
ten-year US Treasury Notes and those on foreign bonds. The reason is that
international investors tend to place their funds in countries with the highest
yielding assets.
It is prudent to pay attention to the interest rate differentials between
foreign bonds, as investors, especially in times of normal economic activity,
will prefer to invest in countries that offer higher yields.
– Euribors, Eurodollars, and Short Sterling: Analyzing and monitoring
the spread between Euribors and Eurodollars is a very favorable approach
among institutional investors in order to understand and track flows. The

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Eurodollars are USD denominated deposits located outside the USA, mostly
in Europe and other international locations. Euribors are rates offered mainly
to prime banks and reflect the rates in the interbank market that European
banks and institutions agree to lend and borrow money from each other.
When there is a significant premium in the spread in the Euribors compared
to Eurodollars, usually investors would be more incentivized to sell their US
assets and flow into the higher-yielding investment. On other occasions, the
spread will be in the favor of the Eurodollars; the interest rate differentials
will favor US assets, hence making them more attractive compared to other
investments, and there will be capital flows toward the higher-yielding
investments.
Investors can also compare fixed income products from the UK, such as
the Short Sterling against Euribors and Eurodollars. Short Sterling is a short-
term interest rate product in the UK. Similarly to the prior exampple, if there
are positive spread differentials in favor of the UK’s assets against those of
US and Europe, there are going to be positive capital flows in favor of UK’s
assets. If there are macroeconomic reasons that cause this spread to narrow
significantly or move in favor of other economies, it may cause investors to
move away from GBP denominated assets and flow into other investments.
As an example, you can see in Figure 7.7 below, in the period from
December 2015 to February 2016, as the UK’s ten-year yield was moving
lower due to expectations regarding Bank of England monetary policy, the
British pound was moving lower too, due to the lower yields.

248
 Figure 7.7
– International Fixed Income Market: We can monitor the international
fixed income markets and pay attention to the interest rate differentials
globally. Historically, resource economies and commodity producers like
Australia and New Zealand offer higher yields which can incentivize
investors to buy assets in those countries, especially if global financial
conditions are positive and investors are more willing to accept risk.
However, in times of uncertainty and when there is a risk aversion sentiment,
investors will most likely prefer safety over the opportunity for a higher
yield.
Let’s use an example in order to further illustrate this dynamic:
From the period between 2014 and early 2016 and due to concerns about
growth in China and Southeast Asia and the resulting drop in commodity
prices, growth prospects in the Australian and New Zealand economy were
put in question, and there were serious concerns regarding future GDP
growth. Therefore, it was expected that monetary policy in these two
countries would become more accommodative, following a lower interest rate
path in order to stimulate the troubled economies.
Hence, as you can see in the following charts, as commodities dropped
during that period (Figure 7.8), expectations regarding the prospects and
potential GDP growth in Australia and New Zealand moved lower as well.
As such, there were expectations for a more accommodative monetary policy,

249
which pushed yields lower (Figure 7.9).

Figure 7.8

Figure 7.9
The result was capital outflows moving away from these two countries,
and the impact was best seen in their respective currencies (Figure 7.10).

250
 Figure 7.10
- The LIBOR-OIS spread: The LIBOR-OIS spread is another “tool” that
can be used to measure risk aversion in the markets and is especially useful if
used in conjunction with the VIX Index. LIBOR rates are the interbank
charges on short-term unsecured loans, and they are commonly used for
unfixed mortgage rates and floating loans. The OIS rate is the assumed rate
of the central bank over a specified time period and provides the reference for
the overnight rate for swaps. By paying attention to their differential, any
“widening” of their spread can indicate potential unrest ahead, sending a
warning to investors who may wish to move away from “riskier” assets and
flow into “safe haven” investments.
In Figure 7.11, below you can see the big spike that happened in the
spread during September 2008, when the Lehman Brothers crisis began.

251
 Figure 7.11
That caused investors to become far more risk averse, preferring safety
over a potential higher return; therefore, there was capital flowing into safe
haven assets.

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Regime Identification and Capital Flows
As the global economy becomes ever more interlinked, increasing levels
of correlation among various different asset classes occur. The globalization
of financial markets, the hunt for returns and “alpha,” as well as advanced
risk management techniques have all contributed to a very close
interrelationship between economies on an international level. For example,
during periods of increased risk aversion, “riskier assets” such as
commodities, junk and emerging market bonds, and (of course) equities, all
tend to move down in synchronicity, and the fear effect is enhanced across all
different continents. This becomes an important macro event and leads to a
focus on the macroeconomic environment and the global outlook.
It is therefore important to correctly identify the current market regime, as
well as the macro narrative that is driving prices, because this will help us
predict the momentum and direction of capital flows in the global financial
markets.
Let us first define two related major market regimes that will help us
determine the catalysts that are driving prices and the direction of capital
flows: Risk-On and Risk-Off.

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Risk-On Regime (Increased/Higher Risk Appetite)
“Risk-on” describes an environment where there is risk appetite; the
market believes that the global economy is strengthening and therefore the
demand for commodities will increase and traders will tend toward riskier
positions. This will have the effect of increasing demand for higher-yielding
currencies, which include the AUD, CAD, and NZD. In this environment, the
carry trade will come into play where the currency with the lowest rate will
be sold to fund the purchase of a higher-yielding currency, the most obvious
example being the JPY sold to buy AUD, CAD, or NZD, thus longing the
AUDJPY, NZDJPY, and CADJPY. In recent years the euro has been used as
a funding currency, due to its low rates. In risk-on conditions equities will
rise, and bonds will fall, with the yields increasing as they do so, and
emerging markets (which represent riskier investment) will benefit.

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Risk-Off Regime (Risk Aversion)
“Risk off” describes conditions where there is a developing aversion
toward risk. In this environment investors can move away from higher-
yielding assets, expecting the global economy growth to slow down or even
turn negative. Investments favorable during risk-on conditions will be
reversed, and, as commodities fall, so will the commodity currencies (the
AUD, CAD, and the NZD). The carry trades will also unwind, pushing up the
value of the funding currencies, notably the JPY and the euro. There are
different stages and levels of risk-off conditions, but if fear enters the market,
there will be a run to safety and liquid assets. Equities are moving lower,
bonds will rise (considered a safe haven investment), and emerging markets
will suffer, alongside the commodities.

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Risk-On and Risk-Off Assets
It is extremely daunting to construct an investment portfolio that is
resilient and performs well across all different economic environments. There
are certain asset classes that will perform well during a deflationary phase of
the economy but can seriously underperform when inflation returns and we
move to a completely different regime.
Assets will behave differently in different regimes, and this is best
illustrated by research that was carried out by HSBC Quant Research. The
Correlation Heat Maps (Figures 7.12 and 7.13) were generated to help us
distinguish between risk-on/risk-off regimes. These heat maps are nothing
more than correlation matrices that show us the correlations among various
different asset classes. Correlations amongst different assets can range from
-1 (perfect negative correlation) to +1 (perfect positive correlation). In the
heat map, we indicate a perfect positive correlation with a dark red color
(assets move in same direction) and a perfect negative correlation with dark
purple (assets move in opposite directions) and with the rainbow spectrum in
between.

256
 Figure 7.12
Source: HSBC
The preceding heat map (Figure 7.12) was generated for the period from
June 2005 till the 19th of October 2005, during normal market conditions.
You can see that correlations were in their usual ranges without any extreme
readings.
Now pay attention to what happens to correlations and intermarket
relationships in Figure 7.13 when we have a major risk-off event, there is a
crisis, and we have very negative sentiment in the markets.

257
 Figure 7.13
You notice how correlations become too strong, either very positive or
negative among different assets. You can see how all the different
international equity markets are very positively correlated, meaning they all
move in the same direction. The same applies for the Australian and
Canadian dollars.
On the other hand, equities are extremely negatively correlated with the
Japanese yen and bonds, meaning they move in opposite directions. So when
crisis struck, people rushed to sell their risk assets, such as stocks and risk-on
currencies like the AUD or the CAD, and moved to safer investments such as
bonds and the yen.
In the table shown in Figure 7.14 below, we have divided major asset

258
classes into two major categories, risk-on and risk-off assets. This simply
means that when we have a risk-on regime, we will be looking to invest in
specific assets that are favored by this regime. However, when sentiment is
negative or if we experience a bearish market, then we will be looking to
invest in risk-off assets. We will explain this in more detail below.

Figure 7.14
Please keep in mind that the market’s regime doesn’t have to be
exclusively risk-on or risk-off; there are regimes where, because of
uncertainty regarding economic developments and the changing nature of
capital flows, there can be mixed signals and intermarket relationships.
There are others that prefer to identify regime based on inflation and
growth rates as you can see in Figure 7.15.

259
 Figure 7.15
In early 2016, as there were concerns about global deflationary pressures,
global inflation was at very low levels and global growth was revised lower,
as shown in the red quadrant above, causing capital to flow to sovereign
bonds and safe haven assets. If you recognize the current regime either by
paying attention to fundamentals such as GDP growth and inflation or risk-
on, risk-off sentiment, then the behavior of investors is more predictable and
you can identify the capital flows moving in certain directions.
Based on the example, at the beginning of 2016, because of lower
inflation and lower growth expectations and a rather strong risk-off
sentiment, investors tended to behave in a certain way, and there were capital
flows in safe haven assets.
The comparison chart in Figure 7.16 shows the returns of a few
characteristic assets that demonstrate capital flows in certain directions at the

260
beginning of 2016, when we had negative sentiment in the global markets.

Figure 7.16
As you can see in this risk-off, lower-inflation, lower-growth
environment, ten-year US government bonds had one of the best
performances, followed by the Japanese yen, as investors sought safety. As
commodities like crude oil were dropping, equities also followed, as well as
commodity currencies such as the Australian dollar. Please also pay attention
to the strong correlation between the S&P 500 and the VT ETF, which
represents the Total World Stock Index. Because of globalization and
advancements of technology, all major asset classes are heavily correlated
and closely connected. Therefore, if we pay attention to the fundamental
catalysts that are driving prices and the current sentiment in the financial
markets, we can successfully track capital flows from one asset class to the
other.

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Conclusion
As the business cycle and economic activity fluctuate and change over
time, capital flows from one asset class to the other as investors try to adjust
and restructure their portfolio to match current economic conditions (Figure
7.17).

Figure 7.17
Therefore, if we understand current macroeconomic conditions and pay
attention to key relationships amongst assets, we will be able to identify
capital flows, which can lead to high probability trades and investment
decisions.
The key is to start asking the right questions!
From Figure 7.17, try to identify in which phase of the economic cycle
we are in at the moment. Is the economy heading into recession or
recovering? Is economic activity expanding or contracting? Each different
phase favors certain assets over others.
After you have identified the current phase, you need to understand the
inflation outlook, as this seriously impacts monetary policy by the central
banks. As we have explained before in previous sections, when the
macroeconomic indicators impact the monetary policy, this in turn affects

262
financial assets and makes investors’ behavior more predictable.
Finally, since we have identified the current financial environment and we
understand where we are on the economic cycle, we can apply our strategy,
either technical or fundamental, to pinpoint the entry and manage the risk.
The important thing is that we can recognize what is affecting the markets,
what is driving prices, and where to look for opportunities. The correct
identification of capital flows, sentiment, and intermarket relationships can
lead to better investment decisions and high-probability trading setups!
15 The Exchange Rate Mechanism was a European initiative tasking member
countries with fixing their exchange rates to each other within a certain margin of
movement. When necessary, this rate was maintained by monetary policy and active
intervention.

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CHAPTER
8

264
 Creating an Environment for
Identifying the Regime
Many investors talk about how some market environments present real
problems for their strategies, while others may create a bonanza. I am not
immune to a tough market environment, so I can attest to how challenging
times can put one’s equity curve under severe duress. Recognizing that
different regimes offer different P&L opportunities, I have made the largest
efforts in my evolution as a trader to benefit from the market
environment I find myself in, rather than be a victim of it.
By dint of little more than persistence and discipline, I have benefited
from favorable market environments in varying degrees for each of my
strategies. The regimes and opportunities presented by such environments
proved fertile ground for the outsized returns outlined in Chapter 3. While
some of this comes down to chance, I make every effort to make chance work
in my favor. To that end, I am always attempting to identify the dynamics of
the market I am in, and I adjust my trading accordingly. That is one of the
tenets of the Protean Strategy, which—like the shape-shifting god it is named
for—seeks to stay ever flexible. After all, it becomes significantly easier for
the market environment to be favorable for strategies when those strategies
seek to embrace the market environment.
So much of the analysis I do is dedicated to detecting and adapting to
market changes, based on what I have learned and what the market itself is
doing. Everything from the time of day I go to exercise, when I read
newsletters, what entries I make in my journal, and the range of hours I trade
are all dynamic endeavors. These are a direct function of the market regime.
In my experience, regime recognition involves a combination of art and
science to understand the current market environment. It is my intention to
get very granular and show how my process of performing qualitative
analysis relies heavily on definable quantitative processes as inputs. It is my
hope that, by pulling back the curtain to the greatest degree possible, the
reader will learn (or at least gain insight into) how to apply this framework
for personal gain.
This does not mean that all analysis stems from qualitative and
quantitative examination of the markets. There are two environments you
should always be aware of: the financial market you are following and your

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own personal life. I am a firm believer that if your personal life is not
balanced, then your ability to objectively assess the state of the market will
likely suffer.
Although this chapter goes into a great deal of detail about my personal
process, the most important takeaway is not what time of the day I wake up
or which newsletter I read, but the logic of my process and the spirit behind
it. A general understanding of how my personal process applies to my
situation will help the reader in developing his or her own process.

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Personal Environment for Identifying Regime
There are five factors for creating the environment for identifying the
market regime:

1. Research
2. Trading Software and Applications
3. Desktop Layout
4. Trading Journal
5. Daily Routine

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1. Research
I made substantial investment in research throughout the process of
generating over $3 million in profits from a starting risk budget of $100,000.
I allocated resources to both off-the-shelf and bespoke research. These
investments proved material in helping me identify and profitably trade the
market regime. Without it, I would not have had as deep an understanding of
the markets and, consequently, I do not believe I would have been able to
maximize return per UoR at the same level. It is my goal to help you
understand which qualities I deem important in research, in order to help you
successfully invest in products and services that add value to your process.
Keep in mind, however, that what works to help me identify the market
regime may not be a fit for every reader.

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Cost-Benefit Analysis
Before subscribing to any research, signal service, or third-party products,
I perform a cost-benefit analysis of a potential return. As a baseline,
research becomes something worth purchasing if based on my analysis I
can generate a minimum tenfold return on investment. For example, if I
invest $10,000 in research, I need to be confident that I can make a
minimum of $100,000 from that research, if not considerably more.
The logic behind a minimum ROI of tenfold is straightforward. In
analyzing the revenue generated on my portfolio, I separate my roles into
four parts:

John Netto, The Investor

John Netto, The Money Manager
John Netto, The Operations Guy
Research/Signal Service/Third-Party Applications
I always start by paying myself as the investor. Therefore, John Netto The
Investor needs to always make between 50 to 80 percent of the profits.
Whoever is risking the capital should get the largest slice of the pie. John
Netto The Money Manager needs to earn between 10 and 30 percent of the
profits depending on how well I maximized return per UoR. John Netto The
Operations Guy needs to earn between 5 to 10 percent of the profits to cover
all of the back office work that goes into running a portfolio.
Let us apply this model to a two-million-dollar portfolio that generates
$500k in total profits with a Netto Number of 1.5. Based on the Risk Factor
Compensation System covered in Chapter 22, the investor should get 70
percent of the profits, or $350,000. This leaves 30 percent, or $150,000, to
split between The Trader, The Operations Department, and Research. After
you add the previous factors up, this leaves you with between 5 and 10
percent to cover your research, signal service, and third-party products. For a
profile such as this, spending more than $50k really eats into the revenue.
If you are not getting between 10 to 20 times your ROI on research, then
you are putting yourself in a position where you are not fairly compensating
the other components of your business. While some of the challenges in this
example may be an issue of scale, it is important you are aware of the
different parts of your process and the value they are contributing.
The bottom line is if you are getting less than ten to one ROI for research,

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then it may be a better value to find a money manager who runs a
similar strategy and invest with them. This way, you no longer have to
handle the operations, pay for research, and deal with the opportunity costs of
managing your own capital.

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Research Pieces of the UoR Process
Ideally, you should look for research that complements your own analysis
—that catches issues you otherwise would not have caught, that points you to
developments you otherwise would not have known about, and that makes
arguments you otherwise would not have conceived. At the same time that
the research introduces new ideas, it should make some intuitive sense to
you. It will not serve you well to trade on research that you believe is flat-out
wrong or incomprehensible—you will likely second-guess yourself as a
trader, misapply rules, and cause yourself a lot of unnecessary problems.
There are at least 25 different sources for market insight I read every week.
However, for this section I focused on five distinct research services, as they
represent different aspects of each area I cull through:

i. Sight Beyond Sight Newsletter by Neil Azous

ii. EconAlpha by Spencer Staples
iii. Track.com by Bob Savage
iv. Hedgeye by Keith McCullough
v. General Research by Ted Mermel (FX Sell-Side Specialist at Société
Générale)

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i. Sight Beyond Sight Newsletter by Neil Azous
As a high-velocity, cross-asset class trader, I rely heavily on Neil Azous’s
Rareview Macro products through his Sight Beyond Sight (SBS) newsletter.
This service helps me define the macro narrative and market regime at any
given time. Neil’s insights on how the professional community is positioned;
his ability to summarize shifts in market sentiment, proprietary interest rate,
and asset allocation models; and his perpetual desire to innovate are just
some of the reasons Neil’s insights are entrenched in my daily routine.
I had the pleasure of co-hosting a live trading webinar with Neil for CQG
focused on the final FOMC meeting of 2015.16 (For reference: this was the
meeting at which the Fed decided to raise rates for the first time in over eight
years.) I believe this webinar both illustrates the robustness of Neil’s process
and grants greater insight into how I approach my own personal trading
The development of all human civilization was based upon our ability to
both consciously and subconsciously identify patterns in nature. It is no
surprise these same skills transfer over to the investment world. I have
developed a very strong intuitive sense of what is and what is not
valuable. Neil’s value was immediately recognizable to me in both his
process and character. After coming across his work in 2013, I assimilated it
without hesitation into the UoR Process. His candor, creativity, and cunning
investment style are all readily perceptible in the SBS newsletter and further
outlined in Chapter 12, Using Options to Trade the Macro Narrative, which
Neil authors.
a. Sight Beyond Sight Newsletter
As you contemplate subscribing to a newsletter, here are some specifics of
why the Sight Beyond Sight (SBS) newsletter is part of my process:

1. Summary and Views. This provides easy-to-digest current information,

including: analysis on the most important themes overnight; actionable
trading ideas across regions and asset classes using both cash and
derivative investments; and a predefined risk management process for
gains and losses on each trading idea.
2. Top Overnight Observations. The SBS newsletter provides a list of the
most important observations on strategy, economics, and policy across
think tanks, bank research, blogosphere, and social media.
3. Risk-Adjusted Return Monitor. Similar to how I use the UoR ratios,

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 Neil Azous has his own proprietary ratios to measure risk-adjusted
returns of hundreds of relationships globally. This is an amazing
corroboration tool to see if I’m focusing on the right areas.
4. Scenario Grid. SBS outlines what asset classes to trade based on the
outcome of large macro events. This is a huge piece of confirmation to
my own process and may highlight potential blind spots in my
portfolio, as well as trades with tremendous asymmetries.
5. Model Portfolio. The SBS model portfolio is the most transparent and
accountable I have ever seen from any newsletter.
6. Data and News. A detailed listing and interpretation of economic data,
central bank meetings, speeches, including links and sources.
7. Trade Lab. This is a tremendously instructive and a transparent idea
generation repository incorporating strong probability analysis, cross-
asset contingency planning, technical, fundamental, and sentiment
analysis.
I spent the Thanksgiving weekend of 2015 dedicated to completing this
chapter. In attempting to show how Neil Azous is such a huge part of my
UoR Process, as well as instrumental in my professional growth, I only had to
look to the most recent letter he published, written on Tuesday, November
24, 2015. Irrespective of how this particular prognostication turns out, the
quality of Neil’s insight helps me stay anticipatory in trading and on top of
the market regime. The following excerpt is a substantial portion of the
November 24, 2015 Sight Beyond Sight newsletter.

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 Sight Beyond Sight Newsletter – November 24, 2015
You Are Not Short Enough Swiss Francs Today…Rest of Europe
Should Be Nervous by Neil Azous
Now a lot of you have asked why we are paying so much attention to
currencies right now and spending considerably less time on the S&P
500? The answer is that currency markets at the moment are very fertile
ground for both directional and relative value trading.
This is very similar to the front-end of the interest rate market in the
US and Europe, not the longer-dated cash bond markets.
In both FX and in front-end interest rate futures, because of the wide
variety of instruments available, you can come very close to “digitally”
re-creating your probabilities and scenario analysis at the moment and
structure them in a way that you know your risk profile when you put on
a trade.

European Interest Rate Market Moves to Pricing in Front-

Loaded ECB Easing
Switzerland Now Hog-Tied
The Rest of Europe: Sweden, Norway, Denmark
A Recap of the Trades We Have Deployed to Capture All of
This

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 European Interest Rate Market Moves to Pricing in Front-
Loaded ECB Easing
The current deposit rate set by the ECB is -0.20 percent. The main
instrument to measure expectations for a deposit rate cut by the ECB is
the 2-yr German Schatz. The yield is trading at -0.40 percent on the
screws today.
More interesting however, is that the December 2016 Euribor futures
contract (ERZ6) is trading at -26 bps. The rough spot equivalent to use
in 3-month Euribor is -5 bps, a difference of -21 bps.
Put another way, the most liquid interest rate product traded in
Europe, has started to price in the following:

1. A 70 percent probability that the ECB cuts its deposit rate by 20

bps to -0.40 percent at its December meeting next week. At this
stage a 10 bps cut would be a “disappointment.”
2. A significant chance that we receive either a front-loaded 20 bps
deposit rate in December, or
3. More than 20 bps of rate cuts over the next 12 months, i.e., that
a 10 bps cut next week is just the first of many to come.
Let us pause briefly and give you a few real-life examples of where
the Street stands relative to the pricing in the market that we have just
sketched out.
Firstly, this morning we saw the first call for a 20 bps deposit rate cut
at the December ECB meeting from a major bank. RBS now sees a 20
bps cut in December, having previously expected 10 bps, and an
acceleration of asset purchases to €85bn per month from €60bn and that
will also be extended out to March 2017, and possibly transforming into
open-ended QE. What this means is that others are sure to follow in
short order, especially considering the German Schatz is already at -0.40
percent.
Secondly, the retail bond team at M&G Investments, a London-based
asset manager, provides commentary on bond markets via the Twitter
handle @bondvigilantes. On November 18th they tweeted this out:
“Well our fund custodian has decided the ECB will definitely cut rates
in December. We now “earn” -0.3 percent on Euro depos, down from
-0.2 percent.” (H/T: JG) So without even a formal cut yet, rates are

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changing on the ground in anticipation of one.
Thirdly, see this FX positioning analysis by BNP Paribas from
November 19th. Now we realize that everyone has a different mouse trap
for capturing positioning. In fact, we have even helped build some for
other paid services, so we know first-hand that track records or models
can be flawed. That said, this is BNP Paribas. As a top French bank,
given their proximity to the market, they see euro flow better than many
others. Even giving them a high standard deviation of error because their
flows are weak, the analysis flawed, or their track record poor, would
still be counter to the sentiment in the market relative to euro positioning
being largely neutral (i.e. -5 on a scale of -50/+50).

Anecdotally, even Deutsche Bank says the short position in the euro
is not large at all. Their proprietary indicator, CORAX, shows that
hedge funds are 30-50 percent of their max positions.
What that tells us is that macro guys may be gunning for the euro,
but real money and family offices are not nearly as sized or as involved
as they were the last time around when the euro was coming from a
much higher price.
At the same time, professionals may have approached this exercise in

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a more balanced way this time around, and have a long European fixed
income position on instead of a large concentrated direct bet on the euro
itself.
Finally, it is important to note that a lot of professionals have made a
lot of money from being short of emerging market FX this year and that
opportunity set is still more appealing than being short the euro. Why?
Because no one really thinks the euro can trade much lower – by which
we mean, no one wants to sell EUR/USD at 1.06 if their target is only
1.05.
From a market standpoint, the way the German Schatz and Euribor
futures are trading indicates someone believes that ECB President Mario
Draghi is on his way to convincing the market that he wants the
currency cross at parity (i.e., 1.00).
Personally, we think that too many professionals are discounting the
fact that President Draghi is going to not just figure out how to get it
down to parity, but will convince the market that he will keep the
currency low, and at the same time even counter the €400bn current
account surplus. It’s just a matter of time, is all.
In that spirit, the latest positioning reports from the major banks that
noted the euro short position may not be as broad based as many had
previously suspected should be self-fulfilling for those who are already
short, and suggests that there is still plenty of scope for new short
positions to build.
Now what does all this mean for the rest of Europe?
Let’s start with Switzerland.

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 Switzerland Now Hog-Tied
Hog-Tie Definition: secure by fastening together the hands and feet
(of a person) or all four feet (of an animal).
In last Wednesday’s edition of Sight Beyond Sight we discussed how
the market was beginning to overshoot the easing expectations of the
ECB, and by extension the SNB, when no actual easing has taken place
yet. As a reminder, the deposit rate in Switzerland is -0.75 percent and
the market is pricing in a 100 percent chance of a -0.25 percent cut to
-1.00 percent and 50 percent chance of an additional -0.25 percent cut to
-1.25 percent in the first half of next year.
That said, there is one key difference now between the ECB and SNB
expectations, and it is becoming visible today for the first time – that is,
this overshoot to an extreme seen in ECB expectations has not extended
into Swiss interest rates, which are effectively unchanged from when we
wrote about them last week.
This tells us a lot, but before we explain what it is, let’s first add in a
couple of other observations related to Switzerland overnight.
On January 15, 2015 the Swiss National Bank (SNB) announced that
it was abandoning its policy of defending a 1.20 floor for the value of
the euro against the Swiss franc. While Switzerland lost it veil of
secrecy a few years ago its other key marketing tool – its safe haven
status – formally died that day as well.
The examples of this continue to add up. During the height of the
Greek drama this summer the Swiss franc actually sold off and didn’t in
any way behave as you would expect a flight-to-quality instrument to do
during a crisis. On Monday of last week, following the weekend Paris
attacks, the Swiss franc sold off again.
Today, the Swiss franc rejected the dogfight between two Turkish F-
16 fighters and a Russian SU24 strike aircraft. As a reminder, today was
the first time a NATO country and Moscow have exchanged direct fire
over the crisis in Syria. The key point is that the market should not be
desensitized to this type of an event yet.
To put this in quantitative terms, a one sigma daily move in the
Ruble-Swiss (RUB/CHF) currency pair equates to ~2.65 percent. The
reaction since this news hit the wires between 3:50-4:00 a.m. EST? Less
than a -0.80 percent move down.

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 On a day, where Europe is also set to renew the sanctions on
Russia for another six-months this is an outright rejection of safe
haven status. This is especially true considering the Oligarchs are now
a lot less likely to move money back to Russia from Switzerland for
another six months. The Swiss franc should be stronger and the Russian
ruble should be weaker, and yet neither of them are.
So what do you get when you add all of this up?
The answer is that the SNB will have to implement a different set of
tools to weaken the currency because it is already a leap to suggest a -25
bps cut to their deposit rate, let alone -50 bps in cuts given how deep in
negative territory they already are and the stress it has caused for their
financial system.
What are these tools?
At this time, Switzerland only applies its negative deposit rate to a
fraction of reserves, currently about 1/3rd of sight deposits. In contrast,
negative deposit rates apply to ALL reserves held at the ECB, Swedish
Riksbank and Denmark’s Nationalbank.
The tool is to apply the deposit rate cut to 100 percent of sight
deposits no matter what shape or size your account base is. Put another
way “we treat all our children the same”. The honeymoon from last
January is over for the 2/3rds of deposits that were given a free pass.
What will the reaction be after Swiss banks are forced to pass on
negative interest rates to all parties?
The answer to that is easy. For money to leave the country and the
Swiss franc to weaken even further.
We have written in the past that an important mechanism by which
Swiss franc appreciates during episodes of risk asset corrections or
geopolitical events – Swiss residents reversing foreign portfolio
investment flows – is no longer in place. The professional community
has yet to get this joke despite the currency showing plenty of evidence
of just that happening. No longer is this the Switzerland and stigma that
your father knew.
At the same time, the significant drop of Swiss yields into negative
territory and the recent emergence of Swiss stock underperformance
relative to European equities is proving to be one more disincentive to
bring money home to invest in local assets. In fact, a top rated European
private research firm, Kepler Cheuvreux, yesterday cut the Swiss equity

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market to neutral. Add that to the notion that the market is pricing in
another -25 to -50 bps in cuts and why would you walk into the lion’s
den? It is not going to be fun in there.
If you don’t believe us, just ask Morgan Stanley and Deutsche Bank.

In mimicking the dovish stance from the ECB, it is not as easy

for the SNB, which already has a -0.75 percent negative deposit
rate. It will need to think how it can make commercial banks charge
deposit holders. Should these efforts bear fruit, Switzerland may
face a wave of capital outflows and CHF hedging, weakening CHF.
Remain USDCHF long and see substantial downside potential in
CHFJPY shorts. (Source: Morgan Stanley)
Due to inverted nature of Swiss interest rate curve, the capacity
of banks to perform a maturity transformation is much more
limited, which causes stresses across the financial system. While
there is likely more room before the zero lower bound is reached in
Switzerland, recent communications by the SNB does not suggest
the Bank is particularly keen to touch the bottom. Ad hoc currency
intervention is, therefore, a more likely first line of defense
following an ECB easing, with the Bank only cutting rates if the
move in the franc was very sharp, sub 1.05 for EURCHF for
example. (Source: Deutsche Bank)
Our conclusion from all of that? It won’t surprise you to learn that we
have increased our short Swiss franc exposure once again. We executed
the following two trades earlier this morning in the model portfolio.

1. Sold 20mm CHF/JPY at 120.53

2. Bought 20mm USD/CHF for 1.0169
As a reminder, we took off our long-dated call options on the Dollar-
Swiss (USD/CHF) last week after more than doubling our premium in a
short period of time. The option premium had reached more than 2
percent of the NAV in the model portfolio and per our rules-based
discipline that was too much risk to hold in the context of the unrealized
profit, and relative to other long US dollar exposure we have on, namely
via the euro.

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Why did we add back a short Swiss Franc position?
Firstly, if the market is beginning to price something in beyond a -20
bps cut to the ECB deposit rate, it suggests that some believe the ECB
will drop the cap altogether on what they believe to be the negative
bound. By that we mean -0.40 percent is not necessarily where the ECB
ends this game, and the levels closer to where the SNB has their rates
cannot be excluded in the long-term. So as long as the market is
beginning to overshoot into this thought process, the harder the SNB’s
hand will be forced to act and that means we need to be more short of
the Swiss franc despite the fact that its interest rate curve is priced to
perfection.
Secondly, our fear of missing out (FOMO) score – the level of
emotional impulse we feel towards putting on a trade – is very high at
the moment when it comes to Swiss franc. It needs to trade at least 10-
15 percent weaker to make us feel better.
Besides, if expectations around ECB easing begin to materially
subside or the FOMC disappoints, we will just reduce the position and
move on.
By the way, in case you were wondering who took over that safe-
haven status from Switzerland the answer is the Japanese yen. It just so
happens to fit the current central bank “triangle”: FOMC tightening,
ECB easing, and BoJ neutral.
This is one of the reasons why we went short CHF/JPY as well,
because we wanted to be long some more yen going into the holiday
period on account of the geopolitical events still unfolding.

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The Rest of Europe: Sweden, Norway, Denmark
Finally, as we have shown for the SNB, the market’s pricing of the
ECB’s ultra-dovish lean has the potential to create a lot of problems
for both the Swedish Riksbank and Norway’s Norges Bank.
It is not even worth commenting on Denmark at this point, but it
is safe to assume that if so many vultures are willing to attack the
Saudi riyal peg to the US dollar (USD/SAR) that positioning will
grow for the euro-krone (EUR/DKK) peg to break at some point.
As we have already pointed out many times, Sweden is running out
of options and like the SNB we believe it will one-day have to pull the
plug on its unconventional measures. Moreover, that day may be sooner
than many think if President Draghi decides to really flex his muscles
beyond what is priced into the market place. Whether it is next month,
or in the first half of next year, the Riksbank will have to let the
currency appreciate. We are long on SEK/CHF, so we look forward to
the day the Riksbank remains on hold in the event of an ECB cut.
At the same time, in contrast to Switzerland where no one wants to
bring money home, Norway is in the process of repatriating assets from
around the world to pay for its fiscal imbalances on account of the oil-
revenue shortfalls. The fact is that with the world’s largest sovereign
wealth fund (~$800 billion) the country is just too rich and doesn’t have
enough assets to implement a QE. So it is likely that it will just cut
interest rates instead (currently 0.75 percent), especially if it wants the
Norwegian krone (NOK) to remain weak in the context of the ECB
overpowering everyone else.
This is one of the reasons why we are short of the British Pound
Sterling and long on the NOK (GBP/NOK). The others are valuation,
with GBP being one of the most overvalued and NOK being one of the
most undervalued currencies in the world, and also because we want to
rent NOK as a place holder for being long crude oil at this stage.

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 A Recap of the Trades We Have Deployed to Capture All of
This
To our point at the beginning and European FX being fertile ground
for directional or relative value trading. Here is a summary of the
positioning and our conviction in the model portfolio:

1. Short euro (EUR/USD)

a. Structured via 250mm EUR/USD April 30, 2016 1.05 put
options
b. Premium currently worth 2 percent of the model portfolio
NAV (it has doubled)
2. Short Swiss Franc (CHF) vs. Long United States (USD), Japan
(JPY), Sweden (SEK), Russia (RUB)
a. Structured in spot
b. Spot positioning is 115mm or 38 percent of the model
portfolio NAV
3. Short British Pound Sterling (GBP) vs. Long Norway (NOK)
a. Structured via spot
b. Spot positioning is 30mm or 10 percent of the model
portfolio NAV
As you can see, access to this sort of rigorous thought process three to
four times a week is what I value in the Sight Beyond Sight newsletter. It has
made a profound difference in my trading.

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ii. EconAlpha
Spencer Staples, head of EconAlpha, has long been my mentor in
understanding how to interpret the economic calendar and impact of high-
frequency economic data on the market. As someone who trades around
macro events, Staples’ ability to outline the range of probabilities of any
given economic or policy event, as well as quickly contextualize high-
frequency economic data, is just one of the reasons why EconAlpha has been
an indispensable part of the Protean Strategy’s success.
I have spent extensive time with Staples since 2012, incorporating his skill
set into my trading. He has been an instrumental part in creating multiple
probability scenarios and contingency plans on an array of macro events from
FOMC Statements to Gross Domestic Product releases.
Spencer’s postmortem, independent analysis of economic data provides
me a three-dimensional perspective that either confirms a regime or alerts me
to a regime shift. Spencer rapidly pinpoints where the data was in line with
expectations and what surprises exist. This, combined with more traditional
quantitative tools like the Citi Surprise Indexes, helps me stay on top of
short-term and longer-term economic sentiment.

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iii. Track.com
Bob Savage’s Track.com does many things. It provides a daily recap of
market events, periodic thought pieces examining deeper market themes, and
some bespoke macroeconomic indicators. Most importantly, it gives me the
one item I could not possibly get while running a virtual trading desk from
my eight flat panels in my living room—live access to individuals who
ultimately make the large-scale buy-and-sell decisions. It’s easy for me to sit
behind my desk and instant message or call people, but the Track.com
networking Idea Dinners really bring me back to my days as a cash game
poker player in Las Vegas.
Going to a Track.com Idea Dinner involves meeting eight to twelve
complete strangers—often fund or portfolio managers, analysts, economists,
strategists, traders, and other market practitioners—then proceeding to have a
highly intellectual discussion of global macroeconomic themes. Bob
moderates all the discussions, so that participants weigh in on current market
themes, express favored trade ideas in the global macro space, and give
market-related fears. Hearing the in-person opinions of a diverse group of
individuals gives me a rush of information—it helps give me a sense of how
others perceive the market, alerts me to issues that I had not considered (and
that my other research resources sometimes do not cover), and gives an
overall sense of participants’ market sentiment and positioning. The net effect
of these dinner-long crash courses is that I am much less likely to be
blindsided by a sudden regime-changing event (the single biggest risk to my
trading).
A key part of Track.com Idea Dinners is being outside my comfort zone—
I am always meeting new people and I never know what will be discussed.
There has not been a single dinner I have attended where I was not nervous
before showing up. Heated debates are as common as friendly conversation—
all are stimulating and it keeps guests on their toes. When you get the email
list beforehand, you want to see what you are going to be up against, and it
can often be intimidating. This pushes me to try that much harder because I
do not come from a traditional Wall Street background, yet I have an
opportunity to hear from individuals who came up in the big institutions and
many who are still entrenched there.
After the dinners are over, Track.com publishes for all of its subscribers
rarefied accounts of the conversation at the dinners. While this is certainly

285
useful for subscribers, and hits upon all the big points discussed, it does not
compare to the firsthand experience.
Further aspects of the Track.com research process and Idea Dinners are
discussed in Chapter 16, co-written by Bob Savage, titled “Diversification
Isn’t Enough – Spotting the Paradigm Shift.” For a tactile person like myself,
Track.com makes the market something I can touch and feel. This is so
essential in trade idea generation, regime assessment, and risk management.

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iv. Hedgeye Real-Time Alerts and The Macro Show
I love the Real-Time Alerts (RTAs) put out by Hedgeye founder Keith
McCullough and his team of 30+ analysts. For me, it is a bountiful source of
idea generation from a group with a proven process. The RTAs cover every
asset class and come out anywhere from three to fifteen times a week.
Hedgeye also produces an interactive daily online show (fittingly called The
Macro Show) as well as a more focused show on RTAs four to eight times a
month. All of the shows encourage subscribers to ask questions. This has
been particularly useful to me as the interaction has helped me to fill in some
information gaps regarding certain events. In addition, McCullough’s non-
consensus, independent research firm also offers a longer-term Investing
Ideas product, a morning newsletter called the Early Look, and Daily Trading
Ranges with levels on 20 tickers. Considering how much Hedgeye has helped
to raise my market IQ, I believe it is an incredibly valuable addition to just
about anyone’s research portfolio.
(Figure 8.1 shows the total realized return of the 378 positions of
Hedgeye RTAs.)

Figure 8.1 Hedgeye RTA Performance Attribution for 2015

In terms of contributing to the performance of the Protean Strategy, no
single day stands out more than the Real-Time Alerts broadcast from
Thursday, April 2, 2015. Friday, April 3 was a shortened trading day because
of Easter falling on Sunday, April 5. The Street was overwhelmingly

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anticipating a strong jobs report, with the survey indicating general market
expectations of 245,000 jobs added in March. As a bit of additional
background, Hedgeye came into 2015 with a non-consensus call for a
slowdown in global growth and deflation pressures to emerge. They
emphatically outlined why putting on trades consistent with late economic
cycle dynamics was a viable investment strategy for a portfolio.
During the RTA webcast, I was trying to get an impression from Keith on
how he perceived the Street’s view of the jobs number to be released Friday
(the following day). He specifically noted that his inbox had never been so
full of emails in his entire career concerned about how strong the number
would be and what it would mean for his call of the economy slowing down.
My thought at the time was if the market is concerned about that strong of
a number, then this could be a monster setup. Given that it was going to be
released on a partial holiday, I felt that, should this number come in lower
than the survey of 245,000, there could be some serious fireworks.
Keith McCullough gave me precious insight that gave me the confidence
to be long Treasuries and the euro into the jobs report. This was fortunate, as
the number bombed, coming in at 126,000 (119,000 less than expected). As
you can see from the performance outlined in Chapter 3, I made over $97,000
on my $1.5 million account in April of 2015. Over $47,000 of that came in
the 48 hours around that payroll number.
Keith’s access to his RTA customers (which gives rise to his ability to
canvass his network for market insight) and his unique perspective on the
market are both essential and invaluable elements of his research product.

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v. Ted Mermel – FX Specialist at Société Générale
Ted Mermel’s daily FX newsletters, which I began reading in 2008 (back
when he was at CIBC World Markets), were one of my gateway drugs into
the world of incorporating the macro narrative and market positioning into
my UoR process. I wrote Chapter 18 based on the processes of how I
incorporate research and information that Ted and other prescient analysts
provide me. This information is pivotal in understanding market positioning
and how the sell side is preparing, analyzing, and reacting to key market
events.

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Summary of Research Pieces
As a summary of what I outsource in terms of regime research, the five
aforementioned resources represent a special consortium for me. Sight
Beyond Sight provides my deep-dive, day-to-day macro narrative; EconAlpha
is my quant economist; Track.com gives me Wall Street access to network
and cross-pollinate ideas; Hedgeye provides high-frequency trade ideas with
a macro bent; and Ted Mermel keeps me apprised of all relevant sell-side
macro aspects. All combined, this has proven an invaluable amalgamation for
regime analysis.

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2. Trading Software and Applications
Trading software and related applications have become the lifeblood of
traders, from home-based prop traders investing their own account to
institutional traders moving billions in capital. Good software is doubly
important for higher-velocity traders, and it directly affects the speed and
ease with which tasks can be accomplished. I use a suite of several software
and application packages while trading.

i. CQG Integrated Client

ii. Bloomberg Professional Terminal
iii. MPACT!™ (Market Price ACTion) and MPACT! Portfolio Simulator™
iv. TradeTheNews.com
v. Unit-of-Risk Software / UoR™ Software
vi. Voice Dictation Software

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i. CQG Integrated Client
CQG is first thing I turn on in the morning and last thing I turn off at
night. CQG Integrated Client has become the gold standard of charting
platforms for futures traders around the world. I have been using CQG for
over a decade and find it indispensable for trading, charting, the API, tech
support, and the ability to monitor accounts at multiple brokers from a single
login. Most importantly, CQG makes charting and trading the macro
narrative effortless. The CQG Integrated Client with server-side spreading
capability has become a critical tool in successfully executing the Protean
Strategy.
CQG’s Real-Time Data feeds into an array of UoR™ Excel Dashboards.
Thom Hartle is an expert at CQG on creating customized spreadsheets that
display market data in a visually intuitive way. Thom created a number of
customized spreadsheets for me (as well as many other CQG clients). Access
to a library of spreadsheets and to Thom’s expertise is included for all CQG
Integrated users. The dashboards utilize the CQG Real-Time Data (RTD)
feature.
CQG’s server-side spreader technology is an integral part of my relative
value, or spread, trading. The Server Side Spreader allows me to benefit from
the company’s co-location at exchanges around the world. This allows me to
track and spread trade the synthetic indexes from one trading window (e.g.,
buying S&P 500 futures and selling Dow futures). This spreading strategy is
discussed in great detail in Chapter 13, authored by Patrick Hemminger. You
can also download a white paper on Spread Trading I wrote for Eurex titled
“Spread Trading Eurex Equity Index Futures: A Guide for Traders” at
http://www.eurexchange.com/blob/exchange-en/4038-
4046/115988/3/data/spread_paper-pdf.pdf.
I have multiple layouts built into CQG that reflect different trading
circumstances. CQG also presents a seemingly endless array of functions for
its more advanced users. This robust functionality allows me to focus on what
markets are in play and more efficiently allocate my risk units. In terms of
trading and charting the futures markets, CQG is my go-to software.

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ii. Bloomberg Professional Terminal
While CQG charts and Depth of Market (DOM) Trading windows
comprise the majority of my trading and charting tools, it is the Bloomberg
Professional Terminal that I use to analyze news, economic data, and conduct
cross-asset research on just about any product in any region of the world.
While there is certainly a very large learning curve to Bloomberg, the service
presents an endless array of functions and seemingly limitless access to
market data. Given the scope of the service, I am simply going to list a few of
the most important tools of Bloomberg for regime identification. There will
be many references in this book to how I use the terminal and its functions.
Here are some of my favorite features (in no particular order) that are very
helpful to identify the regime and a daily part of my UoR Process:

1. Instant Messaging System (“Instant Bloomberg” or “IB”)

2. Economic Workbench < ECWB>
3. Custom Graphs Feature <G>
4. Excel Templates and Functionality <XLTP>
5. Calendar Functionality for all Events and Economic Releases <ECO>
and <EVTS>
6. Backtesting Functionality <BTST>, <OVME>, <FXSW>
7. Central Bank Portals <FED>, <ECB>, <BOJ>, <BOE>, <SNB> (and
more)
8. Earnings Analysis <EA>
9. News Features and Social Velocity Alerts like <TREN>, <TOP>,
<HOT>, <TWTR>, <NH BVSM>, <MMN>, <NRS>
10. Market Maps and Intraday Market Maps <MMAP>, <IMAP>
11. Functions for the Market <FFM>
As an individual trader who does not have the same resources as a
traditional firm, one of the biggest benefits I get from using the Bloomberg
Terminal is their technical support and expertise. Tapping into Bloomberg’s
intellectual infrastructure has been a big help in competing with bigger firms
for alpha in the market. For example, Eric Leininger, who is a fixed income
product specialist at Bloomberg, mentored me on some extremely essential,
yet esoteric aspects of the fixed income global markets. Bloomberg support is
available 24 hours a day, 7 days a week, and I have been able to work

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personally with teams of specialists on some innovative tools catered
specifically to the UoR Process.

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iii. MPACT!™ (Market Price ACTion) and MPACT! Portfolio Simulator™
MPACT!™, or Market Price ACTion, and MPACT! Portfolio
Simulator™ are patent-pending proprietary software programs I built to help
me manage positions, build pre-existing scenarios, and quickly identify
opportunities in the market based on breaking news. My journey in
developing and implementing them into the UoR Process is covered in more
detail in Chapter 20, “The MPACT! of Automation.” MPACT! has enabled
me to manage “regime risk” on positions in multiple asset classes in a much
more efficient manner than traditional risk management processes.
MPACT! Portfolio Simulator is an important part of my preparation
process. I created this proprietary software to run multiple stress tests on an
array of potential breaking news events and market environments to see how
a strategy may perform. Incorporating the MPACT! Portfolio Simulator into
my UoR Process has helped me tremendously. For example, being able to see
20 different iterations of an FOMC statement before the release or how a UK
inflation report may influence different asset classes means that when an
event occurs, it’s not the first time I’ve been through it. Therefore, I’m much
better prepared to act. One does not necessarily need custom software to do
this, but having this process automated definitely streamlines the number of
practice scenarios I can experience. Not only does this help reveal situations I
may not have otherwise thought of, but it frees up time and mental energy to
think more deeply about these events or perform other important tasks.

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iv. TradeTheNews.com
Breaking news is the single biggest factor causing a shift in the underlying
price-action regime. TradeTheNews. com’s breaking news service informs
you in a timely manner of events that may necessitate adjusting exposure to
certain strategies.
TradetheNews complements their breaking news with regular audio
updates about major market events, which are critical in staying apprised of
the shifts in investor sentiment. I often ping them with questions and they
will research something very promptly. Again, while hiring someone to cull
the news is not economically viable, this is a great de facto virtual newsroom.
The December 3, 2015 ECB rate decision was a classic example of the
value TradetheNews provides. There was a tremendous amount of buildup to
this ECB event, as many market observers were looking for Mario Draghi
and the ECB to lower the deposit rate from -0.20 basis points to at least -0.30
or -0.40. Moments before a scheduled ECB decision at 7:45 a.m. Eastern
Time, the euro currency started rallying hard against the US dollar and basket
of G7 currencies. The reason for the rally was a bogus tweet from the
Financial Times that the ECB had left the deposit rate unchanged.
Through their audio service, TradetheNews alerted me to the tweet and
helped me get long the euro immediately. I felt confident that, whether this
was true or not, there was the serious potential for a binary move higher
while the market tried to sort out the veracity of the tweet. It turned out
moments later that the tweet was false, but just being aware of that dynamic
provided a huge opportunity. That day I made $20,000 from the euro.
TradetheNews was a material factor in that success.
While I have gone to great lengths to make my desktop as efficient as
possible, the reality is I can only account for so much. TradetheNews allows
me to use both my eyes and ears when trading the market, and this is a
huge part of the Unit-of-Risk Process.

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v. Unit-of-Risk Software / UoR™ Software
UoR software is analytical software that allows me to aggregate, organize,
and assimilate key performance information om my strategies in a timely
manner to identify shifts in the regime. The software, as discussed in Chapter
20, includes customized ratios such as the Netto Number and Return Over
Risk Budget.

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vi. Voice Dictation Software
I generally do a lot of messaging, tweeting, and emailing through the day
to stay connected to my network. Voice dictation software allows me to keep
my eyes on the screens and be more efficient in actively maintaining
correspondences without having to be constantly typing.
There are different voice dictation software programs out there, and there
is certainly a learning curve when it comes to seamlessly integrating them
into your process. For me, the software is essential in being able to carry on
—and quickly switch between—multiple Instant Message conversations,
send off rapid emails, or be one of the first to tweet out something important
without the need to type. Voice dictation is a huge help in doing this while
keeping my eyes on the screens.

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3. Desktop Layout
If you look back at my first book, One Shot – One Kill Trading,
published in 2004, and examine what I was looking at and the tools I had to
do it, it can be pretty humbling. It is not that the processes and technology
were unsound, but my goodness, have things changed! In 2004, I had a very
solid technical trading approach using Fibonacci levels, inflection points, and
momentum to participate in price discovery.
Where I have evolved tremendously is incorporating a macro narrative,
market sentiment, and regime analysis. Therefore, in what has been an
evolution over the course of several years, my desktop layout reflects my
reality of being exposed to more strategies, incorporating an array of data
sources, and developing proprietary trading software. Every inch of my
desktop is put to use, incorporating not only the key aspects of my first book,
but the new approaches I have embraced as a trader between publications.
Primarily, my desktop is occupied by eight monitors attached to my
computer, each with a particular function. As can be imagined, the trading
software, applications, spreadsheets, and proprietary software I use to trade
the macro narrative can put incredible demands on a computer’s resources.
These demands are exacerbated during times of intense data flow (for
instance, during major macro events like an FOMC Statement or key
economic data releases). At the best of times, there is nothing more
frustrating than having a computer act sluggish or freeze up. When trading a
volatile environment or major market disruption, a poor Internet connection
or a non-responsive computer can lead to major losses.
As such, there are a few areas that should be absolutely non-negotiable in
a trader or money manager’s budget. The first is a redundant high-speed
network to connect to the Internet. The second is a powerful trading
computer. If you cannot connect to the market or rely on your hardware to
manage your positions, then you start the game behind the eight-ball.
I would strongly suggest looking into having a custom computer built that
is designated exclusively for trading. Like just about everything else, you can
do a cost-benefit analysis on exactly how much computer power you need.
Therefore, I had Scott Tafel at TradingComputers.com build me a computer
that could meet my demands. TradingComputers.com gives traders the tools
they need to focus on executing their strategies in an evolving market where
speed of execution, velocity of information, and the need for accessible

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technical know-how increases annually.
As of June 2016, this is the computer that powers the eight 23-inch
monitors I trade on…and it is a beast:

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Computer Specs - The Falcon F-52GT

Chassis: Commander G42 with half blue lighting

CPU / Processor: Intel i7-5930K, 6-cores @4.3GHz, 15MB cache, 40
PCIe lanes, Arctic Storm Phase Change Cooling
Technical Features: X99 chipset, 4x Video card slots, 8 Phase voltage
control, Intel LAN, Gold connections
Power Supply: 750w FirePower MK III Gold Certified
Memory: 16GB DDR4 high reliability memory
Monitor Connections: 8 Monitors Supported - Predator 750.2 (2 video
cards) + 4x 10 HDMIDVI cables
Operating System: Microsoft Windows 10 Pro 64-bit
Solid State Hard Drive for Windows Operating System: 512GB
speed: 415MB/s SATA3 (480GB available / 32GB used for performance
optimization)
System Backup & Extra Storage: 1TB 7200rpm hard drive + Paragon
Backup Software
Not everyone needs to have this. As you will read though, understanding
how I use my computer and the stresses it undergoes gives me peace of mind
to make a substantial investment of time and money in my hardware. I also
have a server co-located at the exchange to reduce latency.

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Screens
As noted, I have eight 23-inch screens stacked four on four. I also have a
laptop and a tablet that rest visually below the screens where I can see them.
The figure below illustrates this configuration on my desktop

Figure 8.2 Trading Desktop

Please refer to Figure 8.2 for screen numbering. As a general
introduction, the screen real estate I spend the most time using are the middle
four monitors (screens 2, 3, 6, and 7). The outer four monitors (screens 1, 4,
5, and 8) can take on a range of uses depending upon what is happening in
the market at that time. While it is not feasible for this chapter to provide
every nuance of every layout I have developed in both CQG and Bloomberg,
the following section should give a strong sense of how I approach my craft
and try to harmonize regime analytics with trading ergonomics.
Lastly, my screen layouts are as dynamic and fluid as my trading style.
Just as with every other part of the Protean Strategy, I am constantly
developing new layouts and exploring new features. I encourage you to do
the same thing. I recommend taking a picture of your desktop every six
months. After some time, look back and see how it has changed. You may
discover things that will ultimately help you to build your ultimate trading
environment.

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Screen 1 (Upper Left Corner)
Screen 1 Figure 8.3 consists of all of my relative-value spreads, synthetic
spreads, and custom indexes on a quote board that is part of my Bloomberg
Launchpad. Within the relative-value spreads, synthetic spreads, and custom
indexes, the quote board is organized into asset classes: Fixed Income,
Currencies, Equities, and Commodities.
In total, there are about 120 quotes visible at any given time. By relative-
value spreads, I am referring to items like the spread between the ten-year
and five-year US Treasury yields, spread between US and German ten-year
yields, and spreads between German and European Peripheral (e.g., Portugal,
Italy, Greece, and Spain) debt.
By synthetic spreads, I am referring to the difference in value between US
and European equities, the S&P 500 and Dow Jones Euro Stoxx, a spread
between gold and copper, positive carry currencies and negative carry
currencies, as well as between high-beta and low-beta US equities.
The quote board has four columns that make up the top two-thirds of the
screen and then I leave room for four charts at the bottom. These charts
represent which four markets from my quote board are most likely to drive
the trade.
The custom indexes are designed based on certain regime dynamics. If the
theme in the markets has been Swiss franc weakness, European bank
strength, and European peripheral debt strength, then I can create a custom
index of that in Bloomberg and chart it. We often go through periods of
microthemes in a regime, and these custom indexes can give me a quick spot
check to see how they are holding up or if they are relevant anymore.

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Figure 8.3 Screen 1

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Screen 2 (Upper Row, Second From Left)
Screen 2 (Figure 8.4) uses the first of five CQG Integrated client pages in
my layout. It contains eight charts covering four products. Because Screen 2
sits directly on top of Screen 6, which is my execution screen with all my
DOM (Depth of Market) Trading windows, I want to have easy visual
reference between the two. The bottom four charts on Screen 2 have a short-
term time frame (given in minutes) for the products I’m watching, while the
top charts are the same product albeit on a daily or weekly basis.
For example, if I’m trading or looking to trade the euro, gold, five-year
Treasuries, and Russell 2000, then the bottom four charts will have all of
these products on a 5-, 15-, 30-, or 60-minute time frame. The top four charts
will have the same products, but on a daily or weekly basis. CQG has tabs
within the window to make your charts more space efficient and I can simply
tab between them if I want to change the interval (e.g., the euro chart has “5
Min,” “15 Min,” “30 Min,” and “60 Min” tabs).

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Figure 8.4 Screen 2

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Screen 3 (Upper Row, Second From Right)
Screen 3 (Figure 8.5) is another CQG page that combines a combination
of visual color clues, two charts (five-minute and daily), and a “market
watch” quote board with about 150 symbols of products I watch ranging
across all asset classes. Each quote on the market watch quote board shows
me a range bar so I can quickly tell where a product is trading relative to its
high and low.
Having this visual tool allows me to quickly glance to understand where
an individual product or asset class is trading on a net basis, as well as
relative to its high and low. In a fast market, this streamlines my decision-
making process.
The Cross Asset Quote Board has a linking function built into it which
allows me to click on a quote and it will populate the two charts in the
window with that respective symbol—as in screen 2, the top chart is longer
term and the bottom is short term. This way if I hear something on
TradetheNews.com, or someone over an IM or Twitter calls something out,
then I can quickly click on the quote and it will populate in my two charts.
Screens 2 and 3 are positioned next to each other because they truly
dominate the two most important areas of my visual real estate, and they
include the charts that matter the most in a fast market. The reality is, if
things get fast, the information on Screens 1, 4, 5, and 8 will not have my
immediate attention and I won’t be able to focus on them. Instead, I will
prioritize my central screens.
Screen 3 is also where I keep my price alerts on CQG. CQG alerts are
very dynamic and alert me when preset prices, Fibonacci levels, and technical
indicators are reached.

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Figure 8.5 Screen 3

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Screen 4 (Upper Right Corner)
Screen 4 (Figure 8.6) is another CQG Integrated Client page consisting of
12 charts. I have many alternative charts that can be easily replaced or cycled
through. Below are the 12 contracts consisting of the markets that are about
98 percent of the futures volume I trade. I update the technicals on these
charts and have alerts programmed. I go with four asset classes: Commodities
(Crude, Gold, Corn), Equities (S&P 500 Futures, Dow Jones Euro Stoxx,
Mini Russell), Fixed Income (US Ten-Years, German Bunds, Euribor), and
Currencies (EUR/USD, EUR/JPY, Dollar Index).

Figure 8.6 Screen 4

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Screen 5 (Lower Left Corner)
Screen 5 (Figure 8.7) is where I run my UoR dashboards outlined in
Chapter 5. The UoR dashboards all run on Excel spreadsheets powered by
CQG’s Real-Time Data. However, given the hundreds of formulas
continuously updating on the client-side, it takes a tremendous amount of
processing resources. Therefore, this screen is one of the major reasons
why at the time of writing this, I have the Falcon F-52 GT with an Intel
i7-5930K, 6-cores @4.3GHz. Without this sort of computing power, the
constant processing of the UoR Ratios would significantly hinder running
other applications.
While I have different dashboards to look through, normally the Netto
Number or Roney Ratio dashboards are the ones displayed. The other
dashboards are something I check up on periodically throughout the day and
at night when doing my postmortem or preparatory work.

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Figure 8.7 Screen 5

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Screen 6 (Lower Row, Second From Left)
Screen 6 (Figure 8.8) is my execution screen using the CQG Integrated
Client. I have five to six Depth of Market (DOM) Trading windows, an
“orders and position” window, and a “fills” window. I have done many
webinars for CQG and if you have the time, I encourage you to go back and
watch some archived footage where I illustrate how to use these. The CQG
DOM Trader allows you to have four products on each trading window;
therefore, I can access 24 products fairly easily. As you can see from Figure
8.8, I keep four DOMs to the right of the orders and position windows.

Figure 8.8 Execution Screen

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Screen 7 (Lower Row, Second From Right)
This is my most flexible screen layout. What the market is doing at this
moment is dominating what is on this screen. I am constantly changing the
content that goes in here. For that reason, I call this the Protean Screen, or a
screen that adapts and changes. For example, right before a big macro event
like a Gross Domestic Product release, I will have all of my economic
analytics ready to process how good or bad this number was.
While there are too many items to list, some of the analytics I have for an
economic event are a spreadsheet that imports from Bloomberg all of the
subcomponents of a data release, a link to the government agency website to
help understand the data, and my instant messaging programs. The instant
messages are particularly important in order to hear from my network of
experts for their take on the data or event. This important information sits on
the left side of Screen 7, so that I can trade on my CQG DOM Trading
windows on the right side of Screen 6. This keeps the most important
information in my peripheral vision. Then as I get the facts in terms of what
the immediate price action is and what is likely to happen going forward, I
can look up at Screens 2 and 3 to see the price action from the charts.
Screen 7 (Figure 8.9) is also where MPACT! (Market Price ACTion), my
“regime risk” management system, can be viewed. MPACT! also helps me
adjust to regime shifts fast by storing predefined scenarios I created. These
scenarios help me deal with the fog of new information by showing me how
price action can be influenced over the coming hours and days.
MPACT! also displays the best asset classes and strategies to take
advantage of it. Therefore, as part of my preparation, I will spend hours
preparing MPACT! Portfolio Simulator to create and work contingency
plans.
Screen 7 also can hold my “Cognitive Empathy Grid.” This is discussed
further in Chapter 18 on Market Positioning and Chapter 19, Emotions Are
Our Greatest Ally. I update this so one can understand how different players
will react to the events of the day. This feeds into the MPACT! Ratio and
plays a role in my process of developing contingency scenarios for playing
the repricing of different news events.

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Figure 8.9 Protean Screen

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Screen 8 (Lower Right Corner)
Screen 8 (Figure 8.10) is for the different Bloomberg Launchpad layouts I
have set up. Launchpad is a very effective part of the Bloomberg Terminal
and allows you to create different layouts that can be called on by selecting
the respective tab. I normally scroll between eight different Launchpad
layouts, focusing on the topic described in their respective tab:

1. Economics
2. Currencies
3. Spreads
4. Equities
5. Commodities
6. Treasuries
7. Options
8. Social Media

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Figure 8.10 Screen 8 – Custom Launchpad Layouts

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Screen 9 (Laptop)
Screen 9 is my laptop, which runs independent of my main computer. It
redundantly runs important functions as a risk measure. On my laptop, I run
another version of CQG Integrated Client in case the main computer were to
freeze up. I also run a virtual private network (VPN) connection to my co-
located server. The server also runs a version of CQG Integrated Client and,
in case I lose both Internet connections in my apartment, then I can manage
my positions on my laptop using the Wi-Fi from my cellular LTE connection
from an exogenous Wi-Fi hotspot.

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Screen 10 (Tablet)
Screen 10 is my tablet. I will usually be watching my tweet deck, which
aggregates all of the tweets I follow. My tablet can also play Bloomberg TV,
access the Sirius XM app for CNBC, Bloomberg Radio, various news
stations, or some calming music. As noted throughout The Global Macro
Edge, controlling one’s emotional state while trading can be just as important
as access to information.

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Custom-Designed Keyboard
As a discretionary trader, I need to be able to act on opportunities in
multiple markets quickly using a pre-configured set of order instructions
combined with the power of my own MPACT! Software. As much as I love
the QWERTY keyboard, it is a clumsy and poor choice when I need to trade
multiple asset classes simultaneously.
Adam Sheldon from Bionic Trader Systems (keyboardtrader.com) and I
began collaborating after he watched me trade a live webinar on CQG. We
are both active futures traders, and we share a tendency for trading large
macro events and breaking news. He understood how much I would benefit
from a keyboard that was custom designed for trading multiple markets. We
found that “The Risk Trade” (see Figure 8.11 below) configuration of
Keyboard Trader would be the best starting point for me, with minor
modifications to address my specific goals. This configuration lets me design
custom baskets and spreads for up to 14 products before any news release.
Then, when the news hits, I can send and change orders for all of these
markets at the same time, within a fraction of a second.
By combining the voice recognition software, custom-configured
Keyboard Trader®, and my Razer™ Death Adder 3500 DPI mouse, which
lets me efficiently move around my array of monitors, I have systematically
removed delays and complications from my order management process.

Figure 8.11 Keyboard Trader

The takeaway from this is that so much of our success or lack thereof lies
in the details and our willingness to refine the little details in our process.

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Each aspect of my UoR Process has been cultivated over years and has
evolved through the culling process of painful experience. More of the ideas
and innovations shared in this chapter than I’d care to admit came at about
2:00 AM, while lying in bed mulling over a losing day or missed opportunity.

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Trading Desk – Omega Everest Desk
The final piece of my environment is my trading desk. While the average
worker who sits at a desk all day is doing themselves no favors, sitting at my
desk and having to deal with the shots of adrenaline that course through my
veins presents a serious long-term health risk. In 2013 and 2014, I went
through a number of serious stress-related illnesses that caused a major shift
in lifestyle. One of those shifts was purchasing a top-of-the-line trading desk
that can raise and lower to my desired height.
As someone who focuses on large macro events in the markets, I need to
be cognizant of the potential risk to my endocrine system. Therefore, sitting
down at my desk while trading a market going through a period of price
discovery may feel good at the moment, but for me it is tantamount to
launching a time bomb in my body. There are numerous articles and research
on the broader issue of health effects from sitting at a desk for prolonged
periods.17 The Omega Everest Desk allows me to stand while trading and sit
when desired from the touch of a button.
The Omega Everest Desk with Embedded Ergo-Tilt Keyboard Tray is 30
inches across by 72 inches wide and raises and lowers my eight flat panels to
my desired height without a problem. At five-foot-eleven, I can stand and
trade in perfect ergonomic comfort.
Speaking to my own experience, I would often deal with post-adrenaline
headaches and fatigue following some mornings of intense trading after I had
been sitting for two to three hours. The Omega Everest Desk has helped
alleviate some of those symptoms. I also notice a difference in my ability to
think clearly while trading when I am standing up versus sitting down. That
ambulatory aspect is a subtle, yet real difference that not only has long-term
benefits for my health, but also my P&L. The bottom line is one size fits all
does not work in investing and has no place in office ergonomics either.
Here is the link to the specific desk I use: tradingdesk.imovr.com

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4. Trading Journal
The trading journal, and its proper management, could fill up a book unto
itself. Many of the greatest traders of all time have had a way to record their
thoughts. The trading journal is also a longstanding tradition. In fact,
probably one of the most famous pieces of trading literature—Edwin
Lefevre’s 1923 book, Reminiscences of a Stock Operator—advocates the
use of a journal more than 90 years ago.
Today’s digital trading journals have evolved considerably from what
Lefevre likely used or from what I was using at the beginning of my career to
plan for the trading day. I have made efforts to embed the most useful
technology in every aspect of my Unit-of-Risk Process, and my trading
journal is no exception. Programs like Evernote, Google Keep, Simplenote,
and Microsoft OneNote have really changed the game of making the Cloud
your trading journal.
My trading journal is important both strategically and therapeutically.
Strategically, I have many trading ideas hit me at random, uncontrollable
times. I can be sitting on the couch, walking Delta, at the store, or lying in
bed at 1:00 AM, and a moment of inspiration can hit me. Therefore, I use a
lot of audio notes, voice dictation software, screen capture software, the
Cloud, and functions like Bloomberg notes in the terminal to capture what is
on my mind. This has been a huge help, because no matter how easy an idea
can be at the time it comes to me, the more detailed notes I take, the easier it
is when I go back later to review.
Therapeutically, trading journals have tremendous value as well. They
allow for much-needed introspection (important for understanding one’s
emotional state), and keeping collected while trading, as well as meditative
moments of quiet reflection. When I do put pen to paper, I have done
something to connect myself to my trading plan. That tangible connection is
very cathartic and brings me a sense of calm and familiarity. When we are
approaching a big macro event and I can feel my energy particularly strong, I
will try to channel that energy and let my stream of consciousness work itself
through things. This means writing several pages in my notebook to
understand my feelings, further visualize how the next day may play out, and
focus my thoughts.
I love to go old school and just jot down on a notepad my basic thoughts
when planning the trading day or pondering what could have been. There are

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studies that suggest this approach also helps with the absorption of the
material as well18. The process of taking pen to paper is something my
longtime performance strategist encouraged me to do, with the contents of
what I write becoming aspects we incorporate into our sessions.
It is during these times I feel particularly connected to the energy and
collective spirit of the market. This calm confidence puts me in a great place
to receive the abundance the market provides. Overall, writing in a journal
has been vital in keeping me balanced and growing as a person. Therefore, it
is something I strongly recommend to anyone looking to maximize their full
potential. Embracing my feelings combined with a consistent process can be
a powerful elixir for investment success.

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Trading Journal Inputs
I realize that, like all people, I can be a bundle of contradictions. I am a
creature of habit who loves spontaneity. My trading journal is a reflection of
that. My trading journal is absolutely critical in the UoR Process and
assessing the underlying regime because there are two aspects to consider.
The first is the market regime itself, using the techniques Jason Roney
outlined in Chapter 4. The second aspect may seem counterintuitive, but I
attribute a great degree of importance on the environment I am working in. In
particular, how that environment either enhances or detracts from my ability
to assess the market objectively. I believe the two are of equal importance. I
incorporate both quantitative and qualitative factors into my journal.

i. Game Plan
ii. Contingency Planning
iii. Market Participants Grid
iv. Regime Score
v. Fear of Missing Out (FOMO)
vi. Qualitative Self-Assessment
vii. Execution Score

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i. Game Plan
Every trading day must have a game plan, even if it is as simple as
executing my strategies as I see appropriate. The first thing when laying out
my game plan in my trading journal is to identify price points on my Cross
Asset Price Grid. The grid incorporates creating a report card on the
performance of the major products I trade in each asset class. The results
serve as a baseline for other analysis.
As I am a believer that—in the end—price action is king, I begin with a
technical approach to assess the market and then return to the macro narrative
from there. This means pulling data outlined in Chapter 5 on UoR Ratios
such as the Roney Ratio, Opportunity Ratio, MPACT! Ratio, and Netto
Number Dashboards. I overlay this data on top of key technical levels
comprised of Fibonacci, market profile, and other technical inflection points.
I then program my CQG alerts with notes attached so that, when the alerts
are activated, the notes remind me of what my plan was when I was in an
objective place. As many times, when the alerts go off in real time, I may let
the impulse of the moment alter my actions. Therefore, keeping this balance
is a constant juggling act that requires real discipline.
Every trading day is different in the level of preparation required. Some
days require us to take on a more path-dependent nature or wait-and-see
approach, while others necessitate exhaustive contingency scenario planning
around events like an ECB or FOMC meeting.
Before every week begins, I will use the weekend to look at the next two
to three weeks of G8 economic, central bank, and earnings events. This gets
my head around how the ebb and flow of macro events may unfold over the
next five to fifteen trading days. As a quick reminder, these countries include
the United States, United Kingdom, Japan, Russia, Canada, France,
Germany, and Italy.
Another benefit from mapping out the economic and central bank calendar
is it helps keep me anticipatory rather than reactionary. It also lets these
events incubate inside my subconscious. Then when I do my prep the night
before, it is not the first time I have given these events some thought. The
scenario grid below (Figure 8.12) is from the webinar Neil Azous and I did
together on the December 2015 FOMC meeting (referenced earlier in the
chapter). Here is the specific grid used for the December 2015 FOMC
Statement.

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 Figure 8.12 Scenario Grid
This starts with the G8 economic calendar and G8 Central Bank Calendar.
For those with a Bloomberg Terminal, the <BCAL> command is a great
aggregator of all of these events.

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ii. Contingency Planning
After I process the scheduled events and extrapolate how they may move
the market, the next step is to identify the five biggest unscheduled or
unanticipated events that may affect an asset class. I call this process
“looking for blind spots” and it has proven to be a very useful exercise.
I learned a lot of how to do this from Robert Savage at his Track.com Idea
Dinners. It is an intellectual exercise that can leave me feeling foolish when
wrong but, again, the important thing is you are staying anticipatory. Here is
an example from a week in 2015 in the FX space following a pronounced
move down in the euro.
The key in looking for blind spots is to think about relatively low
probability events, generally discarded or ignored by the markets, that
nonetheless could logically or strategically happen. This can be done on the
very low probability side (for instance, the United States is considered
relatively unprotected from a major cyberattack on its infrastructure, and it’s
logically possible that its enemies could levy one and would want to levy one
—raising the risk of a major black swan event) to a somewhat low probability
event (a fairly negative economic release when markets are heavily expecting
a positive one).
The qualitative strategic analysis that goes into looking for blind spots is a
major value add when trading against purely quantitative strategies. Consider
the case of the January 16, 2015 surprise statement by the Swiss National
Bank (SNB), when they shocked markets by removing the years-old currency
cap days after reassuring markets that it would not. Different quantitative
models called this a 7, 8, 20, 30, or even 60 standard deviation event (put into
perspective, this should occur once in quintillions of years), but the fault was
from the models taking an inappropriate sample and running with it (if you
quantitatively crunched me sitting at my trading desk for hours in order to
determine the odds of my next move, it would be deemed a hugely
improbable event when I finally got up to take a break). Other models culled
their probability from market placements based on this sampling,
exacerbating the problem. In retrospect, however, the SNB could not have
logically been expected to maintain the cap forever, and some move was
ultimately to be expected, even if it was unlikely on that date (especially
considering the SNB had reassured markets of its commitment just days
before). Accounting for logical contingencies before they happen can be a

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huge value add, even if it just comes to risk management.
To give an example, here are five events that may happen in the week
after I’m writing these words that could cause a short covering rally:

Event Probability
Weak Economic Data in US 24 percent
ECB Member Statement 21 percent
Ukraine Situation Devolves 19 percent
Peripheral Debt Concerns Escalate 18 percent
US FOMC Member Comments 16 percent
I blend multiple qualitative and quantitative methods of coming up with
these probabilities, but the takeaway here is there is a discipline that is part of
my UoR Process and recorded in my trading journal. This process is a key
tool to dynamically assessing the regime. By building out these models of
assessing the drivers and overlaying them on top of key technical levels, I
have put myself in a better position to identify the ebb and flow of the market
around these events. The foregoing is not accomplished by working 15
minutes a day—it takes many hours of preparation, focus, and discipline.

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iii. Market Participants Grid / Cognitive Empathy Grid
This springs from the idea of cognitive empathy or the theory of mind,
covered in Chapters 18 and 19. This idea is that by understanding how others
in the market will perceive events, you become more capable of trading an
event effectively. This also resonates with game theoretic approaches to the
market, which entail guessing the market’s reaction function (including
participants’ reactions to your own trading and the trading of others, and how
that will all affect participants dynamically) then choosing the optimal route.
Therefore, I create a market grid of different segments of the market. This
grid is a key part of my trading journal and UoR Process.

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iv. Regime Score – Regime Profitability Factor (RPF)
As explained in Chapter 5, I assign a score for the implied performance of
each strategy in each asset class. Multiple times a week, I grade out on a scale
of 1 to 100 how my strategies will maximize return per UoR in these four
asset classes: fixed income, currencies, equities, and commodities. The score
is my own assessment and is based on the technical, fundamental, and
sentiment factors driving the market. A score of one means the strategy is
likely to perform very poorly, whereas a score of 100 means it is the ultimate
market environment for this strategy to maximize return per unit-of-risk.
Jason Roney, my trading mentor, was influential in helping me develop this
system. The regime score sets the tone for my sizing, along with determining
what asymmetries exist.
Below is a sample of how the following ten strategies might work across
four asset classes. As explained in Chapter 5, the scoring works on a scale
of 1 to 100, with the higher the score the higher implied Netto Number.
For example, a score of 90 may mean that over this period I expect the
strategy to generate a Netto Number of 3 or higher, whereas a score of 12
would generate a negative Netto Number:

By walking through this process in my trading journal, as well as

collaborating with the people in my network, I have a process that helps me
generate a regime score. I generate this score by factoring in a “Regime
Premium” that either detracts from or adds to how I believe each strategy will
perform. From there, I can allocate risk and further refine my own process of
scoring the likely efficacy.

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 Referencing back to the Sight Beyond Sight newsletter mentioned earlier
in this chapter, this is where Neil Azous’ short Swiss franc (CHF) trade can
be incorporated. If I get a buy signal from one of my mean-reverting systems
in the CHF, I can now incorporate this into my regime score and, more
specifically, into my position sizing. Not only do I have a more profound
understanding of the risk I am taking on by being long the CHF, I can adjust
accordingly in a way that most standalone technical trading systems cannot.
Many purely quantitative strategies can suffer from model decay over
time without a “connect-the-dots” overlay. The backdrop Neil and other
research provide can help a technical system that performs well with a Netto
Number of 1.7 get up to a Netto Number of 2.2. I accomplish this by
incorporating Neil’s CHF call into my regime score. Therefore, I can size that
long CHF trade down or be tactical about how I manage it, understanding
what the backdrop is. This process, in a nutshell, is the heart of The Global
Macro Edge.
This regime score is a huge factor in how I size and manage risk. It’s also
a big contributing factor to the outsized portfolio performance illustrated in
Chapter 3.

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v. Fear of Missing Out (FOMO) – Pre-Trade and In-Trade
The Fear of Missing Out (FOMO) dynamic in trading is something written
about extensively by Denise Shull in Market Mind Games and will be
elaborated upon in Chapter 19, Emotions Are Our Greatest Ally. My own
FOMO score is an active part of my trade journal. Therefore, I record three
types of FOMO scores. The first is my Pre-Trade FOMO, the second is my
In-Trade FOMO, and the third is the market’s FOMO.
Pre-Trade FOMO – Score of 0 – 100
My Pre-Trade FOMO score refers to the level of emotional impulse I am
feeling toward putting on a trade. A score of 100 signifies I have a feeling of
overwhelming desire to get into a trade at all costs and that, if I do not act
now, I will never have a better opportunity. On the other hand, a score of 0
represents a level of fear or panic about getting in and that I can lose
substantially.
The FOMO score is a representation of how I am feeling emotionally, not
about going long or short per se. If I find myself at the higher extreme, it
means my emotional need to enter a trade may lead me to overstate the
benefits and/or overlook the risks; if I find myself at the lower extreme, the
opposite phenomenon may occur. I regard the sweet spot between 35–65. I
record my Pre-Trade FOMO anywhere from one to three times a day
depending upon how active I am in a market and what the context is.
If I do not trade for the day, then I do not record the Pre-Trade FOMO.
However, if I trade for the morning, I may record a FOMO the night before
(while creating my battle plan), when I wake up in the morning, and then at
the end of the trading day. These FOMO scores are very instructive for me,
and make up an active part of my trading journal and Chapter 19.
In-Trade FOMO Score 0–100
I am similar to many people in that my energy can shift once I have
entered a position. Therefore, In-Trade FOMO helps me quantify and distill
my feelings and thoughts while in a trade. By taking stock of them, I can then
ascertain if they may lead me to take an impulsive action that is not part of
my process. In-Trade FOMO is graded the same way as Pre-Trade FOMO,
with a score of 100 giving me a sense this trade cannot miss and will make
money. A score of 0 embodies a sense I better get out now as I feel a sense of
total panic and the trade has no shot of working out.
Qualitatively and quantitatively the most explosive trades in my history

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have occurred when I had the right amount of deference that the market could
take away the profits but was in a calm and collected state about how to
manage the position. An In-Trade FOMO score of between 25–40 has been
present for some of my biggest trading days. These visceral scores seem to
generate much better follow-through in a much quicker fashion than when
my In-Trade FOMO is near 65 to 75. As counterintuitive as this may sound, I
love to have some butterflies, and I embrace this edge the same way any
performer feeds off their nerves right before going on stage. I will expand on
this in Chapter 19, Emotions Are Our Greatest Ally.
Market FOMO Score 0–100
The last FOMO score I record is that of the market. This is the cognitive
empathy aspect that scores how panicky or greedy the market is. For obvious
reasons, this is a huge deal. I am always asking myself, “If this event
happens, what will the FOMO of the market be?” If, for example, there is
good news from earnings, then I ask myself how it will impact trading from a
FOMO perspective. If the score is moderate, then I need to stay tactical with
profits. However, if it is high—indicating that market participants are eager
to pile in—then I really press bets and let winners run.

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vi. Qualitative Self-Assessment
The Qualitative Self-Assessment is graded from 0 to 100 points and is
comprised of three components:

1. Preparation: 0 to 60 points
2. Focus: 0 to 25 points
3. Routine: 0 to 15 points
Preparation (up to 60 points)
For me, preparation breeds intuition. As I am a very intuitive trader, the
more time I have spent planning what can happen, the more in touch I am
with the market energy. I have determined over the years that between 70 to
80 percent of my success comes from how well prepared I am for the trading
day.
I have a template for what I feel is the perfect preparation for each type of
trading day. For instance, prepping for a day with no macro events is
different than getting ready for a day with a major data release. I have
protocol that I follow before an ECB meeting and, if I do all the things on my
checklist, then I get the entire 60 points. If I only do part of the list, then
preparation is scored commensurately.
Part of the preparation score is doing the write-up at the end of the day
because, ultimately, these notes will be referenced in the index system of my
trading journal. The better my notes are, the more prepared I am for the next
time.
Considerations in Generating My 60-Point Preparation Score:

1. Did I go back and look at past events and setups in recent history and
examine those outcomes?
2. Did I update all of my technical levels on my charts and corresponding
price alerts on CQG and Bloomberg?
3. Did I review and analyze all of my UoR ratios, synthetic spreads, and
relevancy of my custom regime indexes for the day and week?
4. Did I look over the Econ, event, and earnings calendar for the time I am
trading?
5. Did I build at least five contingency plans for the period and stress test
those on MPACT!™ and MPACT!™ Simulator?
6. Did I assign a regime score and create a regime grid?

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 7. Did I consult with my network to check for confluence and overlap with
my setups that match up with other things people are seeing? Did
consulting with my network reveal something I may have completely
missed?
8. Did I read the Sight Beyond Sight newsletter by Neil Azous, and other
pertinent research?
9. Did I write a substantive postmortem, do all necessary screen captures,
and record an audio file for next time? Did I outline items such as what
positions and timing would have been best and if there was anything in
my process that could have reasonably identified this ex ante?
Focus (up to 25 points)
The Focus score refers to how much I am in step with the energy of the
market. This by no means suggests the market must be on my mind all the
time, but that I am not distracted by something else that has my attention.
Something that can contribute to decision fatigue, leading me to take
shortcuts in thinking about an issue rather than tackling its aspects head-on. I
know when I am in the flow state (otherwise known as the “zone”), and this
score incorporates that.
Considerations in Generating My 25-Point Focus Score:

1. On a relative basis, how is my attention to the market? Are there outside

issues that have consumed more of my time than normal?
2. How has my concentration been over the last 24 hours, 48 hours, and
week?
3. How balanced is my energy? Am I coming from a position of abundance
or scarcity?
4. Am I in rhythm with the market and do I feel in touch with its energy?
5. Generally, how intuitive do I feel? Do I have a calm confidence or
lingering doubt?
Routine (up to 15 points)
My routine is very important to my trading, as I try to maintain fairly
controlled conditions. There are so many other surprises that can arise during
a trading session that I don’t want my routine throwing me off as well. For
instance, if I have forgotten to eat, then the accompanying hunger (and
maybe jitteriness) can throw off my whole mental state, coloring how I
perceive trading opportunities. Given that I rely on my intuition so heavily, I
wouldn’t, for instance want a missed breakfast to make me an unnecessarily

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aggressive trader (or boost my FOMO for pork belly and frozen concentrated
orange juice futures).
Considerations in Generating My 15-Point Routine Score:

1. Am I traveling? For how long have I been traveling?

2. Have I slept? When? How much?
3. Have I eaten? What have I eaten?
4. Have I meditated? When? For how long? Was I able to focus?
5. Have I journaled?
6. How is my overall energy?

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vii. Execution Score
The execution score is very important and much can be gleaned from this
grade. I have a process for grading how well or poorly I carried out my plan.
This is based on multiple factors and is graded on a range of 0 to 100.
Factors in Generating the Execution Score

1. How well did I stick to the plan of getting into the positions I’d
decided upon? (0-60 points)
a. How well did I assimilate my intuition into the timing of my
positions?
b. How did the energy of the market impact my execution?
c. What may have detracted from execution?
d. What may have enhanced execution?
e. What was my pre-trade FOMO?
f. Could I improve?
2. How well did I manage the positions once I was in? (0-30 points)
a. How well did I assimilate my intuition into my position
management?
b. How did the energy and regime impact the way I managed
positions?
c. What may have detracted from position management?
d. What may have enhanced position management?
e. What was my in-trade FOMO?
f. Could I improve? (For instance, if my target was for the market to
go to this point in this amount of time, did I give my plan a
reasonable chance for success?)
3. How well did I adapt to market conditions and carry out
contingency plans given the information I had? (0-10 points)
a. How well did I assimilate new information, and my intuitions about
this new information, into a contingency plan? Did I update
probabilities as new information came to light?
b. How did the energy of the market impact the way I carried out the
contingency plan?
c. What may have detracted from contingency management?
d. What may have enhanced contingency management?

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e. What was the market FOMO and how did my in-trade FOMO
change?
f. Could I improve?
Example 1. I am short US ten-year Treasuries and a European
Central Bank (ECB) Governing Council member suggests more QE
must be done, catching the market off guard. Despite US data
improving, bonds begin to rally, carrying with them the US
treasury market. Given this was not part of my base case, did I
adjust accordingly or feel sorry for myself and hesitate? Was I able
to stay ruthlessly impartial and maintain my Protean state?
Example 2. I was bearish silver. The rest of the metals are
really weakening and the dollar is picking up strength following
some overnight comments from a Central Bank official. Was I
content to take profits or was I dynamic enough to assess both
situations and press my bets when I was winning? How well did I
taper my position sizing? Given that the factors I thought would
play out did so, was I looking to add to the position (as this trade
has the potential to be an inflection point in a repricing of the
markets)?
I can record and build a personal repository of reactions to
exogenous factors like a surprise announcement, extreme price
move, or being stopped out. Then I can reference this repository for
future events. This makes improving easier over time.

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Bad Beats and Good Breaks Log
Many of us as traders can adopt a victim mentality at times when things
do not go our way. From my days as a cash game poker player, I keep a bad
beats and good breaks running logbook. In here, I outline trades that worked
in my favor as well as genuine bad luck. This is a great reference point to
keep me balanced because at any time I can immediately quantify just how
“unlucky” I am. Despite what I may “feel,” based on my logbook things tend
to even out in the end.

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5. Daily Routine
As noted before, I am a creature of habit who loves spontaneity. With that
said, no one day is ever the same, and market events often dictate how I will
approach a day, or even a set of days. How well I adhere to this approach is
what makes up my “routine” score in my trading journal. The routine has
been a work in progress score for years, and it is evolving even as we go to
press.
If you look at the performance in Chapter 3, you will see in October of
2015 that I had my worst trading month ever. I had my biggest one-day
drawdown of my career on October 2, 2015. This setback was quickly
followed with a nice score to make it all back by October 15. I then reached
new P&L highs on the year on October 26. This joy was short-lived as, on
October 28, I experienced a crushing loss that was twice the amount I lost on
October 2.
I have always been very aware of how my trading energy is acting and
how critical being in a routine is, but I needed something to formalize it. For
me, not having a system to at least acknowledge these things has proven to be
very disruptive to my equity curve. In particular, I have noticed the potential
for “slippage” in my performance from traveling, a hectic schedule, and
unexpected life events. By formally having my routine written down, I can at
least have a process to address these potential disruptions and put in place a
process to work through it.
I have a Fitbit and I track my food, exercise, heart rate, sleep, etc. I have a
database of all of this stuff. This factors into my Qualitative Self-Assessment
and personal regime score. If I am in a routine and well-prepared, I perform
better. Therefore, why not incorporate this into the risk management process?
While some of the aspects of The Global Macro Edge may seem a little
off the beaten path compared with what you might expect from a trader, I
want to share with you as many details as possible about my process. I
believe these details are the important points that can help others enhance
their own success. Much of constructive regime recognition starts with
yourself. Where are you personally? How objective are you? Are you
frustrated, angry, or mad? I believe all of these things play a factor.
Being a native Californian and living in Las Vegas, I have spent most of
my life trading in the Pacific Time Zone, where the clock is set three hours
earlier than the Eastern Time Zone, which dictates much US trading. Couple

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this with an eight-and-a-half-year career in the US Marine Corps and you end
up with the following sort of schedule:

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Typical Day (All Times Pacific)
3:45 AM – Wake up and find my breath. Spend a few minutes visualizing
how I want the day to go. Acknowledge my energy.
4:00 AM – Stretch and listen to some calm instrumental music. Center my
energy and really breathe well.
4:10 AM – Drink some herbal tea and consume 20 grams of protein. Start
to look at overnight data on my smartphone. Log onto trading computer in
my living room (a total commute of 50 feet). A lot of European Data hits
between 1:00 and 2:00 AM Pacific, so this is a chance to get a feel for things.
4:15 AM – Debrief with Spencer Staples from EconAlpha, breaking down
economic and policy events of the day, range of outcomes for those events,
and what factors could reinforce current regime or alter it.
4:35 AM – Debrief with Jason Roney to include going over developments
in Europe and impact on regime score for the day.
4:50 AM – Debrief with Bill Glenn on Global Fixed Income Dynamics,
technical levels, auctions, macro narrative.
5:00 AM – Review and update game plan accordingly.
5:10–8:45 AM – Full on Trade Mode. Still messaging, taking notes, and
researching depending on price action.
5:20 AM – Watch fixed income and metals markets open
and prepare for US Econ Data.
5:30 AM – Release of US Economic Data.
5:32 AM – Receive talking points from Spencer Staples at
EconAlpha on Economic Data.
6:00 AM – Crude Open and update regime grid and
technical levels.
6:10–6:25 AM – Eat breakfast and decompress.
6:30 AM – US Equity Markets open.
7:00 AM – More US Economic Data.
7:30 AM – On Weds and Thurs, DOE and EIA Natural Gas
Inventory Numbers.
8:30 AM – Watch European equity close, read Sight
Beyond Sight newsletter in its entirety.
8:45 AM – Wind down trading, start to find my energy,
record some quick talking points.

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 9:15–10:00 AM - Walk my golden retriever, Delta, and center myself
10:15–11:00 AM – Record written and audio notes in trading journal,
screen captures, postmortem execution score, follow up with network over
IM and phone.
11:00 AM – Only in the once-every-six-weeks case of an FOMC
statement or possible release of important FOMC minutes will I be around
the screens at this time. I’m basically done trading for the day at this point.
Could I stay around and try to make more? Maybe, but life is about balance.
That said, I will still check back in on the markets before the close. Also, if
we are going through a unique regime shift, I can rearrange my schedule and
adapt to this (as the word “protean” suggests).
The aforementioned is a good seven-hour trading day. I now relax for the
next few hours and may work out at the gym, go to yoga, or watch some
DVR of some totally mindless junk food reality TV like Vanderpump Rules,
Million Dollar Listing, or Man vs. Food.
1:00 PM – Nap for 60 minutes.
2:30–4:00 PM – Write, research, and edit The Global Macro Edge (from
2011 through early 2016, but not anymore obviously).
4–6:00 PM – Family time.
6–7:30 PM – Consult with network, construct trading plan for the next
day, update regime grids, run MPACT!™ Simulator, record my FOMO,
update contingency plans, update charts and alerts on CQG and Bloomberg,
etc.
7:30–8:30 PM – Family time.
8:30–9:00 PM – Thirty minutes of visualization and centering my energy.
I let myself feel all of my emotions and honor my thoughts for what they are.
9:00 PM – In bed.
This really is a day in my life and helps explain the process I use to tap
into the energy of the markets and identify the regime. It lasts 15–16 hours
but has multiple breaks and balance points. This schedule took more than a
decade to evolve and goes through alterations based on the time zone
differences and my locations.
The bottom line is I grade this as a trading journal input because life
happens. While I am the first to admit that adhering to a schedule like this
365 days a year is not feasible for most, at least we can be aware of the
potential to not be at our best. This does not mean bad things will happen, but
in my trading journal, I want to acknowledge when I am not following my

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routine. It is an anticipatory risk management measure and, by scoring it, I
am giving myself that much better of a chance to maximize return per unit-
of-risk.

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Conclusion
While this chapter has focused heavily on the intricacies of my personal
process, it is hoped that readers have generalized and rarefied some of these
principles into approaches that work with their own personal circumstances.
It is further hoped that this chapter has been beneficial to different types of
financial actors.
Investors can get some great perspective by seeing how I, an active
manager of my own capital, put all of the pieces together on a day-to-day
basis. This insight can be used to understand more about what a manager
goes through in choosing research and how, at a practical level, that research
is incorporated into their process.
Money managers reading this chapter will hopefully appreciate all of the
nuances that go into building a successful process. This entails designing a
process that continually evolves and incorporates newfound knowledge and
the changing circumstances of the market regime.
Advisors, in their attempt to be the best third-party expert, must go
beyond pure performance and dig into the subtleties of a manager. This
chapter hopefully provided a strong foundation for understanding one
approach to asset management, and potential idiosyncrasies that may exist
under this approach. This may also provide a foundation when performing
due diligence to ask some of the more qualitative questions.
While this chapter has given a broad outline of my personal trading
process as it currently stands, keep in mind that it is a continuously evolving
journey, and The Global Macro Edge is simply a snapshot of where I am
right now. Just as my process has changed markedly over 15 years of trading,
I expect it to continue to change in the future. To truly embrace a Protean
Strategy, one must be as fluid as the shapeshifting god Proteus—adapting
methods in the face of new technologies, new market regimes, new personal
or environmental circumstances, new discoveries, and to your own new
process.
Equally important, one must be open to that change, remaining ever-
perceptive of the markets, the environment, and the self. Only by
understanding the environment and realizing when it has shifted can one
adapt to it. If you suddenly find yourself underwater, do not keep walking—
learn to swim. (If you keep close enough to an air supply, you can even learn

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it by trial and error—though you may do it more quickly and have a more
effective stroke if you learn it from more accomplished swimmers.) If you
find the heat slowly increasing around you, be aware of the change, and get
out of the pot when the time is right. If the wind hits you square in the face,
do not stay rigid (it is a good way to snap), but bend with it. If you find
yourself faltering, flailing, or failing, first recognize that you are doing so and
then figure out why—only then can you fix it.
16 The webinar can be viewed at the following link:
http://news.cqg.com/events/2015/11/webinar-live-trading-final-fed-decision-2015.
17 http://www.emaxhealth.com/1506/diabetes-work-take-frequent-walking-breaks-
control-blood-sugar and http://www.emaxhealth.com/1020/breaks-sitting-important-
heart-health-waistline
18 http://pss.sagepub.com/content/early/2014/04/22/0956797614524581.abstract

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 PHASE II

Strategy Creation

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CHAPTER
9

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 Chassis of the Financial
Markets – William Glenn
“You mean to tell me that the success of the economic program and my re-election
hinges on the Federal Reserve and a bunch of fucking bond traders?”—Former
President of the United States of America, William Jefferson Clinton, as quoted in
Bob Woodward’s The Agenda
“Who is this guy?” was the thought that raced across my
mind as I pulled my head back from my eight flat panels.
Convexity? Cost of funding? Repo markets? Do I need to
know this? The voice was intelligent, well-paced, enthusiastic,
and extremely knowledgeable about the various idiosyncrasies
of the Treasury market. I continued to listen as Jessica
Kurjakovic fired off questions to this fixed income savant and
other Trade the News webinar panelists. The deluge of global
macro insight continued raining down as the European debt
crisis in spring of 2010 was the topic du jour. John Floyd was
next up, followed by Jessica Hoversen; Scott Colburn came
after that, and Don Wilcox added more perspective. Lastly, my
role as the “trader” on this panel was put to the test.
After such an intense cerebral expansion, I had to follow
up and put a face and handshake to the voice that was fluent
in “bond-speak.” The meeting did not disappoint. Bill Glenn’s
knowledge of the Treasury market was only superseded by his
engaging demeanor and warm disposition. In the coming
years, he would be instrumental in contributing to the success
of the Protean Strategy. The challenge with incorporating
fixed income strategies for many investors and myself is
having the resources to understand what interest rate regime
is in place and how all of the various components can impact
the market. Bill Glenn was a big part of helping me solve
those problems.
Beyond the timely market insight shared over Bloomberg
IMs, evening phone calls, and daily newsletters, he is a fellow
trading gladiator. Bill is a person who comprehends a number
of the psychological nuances, thereby shepherding me through

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some of the inevitable highs and lows experienced by all
discretionary traders.
Working on this chapter with Bill from 2011 to 2015 was
very instructive. We were able to incorporate aspects that
profoundly influenced the Treasury markets during these
paradigm-changing years. It helped me further crystallize the
process of incorporating fixed income dynamics into not only
trading underlying fixed income products, but contextualizing
the rest of the global macro universe.
Bill Glenn started on Wall Street during the summer of
1997 in the analyst program at Salomon Brothers, Inc. He
joined the firm after completing a double major in electrical
engineering and economics and finance at Bucknell
University. At Salomon Brothers he completed a two-year
analyst rotation on the finance desk, during which time he
learned how the firm funded itself through equity, commercial
paper, and the repo market. He also spent six months in Hong
Kong leading up to the fall of Long-Term Capital
Management. After his analyst stint, Bill entered the famous
Salomon Brothers training program, and then was hired by
the US government bond desk, where he cut his teeth trading
Treasury bills, short coupons, and two-year notes. In 2003, he
moved out the curve to trade fives, where Bill stayed until
2006, when we joined the proprietary desk. When the financial
crisis hit the industry hard, Bill moved to TD Securities to
assist in building the new US rates business in New York.
There, he has worn many hats, including trading, sales,
strategy, technical research, and relationship management.
—John Netto

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Overview of the Treasury Market
The appeal of being a part of The Global Macro Edge was not only the
opportunity to share my experience for something I am intensely passionate
about, but to help clear up a great deal of misinformation on fixed income
investing. One of the biggest challenges facing most market participants is
being adequately compensated for the risk they are taking on any given
investment. The period from 2009–2015 saw global bond markets rally,
which brought yields to multi-decade lows, only exacerbating the problem.
This low interest rate environment forced many portfolio managers to “chase
yield” in order to meet their return objectives without fully understanding the
macro environment and potential risks. This chase for yield made its way into
nearly every asset class, with Treasuries being the tip of the spear.
The bond market is as liquid as it is complex. It is a market filled with
multiple opportunities for those with the fundamental, technical, and
qualitative understanding to execute. This chapter, like the book, is focused
on the process, not necessarily the result. It will lay out a framework to help
traders, investors, and financial advisors gain clarity on how to screen, invest,
and dynamically manage a risk-based fixed income strategy for a portfolio.
As you read through this synopsis of the fixed income market, remember
that both John Netto and I believe that by understanding what the funding
markets are doing, you have a leg up on how the rest of the investment
universe will fall into place. In order to accomplish this, I will discuss the
following aspects:

Overview of the treasury market to include

Terminology
Repo operations
OIS and Fed Funds Forecasts in the Summary of Economic
Projections
Job of a Treasury flow trader

Benefits of having a focus on Treasuries as an asset class in your

portfolio
What sort of markets fixed income strategies can struggle with
What distinguishes Treasury traders and how they generate alpha

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 How a typical Treasury trader generates P&L for their firm
Trading Treasury auctions
What to watch and how I make buy and sell decisions
One-day perspective of a Treasury trader
Screen setup to view the fixed income space

Key takeaways for implementing fixed income strategies

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Beginnings
I started in the business at Salomon Brothers, Inc. (“The Firm”) in the fall
of 1997. My prior knowledge of the financial world was shaped by what I
saw on CNBC’s Squawk Box, focusing on the equity market. My education
in the bond market was fast and furious when I stepped onto the 42nd floor at
7 WTC. An analyst rotation took me to the famed finance desk, where John
Meriwether once reigned. The only difference was the faces; the “game” was
still the same.
The finance desk and fixed income trading floor were full of savvy, smart,
aggressive traders analyzing the bond market. The traders on the finance desk
explained how funding was the key to levering positions and understanding
the internal bond math dynamics that made bonds look “cheap” and “rich.”
The bond traders, meanwhile, pored over models attempting to capture mis-
priced securities that could be bought or sold for a profit.
I can recall the fall of 1998 when the Russian ruble devaluation led to the
widening of European convergence trades. Consequently, many macro and
relative-value hedge funds were forced to liquidate their trades due to margin
calls on losing positions. As the cracks appeared in the dike, no one knew
who had what exposure to the crisis, which made borrowing money and
funding positions difficult. These risks and illiquidity put pressure on broker-
dealers to find and secure funding for their assets. In 1998 Salomon Bros was
a bulge bracket financial services firm, with no parent bank holding
company. This meant the firm had no deposit base to fall back on for funding
in a time of need. They had to search daily for funding of their long and short
positions in fixed income securities. It was through longstanding trusted
client relationships that the Firm was able to fund the dealer through one of
the most historic financial meltdowns in history. Most people know this crisis
as the one that brought the downfall of Long Term Capital Management.
I am going to discuss funding market basics first. This will explain the
importance of the Fed’s overnight lending rates, which is critical in
understanding the way broker-dealers and banks fund their massive balance
sheets. The influence of the overnight rate reverberates throughout the entire
treasury complex.

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Glossary of Key Terms:
Treasury Future Basis trade: Trading government bond futures against
the underlying securities to exploit discrepancies in their relative pricing.
Going long bonds and short futures is going long the basis; short bonds and
long futures is going short the basis.
Butterfly: A spread trade that takes positions across three points of the
yield curve, known as the “wings” (the longest and shortest maturity dates)
and the “body” (the middle maturity date). The body is sized at twice the
DV01 of each of the wings, rendering the entire spread duration-neutral.
One’s position in the butterfly is the same as that of the body (i.e., if you are
long the body and short the wings, you are long the butterfly, and vice versa).
Carry: The interest earned from owning a bond less the cost of financing
it in the repo market.
Concession: The tendency of the bond market to weaken slightly before a
Treasury auction to make prices more attractive to buyers.
Cheap/Rich on the Curve: When a given bond or maturity sector is cheap
on the curve, it has a higher yield/lower price than expected according to an
idealized model of the yield curve. When it is rich, it has a lower yield/higher
price than that implied by the curve model.
Curve Flattening: When the spread between the yield on shorter- and
longer-maturity bonds narrows. A flattening as yields decline is known as a
bull flattening, and generally represents either concerns about low growth and
inflation or a flight to quality/risk aversion. A flattening in which yields go
higher is known as a bear flattening and is consistent with a belief in
forthcoming interest rate hikes. Note that when the yield curve is inverted, a
flattening represents a rise in short-term yields relative to long-term yields
(i.e., an increase in the inversion).
Curve Steepening: When the spread between the yield on shorter- and
longer-maturity bonds widens. A steepening as yields decline is known as a
bull steepening and is consistent with a belief in imminent rate cuts or policy
easing. A steepening that occurs as yields rise is known as a bear steepening
and can represent pending Fed Funds increases, or belief in the central bank’s
ability to control inflation. Note that when the yield curve is inverted, a
steepening represents a rise in long-term yields relative to short-term yields,
i.e., a decrease in the inversion.

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 DV01: The dollar value of a one basis point move in a fixed income
security. Used to determine the desired size of a position: “Buy five-year
notes in $150k of DV01.”
Eurodollars: A strip of futures contracts that settle into three-month dollar
LIBOR. They can be used to speculate on the future level of short-term
interest rates or to hedge exposures in other products such as Treasuries. The
futures have quarterly expirations, and traders often refer to them in “packs”
of four, or a “strip.” The first four contracts are known as the white pack,
followed by reds, greens, blues, and golds.
Fed Funds Market: Unsecured interbank lending market in which eligible
institutions can lend their excess reserve balances at the Fed. After Fed asset
purchase programs created a substantial supply of excess reserves, the Fed
instituted IOER to effectively eliminate commercial banks’ participation in
the Fed Funds market. Federal Reserve policy is conducted by guiding the
Fed Funds rate to a given level or range.
FRA/OIS Spread: The spread between the lending rate on unsecured
interbank borrowing, such as LIBOR, and that of an equivalent-maturity OIS
swap. This spread provides a proxy for pressure on funding markets and/or
bank credit risk.
GC: General collateral, or Treasury securities used in repo market
transactions.
IOER: The interest on excess reserves that the Federal Reserve pays
banks on reserve balances above those required by law. Established in 2008
to allow the Fed to maintain control of the Fed Funds rate by ensuring that
eligible banks lend money to the Fed at the IOER rate rather than lending it in
the Fed Funds market.
Interest Rate Swap: A derivative contract in which cash flows are
periodically exchanged for a predetermined period. Although there are many
kinds of swaps, they typically entail one party agreeing to pay or receive a
fixed rate, while the other party receives or pays a floating rate.
Inversion: A situation occurring when shorter-term yields are higher than
longer-term yields. Widely used as a signal for a forthcoming economic
slowdown or recession.
LIBOR: The London InterBank Offered Rate, which is the rate that a
panel of banks estimate they can procure unsecured funding in the interbank
lending market. Administered by the British Bankers’ Association until 2013
and subsequently by the ICE. While many interest rate swaps settle into

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LIBOR, the actual volume of unsecured interbank lending has almost
completely vanished as of 2016.
On-the-Run/Off-the-Run: On-the-run bonds are the benchmark securities
for a given maturity sector, and are the most recently auctioned securities in
that sector. They tend to be highly liquid and easy to finance. Off-the-run
bonds are non-benchmark securities that enjoy much less market liquidity.
During times of market stress the yield spread between on-the-run and off-
the-run bonds tends to widen.
Overnight Index Swap (OIS): An interest rate swap where the floating
rate is an overnight rate that is heavily influenced by official policy rates.
Examples of the rates used in OIS swaps include the Fed Funds rate, EONIA
(Europe), and SONIA (UK). Because there is no exchange of principal, OIS
incur little credit risk (unlike LIBOR, which is based off unsecured interbank
lending).
Repo: A repurchase agreement that is used to fund bonds on a leveraged
balance sheet. The bonds are lent to customers in return for loans of a
specified (usually short-term) period. Afterward the transaction is unwound
and the bonds are “repurchased” by the dealer, who returns the cash to the
client. If a dealer sells a bond short and needs to borrow it to deliver, this
process works in reverse.
Roll-down: The capital appreciation that a bond exhibits as time passes
and it moves from a higher- to a lower-yielding point on the yield curve.
RRP: Reverse repo facility conducted by the New York Fed. By paying a
fixed rate for short-term funding to cash-rich counterparties, including money
market funds, the Fed puts an implicit floor on the level of short-term interest
rates.
SEP: The Summary of Economic Projections released by the FOMC four
times a year. The projections include summaries of FOMC participants’
forecasts for economic growth, inflation, and unemployment several years
into the future. The SEP also includes a “dot plot” of where committee
members, both voting and non-voting, believe an appropriate level of the Fed
Funds rate to be at the end of each of the next several years.
Special: When a Treasury security becomes difficult to borrow, it is
known as trading special. In this case dealers will offer to lend cash at rates
below the GC repo rate, including negative rates, in an attempt to secure
bonds to borrow.
Swap Curve: A yield curve built from swap rates rather than government

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bond securities.
Tail: When an auction results in bonds being issued at a higher yield than
that at which the WI bond was trading immediately before the auction. When
an auction results in bonds being issued at a lower yield, it is said to have
been “through” the When-Issued yield.
TED Spread: The yield difference between LIBOR and the equivalent-
maturity Treasury bill; a measure of stress and liquidity in funding markets.
WI: “When issued,” a new bond that has not been auctioned yet. In the
run up to a Treasury auction, the new bonds can be traded WI on a yield
basis, then delivered after the auction.
Yield Curve: An actual or virtual plot of the yields of government bond
securities across the range of maturities.

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Funding
The finance market, also known as “repo” market, is the backbone of the
fixed income floor, followed closely by the U.S. Government Bond Trading
Desk (aka “The Treasury Desk”). Banks and broker-dealers have many
different options to fund themselves. They can borrow, issue debt, or use
special finance vehicles. These include LIBOR (London Interbank Offered
Rate), the Fed Funds market, issuing commercial paper, issuing bonds,
equity, and a few other capital markets options. The “repo” or repurchase
agreement is a main source of funding for securities or liquid assets that
dealers have on their balance sheet. The Federal Reserve (“The Fed”) sets the
Federal Funds rate, the interest rate at which depository institutions actively
trade balances held at the Federal Reserve. A repurchase agreement is one of
the cheapest ways for banks to create financing and is usually based on the
Fed Funds rate. Typically Treasury repos trade a few basis points lower than
borrowing unsecured money in the Fed Funds market (See Figure 9.1). The
bank lends assets and borrows cash against them, creating a short-term
collateralized loan. It is very much like a mortgage where you borrow money
and post your home as collateral against the loan, except repo trades are
overnight to a few months in maturity, and instead of your home, they
hypothecate the Treasury inventory.

Figure 9.1
By performing repos, banks and broker-dealers are able to borrow cash
against the inventory of securities they hold on their balance sheet.
Unsecured funding is expensive, while a repo, which is a collateralized
loan lets the broker-dealer borrow money at a lower interest rate. Over

358
time, the repo market has grown into a mechanism for firms to not only fund
their long positions, but also cover short positions. These shorts are a result of
selling securities which the dealer does not own and has not bought back yet.
Broker-dealers hold large quantities of Treasuries and securitized
mortgages on their balance sheets, which they lend out to clients who have
cash that needs to be invested. These securities, which the firm owns, are also
known as “longs” or long positions. There is a natural symbiotic relationship
between the money funds (who have cash) and broker-dealers (who need
funding). The cash being borrowed is typically from a “liquidity account,”
which is part of a larger portfolio. The liquidity account is where your local
bank holds a portion of its deposits or a money market fund keeps un-
invested cash. A bank or fund does not know when they will need to return
your cash, and the liquidity account allows them to invest these monies for
very short periods. Lending money overnight against US Treasuries is a safe
way to earn a small interest rate on “safe collateral” for a short period. As of
this writing, examples of firms with cash are money funds and bank
portfolios, such as State Street, Fidelity, Chase Manhattan Bank, or your local
savings bank.
Most of the Treasury collateral that is transferred in the repo market is
known as general collateral, or GC. This is any non-special Treasury bill,
note, or bond that sits on the balance sheet. When and if a short base develops
in an issue, it will become known as a “special” and have a lower borrowing
rate attached. I will discuss this in further detail later.
A typical repo market transaction would go something like
this:
Cust: “Where can you offer me $250MM of Treasury
collateral overnight?”
Bank: “I can offer Treasuries at 20 bps.”
Cust: “Done.”
Bank: “Done.”
What just happened? A customer called the repo desk of a broker-dealer
and asked where the dealer could offer $250 million of Treasury collateral.
The trader at the dealer gave them a rate of 20 basis points (“bps”). The
customer says “done” to accept the price, and the trader replies the same way
to confirm that the trade has been executed. The customer just borrowed $250
million in Treasuries overnight yielding a return of 20 basis points a year.
The loan unwinds the next day as the customer returns the Treasury collateral

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and the dealer returns the money. An illustration of the transaction is given in
Figure 9.2.

Figure 9.2
The funding market is the true proxy of the sentiment of supply/demand
for money over a short-term period. We can see this supply and demand for
cash by the prevailing interest rate of the overnight market. When there is an
excess of collateral on broker-dealer balance sheets, the rate will climb
because the broker-dealers will be willing to pay more in order to fund their
long positions. At times when there is a greater need to hold highly rated
assets such as Treasuries, rates will fall. This demand is because the tides
have switched and accounts with cash want to hold highly rated Treasury
collateral rather than riskier higher-yielding assets.
During the onset of the financial crisis in 2007, accounts borrowed
Treasury collateral rather than owning commercial paper or riskier assets.
Commercial paper is short-term debt issued by an institution to generate
funding. This demand for Treasuries drove Treasury repo rates to historic
lows, and on spread to the Fed Funds rate. (See Figure 9.3)

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 Figure 9.3. Fed Funds Rate vs. Overnight GC Rate
The repo market serves two purposes: (1) to fund long assets and to cover
shorts in bonds created from customer flow and (2) hedging. If a dealer sells
a security to a customer and is unable to cover or buy back the short, they
need to borrow the bonds to deliver them to their buyer. The dealer will go
into the repo market and borrow the bonds that they are short so they can
deliver them to the prospective buyer. These shorts in specific issues are
known as “specials” (see Figure 9.4), because they have a lower or “special”
rate attached to them when borrowed and lent in the repo market.
The transaction where a bank borrows a specific issue is called a “reverse
repo”, Bank XYZ would be reversing the normal directionality by borrowing
a security rather than lending it for cash.
For example: Broker-dealer XYZ sells $100 million ten-year notes that
they do not own to a customer. As a result of not owning the bonds, the
dealer needs to borrow them to have securities to deliver to the customer. The
firm will go into the repo market and borrow the issue; as noted above, the
interest rate paid on the cash borrowed against the ten-year notes is less than
the standard GC rate because the dealer needs a specific issue.

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Figure 9.4

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Nuances of the Level of the Funding Rate: Carry-
Positive and Negative
All markets are based on expectations; the bond market is based on future
expectations of interest rates, inflation, and risk. Bond participants are
constantly thinking about the future structure of interest rates: short rates,
long rates and all the ones in between. When we look at the bond market,
we start with the shortest rates and build the yield curve (“curve”) based
on our expectations.
The yield curve is a visualization of interest rates versus maturity. When
we talk about the curve getting steeper or flatter, we are describing the
change in the slope of the curve. If the difference between the 30-year rate
and the two-year rate is two percentage points or 200 basis points (2.40
percent - 0.40 percent), and then the 30-year bond rallies in price, the
movement higher in price of the 30-year bond drives its yield lower and this
in turn, flattens the curve. As an example, if the bond rallies 25 basis points
and the two-year note does not move, the curve will now be 175 basis points
(2.15 percent - 0.40 percent) or it will have “flattened” (see Figure 9.5).

Figure 9.5
If rates are going to rise, the prices of the underlying Treasury securities
are going to fall. The relationship between bond prices and yields is inverse.
Common sense would dictate you do not want to be long assets that will fall
in value.

363
 If prevailing market interest rates are 5 percent, one is willing to pay
more (a higher price) for a bond with a 10 percent coupon.
On the other side, if you believe rates are going lower, you want to be
long because this means prices will be rising. It is also important to
understand how Treasuries will move based on changes in very short rates.
Products such as the Fed Funds rate and Overnight Rate can play a huge role
in this regard.
Here are a few examples of how the market will interpret and move based
on these “expectations” and what was going on while this book was being
written.

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Scenario 1:
The Treasury market in 2011 and 2012 was dominated by Federal Reserve
policy actions. The Fed announced the Federal Funds rate would remain low
for a prolonged period in order to bolster economic growth. Because of this
policy shift, the market saw two stages of buying. The first stage was in
anticipation of lower yields and funding levels. Once it became evident that
the Fed truly was committed to holding the Fed Funds rate at low levels for a
prolonged period, investors bought short-dated Treasuries.

Bond traders bought two-year notes and three-year notes yielding 0.28
percent and 0.42 percent respectively, confident that the Fed would
NOT raise rates. If rates are on hold, the chance of prices falling (yields
rising) is very slim, which creates a backstop for traders.
This situation created an opportunity where traders could purchase
securities that yielded more than what it cost to fund them, creating a
“buy cash securities and carry the bonds trade.”
Buying of the front-end drove yields lower in twos and threes, which
steepened the yield curve.
It is this dynamic that often sees the curve steepen when markets expect
Fed policy easing.
The risks to the buying of front-end securities and carrying them are
twofold:

1. The economy rebounds and the Fed needs to raise rates.

2. The level to which you are funding your securities rises.

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Trade example:

In June of 2012 the Fed announced a commitment to holding rates low

until 2015 (see Figure 9.6).
Three-year notes with a maturity of 5/2015 were trading at 40 basis
points (bps).
At the time of this pledge from the Fed, the cost of funding three-year
notes in the overnight market was 0.20 percent. This allowed traders to
own three years at 40 bps and fund them at 20 bps, generating what
looks like 20 bps of nearly “risk-free” carry.
One can look at where the two-year traded and see that if a Treasury
trader held the threes for a year, they would “roll down” the maturity
curve to the two-year, which traded at 0.28 percent. If the trader
anticipated rates to stay low, then they could actually earn a further 12
bps’ worth of capital appreciation by holding the bonds and letting them
price to a 0.28 percent yield.
This trade was done in massive size, driving yields lower in the front
end until the expectations of future interest rates met the level of
funding.
Once again, it is all about the market’s expectation of future interest
rates, which is why Fed announcements move Treasuries so powerfully.
There is huge potential for far-ranging implications nearly every time a
major Fed event happens.

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 Figure 9.6
Trade Implementation Using Two-Year Notes:

Buy 100 MM two-year notes (0.25 percent 5/31/14) yielding 0.30

percent. Generally, most traders don’t have the 100 mm to pay for it
outright. They go to a dealer and ask their repo desk to “bid 100MM 2s”
and borrow cash against it.
Repo 100MM twos at 0.20 percent. You now have a cash-and-carry
trade where you are earning 30 bps annually on the two-year while
lending it and paying 20 bps to fund it or borrow the cash to pay for it
(see Figure 9.7).
Market participants do what the Federal Reserve has encouraged
them to by buying short-end securities and driving short-end
Treasury rates lower. You can see the direct and indirect
implications of Fed action working together with bond investors.
There is no such thing as a free lunch. While the Fed clearly laid out its

367
plans, in the event of a significant strengthening of economic data that
surprised the market, a violent unwinding could have affected things. If
Treasury traders have to adjust their timetable for potential Fed
tightening, it is possible for markets to be caught offsides badly. This
famously happened during the bond market rout of 1994, and more
recently during the “taper tantrum” of May/June 2013.

Figure 9.7

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Scenario 2: Extension of Twist
In June 2012, the Fed announced a maturity extension program
(“Operation Twist”), in which it would sell $267 billion securities with
maturities shorter than three years and buy seven 30-year Treasuries and
mortgages. This was a new iteration of Fed easing policy after the Fed Funds
rate reached the zero lower bound and prior programs of large-scale asset
purchases had been executed. The purpose of the program was to lower long-
term interest rates and flatten the yield curve. By lowering long-term rates,
the Fed hoped to encourage corporations and homebuyers to borrow and
invest, thus creating economic growth.
As discussed earlier, one of the responsibilities of Primary Dealers is to
provide liquidity to the US Treasury and the Federal Reserve. As a result,
dealers needed to bid on the short-dated securities being sold by the Fed and
offer the longer-dated bonds that the central bank wished to buy. When dealer
balance sheets get larger, their demand for cash increases. This demand for
cash or funding drives the interest rate or cost for that cash higher. This was
an unintended consequence of selling large quantities of short securities to
the market: dealers needed to secure funding for these assets. This had
implications for the cost of funding carry trades in the repo market.
This impacted the return of the cash-and-carry trader. As a result of
increased funding costs, the return of carry trades went down. Without the
same profit potential behind the exposure, traders will unwind their trades,
putting further pressure on the front end. For example, funding for our two-
year note mentioned above, which yielded 0.28 percent, rose from 20 bps to
30 bps. This took the carry from positive 8 bps to negative 2 bps, thus
destroying the rationale for the position and prompting an exodus from carry
traders.
The Fed Twist policy affected market expectations about the pricing of the
front end of the yield curve relative to other maturities (see Figure 9.8). Not
only was there the immediate price impact of the Fed’s flow to consider, but
also the secondary effect on the existing stock of market positions, such as
the two-year carry trade described above. The chart below illustrates how the
yield curve flattened in anticipation of Operation Twist by depicting the yield
spread, in basis points, between the three- and seven-year portions of the
Treasury curve.

369
 Figure 9.8
As Twist progressed, driving funding rates on short-dated bonds higher,
both the Fed and institutional clients were selling front-end paper. These
flows created two market dynamics:

1. A flatter yield curve

2. Ongoing pressure on short-term funding levels
Repo rates rose because of dealers’ demand for Treasury funding. The
following trade outlines what a bond market participant may have done at the
time of Twist.
Scenario 1: The trade is to sell two-year notes and buy seven-year notes.
In order to do this trade, we need a few pieces of information about the
securities and then calculate the amounts we need to trade.
Quantifying risk in the bond market is done by calculating the dollar value
of a basis point, or DV01, for each product across the yield curve. DV01 is a
risk measure used to measure price sensitivity with respect to yields in
absolute dollar terms. The interest rate sensitivity of a bond is dependent on
its maturity and coupon rate. The longer the maturity of the bond, the more
sensitive its price will be to a move in interest rates. DV01 allows traders to
understand their risk to interest rates by calculating how much their position
will move in price due to a move in rates.
It is calculated:

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 Price (bond yielding X – 0.005 bps) – Price (bond yielding X + 0.005
bps) = DV01. This will be outlined below:
Five-year note: 0.625 11/30/17 with yield of 0.607 percent
DV01/mm = PRICE(0.612) – PRICE(0.602) = 100.507591-100.459117
= $490.74 per bp
The convention is to quote the DV01 for a one-million notional of the
bond
On Bloomberg type YA <GO> (see Figure 9.9)

Figure 9.9
Trade Example:

Sell $100,000 bp of two-year notes versus seven-year notes

DV01s: two-year is $199 per million, seven-year is $672 per million.
Also found using YA<GO> on the Bloomberg Terminal
Now that we know the risk of the bonds, we will weigh the trade
accordingly.
($100,000) DV01 / $199 per MM = (502.5) MM two-year notes

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 100,000 DV01 / $672 per MM = +148.8 MM seven-year notes
This trade of short 502.5 MM two-year notes versus a long of 148.8
seven-year notes will give you $100,000 per bp of exposure to a curve
flattening trade, meaning for every basis point the seven-year yields
trade closer, or “flattens” to two-year yields, you will earn $100,000.
Conversely, if the spread between the two-year yields and seven-year
yields expands, or “steepens,” you will lose $100,000 per basis point.
In an environment with short rates held low and the Fed purchasing long
maturity securities, opportunities for market participants were created. The
aforementioned was an overview of how short-term interest rates and Fed
actions were driving the front and long ends of the Treasury market
simultaneously in 2011 and 2012. As the Fed slowly ended its purchase
program in 2014 and then hiked rates in 2015, new opportunities arose.
Whether short rates are at 6 percent, as they were in 1997 when I started in
the business, or at 0.25 percent as in 2009–2015, expectations will always be
changing and opportunities are always being created.

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Short Rates in the Post-Crisis Era
Making bets on future central bank policy changes is one of the central
planks of a global macro strategy. Although we have seen how Fed policy
can influence the Treasury market, other factors can also influence the price
of bonds; typically, the further out the yield curve you go, the less direct
influence that Fed policy has on setting bond yields. For this reason macro
traders typically use other instruments, collectively known as “short rates” or
“the short end,” to express direct views on Fed policy.
For many years prior to the financial crisis of 2008, traders used the
Eurodollar futures strip to bet on Fed policy. Eurodollars settle into three-
month LIBOR, the rate at which banks claim that they can borrow on an
unsecured basis from each other. Unsurprisingly, this historically has borne a
strong resemblance to the Fed Funds rate. The financial crisis, however,
reminded the world that there is a credit component to an interbank lending
measure, and LIBOR rates rose very sharply relative to less-risky instruments
such as equivalent maturity Treasury bills (see Figure 9.10). This difference
is known as the TED spread.

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 Figure 9.10
As a result, a new type of product has emerged that allows investors to bet
on short-term interest rates while mitigating exposure to systemic banking
sector risk: the Overnight Index Swap (OIS.) As the name suggests, an OIS is
a swap contract where the floating rate is based on an overnight rate that is
closely tied to central bank policy rates. In the US this is the effective Fed
Funds rate; in Europe it is EONIA; and, in the UK, it’s SONIA; etc.
The popularization of OIS has led to a number of innovations in the fixed
income market. As a speculator, it is now possible to bet directly on the
outcome of a single central bank policy meeting by trading a forward-starting
OIS swap that captures the period immediately after the target meeting up
until the following one. Note that it is still possible to have a basis between
the OIS rate and the policy rate, usually because of technical liquidity factors.
Nevertheless, this basis is generally much smaller than the historical
difference between policy rates and LIBOR, particularly during times of
stress.
Indeed, monitoring forward-starting OIS swap yields against equivalent
maturity FRAs (forward rate agreements, a generic term for forward-starting

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LIBOR-type interest rates) provides a useful real-time insight into stresses
affecting funding markets. These FRA/OIS spreads, as they are known,
exhibited considerable stress during the Eurozone crisis in 2010–2012, but
subsequently calmed in the ensuing years thanks to ample liquidity in the
global financial system.
Finally, it is important to note that OIS rates are increasingly used to
discount cash flows in derivative instruments such as interest rate swaps,
even when the floating leg is based on LIBOR. Unsurprisingly, not every
country has a functioning OIS market; in these cases, cash flows are
converted to USD and discounted using dollar OIS rates.

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Today’s Fed Policy Tools
Just as markets evolve over the years, creating new instruments to deploy
risk, so, too, has the Fed created new tools with which to implement policy.
For many years, the Fed would conduct policy by buying and selling
securities in order to add or drain reserves from the system, thereby guiding
the Fed Funds lower or higher, respectively. It was only in 1994 that the
FOMC started to formally announce that they were tightening or easing
policy, and a few years after that when they issued a statement regardless of a
meeting’s outcome.
The 2008 crisis brought new challenges, and with them the requirement
for new tools once the target Fed Funds rate approached zero. Perhaps the
most conspicuous was the implementation of large-scale asset purchases
(LSAPs, also known as QE), which influenced bond yields in the manner
described elsewhere in this chapter and created several trillion dollars’ worth
of excess reserves (i.e., bank reserves held at the Fed in excess of levels
required by regulators).
This in turn created its own challenges to the Fed’s ability to guide short-
term interest rates to the desired level. If those trillions of dollars were to be
lent in the Fed Funds market (the traditional destination for banks’ excess
reserves), it would swamp any possible level of demand. To mitigate against
this issue and take most banks out of the Fed Funds market altogether, the
Fed gained the ability to pay interest on banks’ excess reserves (IOER) in
2008. As of 2016 when this book went to press, this level has been set at the
top end of the Fed’s target range for the funds rate, thus effectively removing
commercial banks from participation in the funds market. Some other
institutions, such as Federal Home Loan Banks, are eligible to participate in
the Fed Funds market but cannot receive IOER; in the post-crisis period, they
have been the primary lender in the funds market.
As the Fed slowly begins to normalize interest rates, they still face the
challenge of ample liquidity in the financial system potentially pushing short-
term interest rates below levels consistent with the Fed’s target. To maintain
control of short-term rates, they have introduced a reverse-repo (RRP) facility
that functions in the same way as the private-sector reverse repos described
earlier in the chapter. Counterparties such as the FHLBs and money market
funds can lend money to the Fed in exchange for borrowing Treasury

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collateral. The RRP rate is set at the bottom of the Fed’s target range,
essentially setting a floor to short-term interest rates.
Another arrow in the Fed’s policy quiver has been forward guidance. This
has come in a number of forms and is largely intended to make the Fed’s
reaction function transparent, thus allowing markets to anticipate the stance
of Fed policy into the future. While the Fed has used calendar dates,
economic thresholds, and descriptive adjectives to characterize their
anticipated policy stance, the most enduring innovation in the Fed’s
communication policy has been the introduction of the Summary of
Economic Projections, or SEP (see Figure 9.11).
For many years the members of the FOMC have made forecasts of key
economic variables that have been shared around the table. Starting in 2011,
a summary of those forecasts has been released periodically, thus allowing
the market to see how the Fed’s view of the economy has evolved. This in
turn can influence market expectations, exerting upward or downward
pressure on Treasury yields.
Currently, the SEP is released near the end of every quarter and is
followed by a press conference from the head of the FOMC. The SEP shows
forecasts for real GDP growth, inflation, and unemployment over the next
several years, as well as over the long run.

Figure 9.11 Summary of Economic Projection

Source: Federal Reserve
The committee also provides insight into what each member, both voting
and non-voting, believes is the trajectory for the appropriate policy rate if the
economy evolves in line with their economic forecasts. While the FOMC
stresses that this does not represent a firm forecast or commitment, it

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nevertheless offers Treasury traders an unprecedented view of how the Fed
expects to conduct policy in the future. The projections are summarized in
what has become known as the “dot plot,” displayed in Figure 9.12.

Figure 9.12
Source: Federal Reserve
While markets can infer which dot corresponds to each FOMC member,
as you can see it is not explicitly labeled in the SEP. In practice, markets have
tended to focus on either the median dot or the dots that they believe to
correspond to the most influential members of the committee. In turn, market
pricing has only vaguely corresponded to the levels implied by the dot plot.
The chart below depicts an implied rolling two-year median Fed Funds
forecasts from the dot plot, overlaid against the rolling yield of the eighth
Eurodollar contract. As you can see from Figure 9.13, the Fed’s forecasts
have been much more volatile than market pricing.

378
 Figure 9.13
To some extent, this reflects a failure of the Fed’s forecasting ability; as of
the beginning of 2016, since the inception of the SEP, the unemployment
rate, GDP growth, and inflation have all consistently undershot the Fed’s
forecasts. As a result of weak growth and inflation, the Fed has generally
overestimated the degree of tightening that it will do. The divergence is also
explained by market risk management. When the FOMC dot plot suggested
no change to the Fed Funds rate over a two-year horizon, the balance of risk
was clearly skewed toward an earlier than expected hike. Conversely, as the
dot plot anticipated a more aggressive normalization, the market (correctly)
viewed the risks as skewed toward a more gradual pace of tightening, and
priced accordingly.
It should be clear, therefore, that the SEP and the dot plot are far from
gospel. However, they still contain important signaling information; a
downward shift in the dots is taken as a dovish signal (i.e., bullish
Treasuries), whereas an upward shift is perceived as hawkish (bearish bonds).
As such, deciphering the signals of the SEP and the dots is an important
exercise for a Treasury trader intent on determining which way the wind is
blowing.

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Job of a Flow Trader
A US Treasury flow trader provides primary liquidity to the US Treasury
and secondary liquidity to the customers of their firm. Primary liquidity to the
US Treasury means bidding in auctions and participating in coupon passes.
As a provider of secondary liquidity to customers, a trader must commit firm
capital in performing this role. The trader acts as principal on these trades,
meaning they have discretion to commit firm capital to provide liquidity to
the customer on behalf of the firm.
Unlike on the NYSE, when you send an order down to the stock exchange
or call your broker and say “I want to sell a hundred shares of IBM,” they act
as agent. You pay them a commission to match up a buyer and seller. In a
principal transaction there is no commission. Regulations at the time of this
writing do not allow a firm to charge commissions on principal transactions.
However, they can charge a bid / offer spread. Primary Dealers will attempt
to buy securities onto their balance sheet at one price (bid) and sell them to
another institution at a higher price (offer).

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Auction Process: Primary liquidity to the US Treasury
The auction process is very straightforward and easy to understand.
However, unless you have been involved in the process of refunding the US
Treasury, it can seem quite perplexing. The US Treasury auctions bills, notes,
and bonds regularly to refund itself and roll maturing debt. Each month a
certain amount of existing debt will mature, and the Treasury in turn must
fund the debt, which is rolling off, and any deficit spending. They do this
“refunding” by auctioning securities to the market in what is called a Dutch
auction process, or single price auction. The US Treasury has a schedule that
it uses to auction its securities. Below are the times and frequencies of US
debt issuance at the time this book went to press

One-, three-, and six-month bill auctions take place weekly.

One-year bills take place monthly. Bills all settle on Thursday.
Two-, five, seven-year notes: Auctioned monthly with end of the month
(last day of the month) maturities. They settle on the last day of the
month they are auctioned. If that day is a holiday or weekend, they settle
the next business or good settlement day.
Three- and ten-year notes and 30-year bonds: Auctioned monthly with a
15th of the month maturity. Settle on the 15th of the month in which they
are auctioned.
Ten- and 30-year notes are quarterly issues with maturities in February,
May, August, and November. The auctions in between these months are
“re-openings” of the existing bond. This means in March and April they
will auction ten- and 30-year bonds and add more of the bonds that are
already trading in the market and have a maturity from the original
February auction. This is to maintain and support the Treasury Strip
market.
The lifecycle of a newly auctioned security has three major phases:

The first is the announcement of what will be auctioned. This is when it

is referred to as the “WI” or when issued.
Second is the auction itself.
Third is the settlement, or delivery, of the securities to the buyer.
Typically, issues are announced the week before the auction is to occur.

381
During the time between the announcement and the auction itself, customers
can trade the new issue. At this point in time, it trades on yield and does not
have a coupon. However, despite having the ability to trade the new issue, the
people purchasing the bonds from the treasury will not take delivery until
after the auction takes place and settlement occurs. On the settlement date,
the newly auctioned issue will be delivered to the buyer, at which time cash is
exchanged to pay for the security.
The information given to the market at the time of announcement is size,
maturity, settlement date, and auction date. The security is known as a “WI”
or “When Issued” security. It means when the bond is issued or auctioned, it
will be the next on-the-run security in that sector. For example: the next bond
auctioned in the five-year sector after announcement and before it is
auctioned is known as the WI five-year.

WI means “when issued”, This is the period of time from when the
issue is announced and when it is auctioned.
The WI issue is traded on a yield basis, rather than price. This is because
the coupon has not been set yet. Once it has a coupon, which is set at
time of the auction, the price of the bond can be calculated. They are
largely traded on spread to the current on-the-run.
During WI Period we only know issue size, maturity, and settlement
date.
When the issue is auctioned it will have its coupon determined, which
then allows for a price to be calculated. In order to “price” a bond you
need the coupon, maturity, and settlement date.
A Dutch auction is a single price auction where everyone who participates
and buys bonds gets them at the same price. Since the mid-1990s, the Federal
Reserve Bank of New York, on behalf of the US Treasury Department, has
conducted single price or Dutch auctions. This means if the bonds auction at
1.00 percent, everyone who bought bonds in the auction gets them at 1.00
percent. Prior to the mid-1990s, bidders purchased securities where they bid.
This process was known as a modified Dutch auction and carried what is
known as the winner’s curse. You can imagine if you bid 0.90 percent and
the auction stops at 1.00 percent; you paid 10 bps too much for the bonds.

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Example:
On Monday, August 27, 2012, two days before the August 29th five-year
auction, the When Issued was quoted on a yield spread to the current five-
year note.

The WI five-year note traded 1.25 basis points cheaper (meaning it is

cheaper in price, higher in yield) than the on-the-run five-year note. The
on-the-run is the issue that was most recently auctioned.
On the day of the auction, bids are normally submitted to the US
Treasury by 1 PM Eastern Time. Only when there is an early close or
Fed Meeting or multiple auctions will one be moved to 11:30 AM ET. If
there are two auctions on the same day, they will submit bids at 11:30
for the first and 1 PM for the second.
For example, a five-year trading 1.00 percent with ten billion being
auctioned attracts ten bidders for the auction. The Treasury fills the bids from
lowest yield to highest yield until all securities have been allocated to the
buyers. The yield at which the last security is allocated dictates where the
coupon will be set.
Here’s an example of a Treasury auction

The auction results for this would be a 1.005 stop with 80% at the high.
A stop yield is where there are no more five-year notes to sell but there
is still demand. The bidder who bid the stop or yield where they were
auctioned got 80 percent of what they bid for.
ALL BIDDERS who win receive the bonds at the 1.005 stop yield no
matter what bid they submitted. They go through the lowest yields first,
obviously, up to higher yields until the stop.

383
 The coupon set on this bond would be 1.00 percent. Securities are never
priced over par, and the coupon is always rounded to the nearest 1/8th of
a percentage. In our example, the stop is 1.005; in order to have an
auction price less than 100.00, the coupon is adjusted to the next lowest
1/8th of a percentage, 1.00 percent.
Along with the auction results comes a bid-to-cover; that’s the amount of
total securities bid for divided by what was being auctioned. In our example,
1.06 times the actual amount was being auctioned. People look at this
number, but I find it to be irrelevant.
One critical aspect to keep in mind, and why bid-to-cover ratios can be
misleading, is if someone put a bid in for ten billion five-year notes seven
basis points higher than where it is expected to stop, it is included in the bid-
to-cover. However, it has no implication on the market because it is so far
back from the bid price it would most likely never be filled.
There are three main types of bidders in a Treasury auction:

Primary dealers: At the time of this writing, there are 21 primary

dealers, who provide liquidity and buy some portion of the auction
within the context of the market. Their job is to backstop the auction and
provide liquidity which clients may not be able to provide.
Indirect bid: An indirect bid is a customer bid that is submitted through
a primary dealer. If customer XYZ bids for 500MM of an auction, it will
be entered as an indirect bid.
Direct bid: This is a competitive client bid placed directly with the US
Treasury. Any broker dealer who is not a primary dealer bids as a
“direct.”
Bids are submitted via a TAPS terminal—a direct link between the bidder
and the New York Fed. Primary dealers and direct bidders only have access
to the TAPS terminal.
You can find the results by using Bloomberg. Type < NITRE > or <
NIAUC > into your Bloomberg terminal to see the auction results. You can
also find the results on the US Treasury website www.treasurydirect.gov.
This is a recap of what the U.S. Treasury Auction results would look like
in Figure 9.14. This is a screen capture from the 8/29 five-year note auction.

384
Figure 9.14 Results of a Treasury Auction Using Bloomberg <NITRE> GO

385
A Day In the Life of a Flow Trader: According to Bill
Glenn
The first thing I need to do is create a daily workflow that will incorporate
all aspects of my day. This workflow will be different for every trader;
however, the work you do and the habits you form are very important. This
workflow starts with your homework the night before. This includes
assessing what is coming out the following day, how important economic
indicators are driving the trade, and what the technical landscape is like. Then
I assess what my risks are, what’s going to affect my market and the trades I
have on, and how I will adjust my strategy accordingly.
Typical Time Line (Eastern Standard Time):

7:00 AM Arrive in the office

7:00 – Look over foreign market and how it traded. Check all measures
8:00 AM of risk and how they have performed. For example, where
European debt is trading to the German benchmark. What do
repo rates look like for the day?
8:20 AM Pit CME open for bond futures
8:30 AM Data release
9:45/10:00 Second data release
AM
11:00 AM FOMC first operation (if active)
1 PM Auctions
2 PM Second FOMC operation (if applicable)
3 PM PIT CME settles and closes
5 PM Futures stop trading and bonds close
5:30 PM All broker screens are CLOSED
A day of a treasury flow trader starts during the commute in. Here is the
range of things a trader looks over:

Checking where the market is trading and contacting the overseas desk
to see what the tone of the market is, what foreign flows have occurred,
and any news or macro events.

386
 What data may have come out overnight, how the European markets are
doing, and what non-US flows have occurred overnight.
I am on the desk by 7 AM and begin preparing by going over my
exposure and how the overnight move has affected it.
Combine the events of the day and the technical landscape to create a
script for how the market will trade. The more robust the contingency
plan, the better the chances of the outcome. While it is not possible to
plan for every outcome, it is important to have an idea of what you
believe will occur to narrow your scenarios.
Never be locked into the plan, but let it guide you as the market reacts to
events compared to how it “should” react.
Talk with other traders on both our desk and outside contacts around the
industry. You should not trade on an island. I think it is vital to
communicate with the outside world. I collaborate with colleagues,
salespeople, and customers.
With the development of instant messaging technology, “virtual trading
teams” have emerged. This is a theme that runs throughout this book, I do it,
John Netto does it. People are on virtual trading teams as a result of
technology.
Let’s look at a day so you can understand my thought process:
On 8/29/2012 Chronology of events for the day (Eastern Time) (see
Figure 9.15):

7:00 AM Prepare for the day

Stocks are up overnight, things look to have a positive tone. The
Treasury market felt heavy; it was easier to buy bonds than it was
to sell them. Bias is to go into the GDP number at 8:30 AM with a
small short position and if the number is released in line or
stronger, then sell more longer-dated Treasuries. Typically on a day
where you have an auction, the market should have some bit of a
concession for supply (i.e., prices need to go lower in order to bring
in buyers).
I use a specified set of tools, including DeMark analysis, ATM
(Advanced Trading Methods), and capital flow to do technical
analysis of the market and create a short and intermediate view of
price action. I use them to see how the 8:30 data may provide
volatility around prices. This also provides a technical framework

387
 for how I want to lean and where I can buy and sell. The market
was trading as if it was expecting the data to be in line to slightly
stronger. Therefore, I am looking for technical levels to set shorts.

8:30 AM GDP and personal income/consumption

Stronger data will put a bid into risk assets, such as stocks, which in
turn puts pressure on Treasuries, driving interest rates higher and
prices lower. We have Jackson Hole on Friday and this is the last
meaningful econ data going into that event. This means the data
needs to be taken in the context of how the FED may react and
make any proclamations in Jackson Hole.

10:00 AM Pending home sales

Data was in line and had no market impact on the price activity.

11:00 AM FED buyback

The FED buyback will be in the seven-year sector as part of
operation TWIST and typically provides a bid to the market. The
five-year and seven-year maturities are typically known as
“intermediates.”
At 11 there is a FEB buyback; the FED needs to take securities out
of the market. “Buy that which is being bought.” This creates a
simple supply and demand imbalance in the seven-year note that
should drive prices higher. As a trader, you should be thinking
about where and if you can buy the seven-year sector in order to
offer bonds into the FED buyback.
In theory, the buyback can prop up the market and allow dealers to
“set up” or get short for the supply at 1 PM.

1:00 PM Five-year Treasury auction

You are post-Fed buyback, which means the only event for the day
is now the auction.
On the margin, the auction at 1 PM should push prices lower
because of supply. By being aware of key technical levels, many
times a trader can find levels where the auction should find support.

3:00 PM Close

388
 How do traders want to close out the day? Are they comfortable
holding longs overnight? Are you closing above or below the
auction stop? All these things will give you guidance for the next
day’s price action and setup for the next trading day.

5:00 and 5:30 PM

Futures close at 5:00 PM and all electronic bond trading closes at
5:30.

Figure 9.15 Overlay of Price Action Around Events of the day

Analysis on how the calendar impacted price activity: (See Figure 9.15):

Pt 1. The market drifted lower coming out of the slightly stronger than
expected 8:30 GDP data.
Pt. 2 as the calendar and trading plan suggested, prices moved higher

389
 into the buyback. Dealers need to offer up to eight billion in securities
into the FED at 11:00 AM. They are going to need to be long for that
event or have to take the risk of selling short to the FED and then
waiting for the auction. Flow traders are confronted with decisions to
make throughout the trading day.
Pt. 3 Operation goes off without a hitch. With the auction up next, there
is immediate price concession to move prices lower for the auction.
Pt. 4 The auction stopped at a level inside at the bid and offered yield of
the market at the time bids were submitted.
Pt. 5 As the market held and did not break to lower prices post auction,
market participants felt comfortable holding long bond positions. The
five-year note returned to the opening price for the day going into the
8:30 AM data. It was also the price where five-year notes had traded for
most of the previous day.
You build a roadmap in order to anticipate market movements and set up
positions in anticipation of daily events. Volatility is expected around the
8:30 AM GDP number and 10:00 AM housing data release. As you receive
economic data and see price volatility, there is usually an opportunity for
price discovery. This is why having a plan is so important as it prepares you
to react rather than be paralyzed by the trading day.

390
What Do We Watch?
Besides economic data, Treasury traders monitor specific relationships
inside the Treasury curve and other global interest rates. Market participants
focus on more than just US Treasury markets. Close attention is also paid to
Fed Funds, LIBOR, and other G7 Treasury markets; these include but are not
limited to the Bund market (Germany), Gilts (UK), and JGBs (Japan). As a
rates trader, you need to watch whatever is driving the market at any given
time. During the European crisis the market was particularly attuned to the
spreads between Bunds, LIBOR, and European Sovereign rates.
The rest of the world acts as a gauge for risk assets. Typically riskier
assets are bought when the world is safe and people are comfortable buying
those risky assets. As the world becomes less certain and cracks emerge, risk
assets will go for sale and that money will flow into a “safe haven.”
Historically the Treasury market acts as this safe haven for cash. As Spain
and Greece widened vs. Germany, US Treasuries acted as a safe haven. This
environment helped drive prices higher and yields lower (see Figure 9.16).
At one point in 2015, the German ten-year Bund was trading at negative
yield.

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 Figure 9.16
Being aware of where safe haven flows are moving in both US Treasuries
and global markets provides tremendous context for what market sentiment is
doing. This is instructive and critical when assessing how to take on
exposure. For example, the bid in the German bunds was accompanied by a
collective appetite for US Treasuries, which saw yields trade at multi-decade
lows. When this sort of risk environment exists, it sets up two situations:
The first being Treasuries will continue to rally and drive yields lower as
real money funds seek safe haven dollar-based assets.
The second is the awareness of an asymmetrical reversal trade when/if
things come undone by a key announcement or resolution to the crisis. These
reversal trades tend to be violent because they catch the market structure
leaning the opposite direction. As discussed by John Netto in Chapter 18 and
others throughout this book, how market participants are positioned is critical

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when planning out a trade. The Treasury market is no exception.
Both of the aforementioned scenarios provide opportunity for a Treasury
trader and necessitate one to be diligent and well prepared for the event when
it occurs. Issues such as how the market is positioned, technical levels, and
how the calendar is configured for both economic data and key policy
speeches all play a role in figuring this out.
LIBOR has been discussed throughout this chapter. At eleven o’clock
London time every trading day, the LIBOR fixing is announced. This is the
fixing for the London Interbank Offered Rate. It is described as the rate at
which dollar assets are borrowed and lent by banks outside of the US. It
implies an aggregated bank credit rating based on the member banks. This
typically puts LIBOR’s implied credit as high single A to a double AA credit.
Along with the LIBOR rate, I watch Eurodollar contracts. Eurodollar
contracts are forward three-month contracts based off the expectation of
where LIBOR will be when the contracts mature. Eurodollar contracts are
used as another viable hedging tool for Treasury traders. They are one of the
most liquid interest rate markets in the world.
As a Treasury trader, I can compare a two-year note and a two-year strip
of Eurodollar contracts, and be looking at the difference between US
Treasury yield and LIBOR.

Figure 9.17

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 The two-year Eurodollar strip is composed of eight successive contracts
separated by quarterly time frames (June 2013, Sep 2013, Dec 2013,
etc.) put together to create a two-year expectation of where LIBOR will
set. See Figure 9.17.
From these rates you can calculate the two-year TED, which is the
acronym meaning Treasury vs. the Eurodollar strip. Just as you can trade
the relationship from two-year notes to seven-year notes, you are able to
trade the relationship between LIBOR or AA bank credit and the two-
year treasury.
In 2008 when banks began to incur massive losses, TED spreads widened.
This is because of the inherent risk of banks and their subsequent influence
on LIBOR and their credit worthiness. As banks were downgraded, LIBOR
had to widen versus Treasuries. This widening drove 2 year TED spreads out
200 basis points to 250 basis points. Post crisis they gravitated back to the
long-term average of 20 bps in 2013.

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How Does a Flow Trader Make Money?
The most important concept every market participant needs to understand
is anytime a trader commits capital in the marketplace, they become a risk
manager. You need to figure out what the risks are to your trade, just as we
outlined with the trading day. These include economic data, fundamental
flows to the marketplace, auctions, and buybacks to name a few. One concept
I try to explain to other traders is TIME. Rick Knox, who developed the
ATM indicators explains time as risk. This very important concept needs to
be considered by all risk managers.
When you layer the concept of providing liquidity to a client, many times
you are getting long and short when you want to be the other way. This
means as the market becomes bullish, you are being asked to offer bonds, and
in turn getting short into bullish price activity. Treasury flow traders need to
understand the curve, butterflies, and the relative “cheapness” and “richness”
of all the liquid points on the curve. By knowing and understanding these
relationships, we are able to provide liquidity to the marketplace and
sometimes hedge losing trades, or even transform them into profitable ones.
The liquid points on the curve include:

Front end: two-year note, three-year note, two-year futures contract

Belly: five-year note, seven-year notes, five-year futures contract, ten-
year futures contract
Long end: ten-year notes, 30-year bond, classic bond contract, ultra-
bond contract

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Types of trades:
There are three main types of trades I do as a flow trader. Each uses a
single point or multiple points on the Treasury curve.

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Duration
A duration trade is the cleanest and simplest trade. You buy the market
and get long or sell the market and get short bonds or futures contracts. The
interest rate risk to this trade is the DV01 of the bond you are long or short
times the size of the trade.
As discussed earlier, the risk measure for owning a bond is measured in
yield sensitivity with DV01. Price movements are measured in “ticks.” In
dollar terms, a bond tick is 1/32 of price and is worth $312.50 for 1mm in
notional value, while a tick for a futures contract with a $100,000 notional is
worth $31.25. Whether you are managing your trade using a price or yield
stop, there are risk measures to use.

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Curve
A curve trade incorporates trading two points on the Treasury curve at the
same time. Each side is DV01 weighted to offset the risk in the other leg of
the trade, meaning you are neutral to the overall level of interest rates. This
means you are long one instrument and short another and have “equal DV01
risk” in each. A trader will look at the relationship between different points
on the curve at select times in order to calculate beta-weighting amounts to
smooth the directionality of the trade. Chapter 13, Patrick Hemminger’s
discussion of spread trading will touch on a number of these aspects.
Treasury traders pay close attention to the yield curve and study the
relationships between different maturities on the curve. The following
example illustrates this. Typically, when there is supply in the bond, the long
end of the curve will have a supply concession, meaning prices will be softer.
Consequently, yields for the issue will rise as it prepares for the supply of
new bonds to come to market. This “concession” is because of the large
quantity of bonds that need to be auctioned.
As a risk taker, you are looking to see how the curve responds to auctions
and buybacks. Treasury traders are keenly aware of when the curve “should”
steepen and instead flattens. These moves can provide insight into changes in
expectations of interest rates, or flows within the marketplace.
Leading up to and during a Fed easing period, you should be constantly
watching the curve versus the two-year note. In anticipation of the FED
easing interest rates in the spring of 2007, the Treasury 2s10s curve began to
steepen. This steepening lasted for over a year (see Figure 9.18). The spread
between two-year notes and ten-year notes widened by over 200 bps. By
understanding how the curve acts in times of easing or tightening, you will be
able to profit from these relationships. The macro concept here is the
“expectation” of rates falling. This expectation is what brings buyers into the
two-year sector and drive the two-year down in yield vs. the ten-year note.
You can see how the steepening in the curve began almost three months
before the first Fed easing.

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 Figure 9.18
Example of Curve Trade 1: A trader is bearish with a three-year auction
the next week.

The trade is to buy two-year notes, and sell three-year notes against it,
DV01 weighting the trade. This trade is known as “buying the
curve”; your position in the shorter maturity designates your
direction in the curve.
The DV01 of the three-year note is calculated along with the two-year
note, which is then used to calculate the ratio of two-year notes you will
be long to how many three-year notes you will be short.
Two-year DV01 = $192/bp, three-year DV01 - $299/ bp
The overall DV01 risk of the trade must be managed by each trader
and based on where the trade is “wrong.” For this example, we will

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 get short 350MM three-year notes.
(350MM) * $299/bp = $104,650/bp of curve = 545MM two-year
notes

As a trader and risk taker you are now short the issue the Treasury is
selling and long a sector which most likely will not cheapen as much as
the three-year.
As the bond market trades down, the three-year point will move more than
the two-year, and in turn steepen the two-year – three-year curve (see Figure
9.19). You are “short that which is being auctioned” and can provide liquidity
to customer selling and the auction process for the US Treasury.

Figure 9.19

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Butterfly
A butterfly trade is our third type of trade, and it incorporates three points
on the Treasury curve. A butterfly is just that, a trade with two wings and a
body. The direction of your position in the middle maturity issue will
describe your position in the butterfly. If you are long the body, you are “long
the fly”; conversely, if you are short the body, you are “short the fly.”
Against the position in the body you will have an opposite position which
is equally DV01 weighted in a longer and shorter maturity bond. The longer
and shorter maturities are called the wings. We are looking for the body to
richen in relation to the wings when long the fly, and cheapen when short.
While initially butterflies may appear to be complex curve trades, when
understood, they provide another dimension for expressing a market view and
more effectively managing risk. They can also be used to express the
directionality of the market and the richness or cheapness of securities vs.
each other.
Example: For a long $75,000 / bp 2s5s10s trade you are long the five-year
note (the body) and short the two-year note and ten-year note (the wings)
against it.
It is broken down into a 2s5s curve and the 5s10s curve. Convention is to
weight these trades with 50 percent of the body risk in the short wing and 50
percent in the long wing (see Figure 9.20).

Calculate the weights in each leg with the DV01 risk measure
$75,000 / five-year Body DV01 = $75,000 / $465 = 161MM five-year
notes
50 percent of the risk in the two-year = $75,000*0.5 / $188 = 199MM
two-year notes
50 percent of the risk in the ten-year = $75,000 * 0.5 / $872 = 43MM
ten-year notes
On Bloomberg this can be calculated by using BFLY <GO>.

401
 Figure 9.20 Using BFLY <GO> in the Bloomberg Terminal

Figure 9.21 Price Chart of Butterfly Spread Between Two-, Five-, and Ten-
Year Treasuries

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Relative Value: RV
The last major analysis we perform is to evaluate each issue in the
Treasury curve against LIBOR. The LIBOR market gives us a clean and
smooth interest rate curve. This is because the cash flows and interest rates in
the LIBOR curve are not restricted or influenced by supply or demand issues
that we see in the Treasury curve.
The first step is to create a smooth LIBOR curve, and then compare these
rates to the yields of each point along the Treasury’s curve. Just as we did by
comparing the two-year note to the Eurodollar futures strip. Each trader and
analyst has slightly different ways of comparing these curves. I was always
partial to discounting each of the cash flows of the Treasury note by the
discount rates associated with each corresponding date on the LIBOR
curve. From this point, I compare the spread in yield of the Treasury to the
synthetic LIBOR bond.
By doing this, we can see if an issue is rich or cheap versus other issues in
the Treasury curve. If an issue is relatively rich (priced too high), it may
present us with an opportunity to provide liquidity on the sell side, and
conversely, if it is cheap, we may have a better opportunity to provide
liquidity as a buyer.
I have worked with some of the best Treasury flow and relative-value
traders in the world. From watching how they trade firsthand, I have learned
that they are always aware of what is rich or cheap versus other points
and issues on the curve. If you have to buy a security, you may not want to
own, you will treat that security differently than an issue you believe is
cheap.
I have always followed the historical relationships between all the liquid
points on the curve. This tells me how the curve “should” move in a rally, a
sell-off, and other curve and rate shifts. By understanding how the curve
“should” look, this gives me the ability to take advantage of short-term
dislocations in price and yield inside the Treasury curve.

403
Customer Flow
How do Treasury flow traders provide liquidity to customers? More
importantly, how is this done while concurrently maximizing return per unit-
of-risk? As a flow trader, you need to have an understanding of multiple
factors:

The short-, medium-, and long-term dynamics of the market

(specifically, having an opinion).
Do you believe yields are going lower or higher?
Will the curve be steeper or flatter?
Do you think the market is going to be well bid? Are you going to have
to offer paper as a trader?
Flow traders are not portfolio managers; they are price makers and short-
term risk managers. The best flow traders are able to anticipate the order flow
that will come into the firm. In turn, irrespective of what market you trade,
understanding and anticipating market flows can provide insight to positions
and price activity.
Take a look back to the trading day example earlier in Figure 9.15. If a
customer sells you paper (bonds) around 10:30 AM, then you need to make a
decision. Sell the risk back out, or hold for the 11 AM buyback where the Fed
will be buying securities? If you decide to hold the bonds you bought, you
have turned a customer trade into a duration trade, the simplest of all trades.
A duration trade means you have duration risk or DV01 risk and you are long
or short the market. In this case, you are LONG duration looking for yields to
fall and prices to rise.
Flow traders use every liquid point on the curve to hedge order flow. As
an example, if you buy seven-year notes from a customer and are unable to
find another buyer, you can use other points to hedge your duration risk. This
leads into the curve trade.
Example: You are bearish and looking for a steeper curve (10s 30s) based
on your trading plan. A customer asks you to bid 100MM ten-year notes. As
you buy the 10’s and transfer the risk from the client to the firm, you realize
the market is for sale and you will not be able to move the risk at a point of
value. Instead of immediately selling the 10s at a loss, you can sell 30-year
bonds and enter into a steepener.

404
 Trade: Hit on 100MM 10s (customer sells the firm 100mm ten-year
notes), if there is liquidity, sell 30-year bonds as a hedge.

Long 100mm 10s: Risk = 91,200 DV01

Sell risk weighted 30 yrs. $91,200 / $1990 (DV01 of 30-year) = 45
bonds
If you were unable to sell 30-year bonds, you could sell the corresponding
bond futures contract; do the same math except using the DV01 of the bond
futures contract.

405
Recap
Market making is taking the macro perspective and overlaying
technical analysis and order flow from clients. This balance is the heart of
being a Treasury trader. At a higher level, it is about understanding relative
value and the nuances of each issue. Each trader in every market is a little
different; you will need to find your own strengths and weaknesses and use
those to figure out what kind of risk taker you are.

406
Trading Treasury Auctions
The curve, butterfly, and duration trades, which were explained earlier,
can all be applied to the auction process. For this explanation, a five-year
auction will be used. However, the analysis would work for any one of the
Treasury auctions.
Just like any liquidity trade, analysis is done on the five-year note and
how it will perform going into and out of the auction process. Typically, there
should be some level of concession in the issue as the time for the auction
approaches. This concession would be the cheapening (prices lower, yields
higher) of the five-year butterfly or the outright yield in the issue to move
higher.
Anytime a trade is being constructed, the following aspects are
considered:

What do we know?
US Treasury will sell 35 billion five-year notes
Auction to be held August 29th, 1 PM

What don’t we know?

How much will the market cheapen
What will the stop level on the issue be
How will the WI perform versus the on-the-run

What are our risks?

Economic data coming out that day
Customer flow that needs to be traded (How much demand will
there be for the new issue)

Being short the bond market simply because of an auction is not a

strategy. It is important to remember that just because the Treasury
needs to sell 35 billion of an issue, it does not necessarily mean the issue
HAS to cheapen—prices go down and yields go higher. Should the
technical bias, fundamental view, and supply dynamic align, THEN you have
a trade opportunity.
Let us assume we short the five-year note. We can do this in three

407
different ways:

Short the issue outright (directional trade)

Short the issue versus a risk-weighted amount of another issue (curve
trade)
Short the issue versus a longer duration and shorter duration issue
(butterfly trade)
In the process of providing liquidity, we may be short the five-year note
for the auction. If we do not want to be short outright, we have to be long
something else. We use our DV01 weighting (reference back to the paragraph
before as to what the risk measures are) and enter into a curve trade. By
doing this trade, you are looking for the five-year note to cheapen more than
some other security.
If you have no opinion on the curve or direction, you could sell the five-
year and enter into a butterfly transaction. An example of this strategy would
be to short the five-year note and buy a risk-weighted amount of the three-
year and seven-year note.

408
Screen Setup to View Fixed Income Markets

Pricing Matrix
The first and foremost tool a trader needs is their position sheet or pricing
matrix (see Figure 9.22). This will include:

All the issues you trade

Yield and price of the issues
Spread of the issues to the benchmark for the sector
We marked them on the spread for liquid points. Everything in the
off-the-run section of the two-years is marked in the “two-year
section.” That is a liquid point on the curve.

DV01 (Dollar value of 1 basis point) or risk measure for the issue
Book risk showing the DV01 for each sector you have a position in.

409
410
Figure 9.22

411
Futures and Cash Bond Execution
I then have execution screens where I can trade cash bonds and futures. I
have used the DOM look or depth-of-market trading for this. As a flow
trader, you are looking for a way to clearly watch the market and execute
quickly and efficiently. CQG offers a clean, fast execution system for futures
and cash. Figure 9.23 is an example of what a screen layout for me would
look like:

412
Figure 9.23

413
Off-the-Run Trading

414
Figure 9.24 BrokerTec “Swap Box”

415
 Figure 9.24 is a BrokerTec “swap box” for off-the-run Treasuries. As you
can see from the highlighted line above for the five-year, it is a system where
buyers and sellers of off-the-run or not recently issued securities come
together. There is no outright electronic market for the five-year note that was
auctioned in July; however, dealers will make markets in the bond to clients.
The trader will buy or sell the off-the-run “on swap” to the liquid on-the-
run. If I am bidding for the 0.625 “of” 8/17 (the August 2017 maturing
paying .625 percent) versus the five-year, you can see I would be bidding
100-01 on the 8/17s, which is -2.86 bps in yield to the five-year. You
simultaneously “swap” or exchange the off-the-run for the locked instrument.
If we are hit on the issue, or buy it, we simultaneously buy the off-the-run
8/17 issue at 100-01 and sell a DV01 weighted amount of the five-year at
100-16.
In order to watch other markets, I use Bloomberg as my main data source.
Figure 9.25 is a screen shot of the markets that I watch.

416
Figure 9.25 – Bloomberg Launchpad Layout of Markets I Follow

417
Indicators for Buy-and-Sell Decisions (ATM, DeMark,
Fibs, Fundamentals, Technicals, Global Macro Drivers)
Charting is a huge part of my analysis of the market and critical to
constructing a quick visual assessment of the landscape of Treasuries. I
believe that market participants committing capital in the marketplace drive
prices. By looking at charts, you can find where capital is committed and so
where the large players are active. This can be used to manage risk by
visually seeing where a trade is wrong and where it can profit. These price
levels are then used to calculate the risk/return profile on the trade and make
decisions about whether to take the trade or not.
CQG is my main tool in performing this task. I have programmed many of
my own indicators and proprietary analysis, as CQG lets me easily create
those tools. I then display them on the chart. Bloomberg improved their
charts considerably between 2010–2013, and I use their data and charts for
what I cannot chart on CQG.
For three years, I analyzed every traditional technical indicator I could
find. I diligently tested them for some level of consistent prognostication of
future price activity. Everything I looked at delivered marginal results at best.
The indicators tended also to only work in specific circumstances, such as a
trending market or a sideways market.
I began using Tom DeMark’s indicators early in my search. His indicator
set provides a fabulous way to find exhaustion and classify price activity. I
believe Tom has found something very “internal” to price activity. His
indicators work on stocks, commodities, bonds, and his patterns can be found
in nature. I specifically use TD Combo and TD Sequential on multiple time
frames looking for confluence of exhaustion or trend.
In 2006, I had the pleasure to meet Rick Knox, founder of Capital Markets
Research, at a presentation at the New York Mercantile Exchange (NYMEX).
Rick is a tall southern gentleman who is well spoken in the world of trading
almost every asset class. Rick was presenting on behalf of Tom DeMark’s
indicators.
With the suggestion of a friend at CQG, I took a trial of Rick’s Advanced
Trading Methods indicators and set to work. This began what would become
the missing link to my technical analysis.
In “Bill’s book of technicals” (yet to be written), I use three schools of

418
thought. The “pillars” of price activity include:

ATM for trend bias, cyclicality, position entry, and risk management
Capital flow to find exit levels
DeMark indicators for exhaustion
When I say cyclicality, I reference the cycles in the market that are based
on the ebbs and flows of supply and demand. Human beings are creatures of
habit. For the most part, we get up at the same time each day, we take the
same route to work, and we attempt to go to bed at the same time each night.
Because the market is simply a collection of individuals trading, I subscribe
to the belief the market is cyclical because both our world and we are
cyclical.
Tom DeMark incorporated the Golden Rule and how it applies to price
activity. Rick stumbled onto the phenomenon of how human cycles and
habits can be expressed in price activity. As a classically trained engineer, he
realized that these tools presented the framework to evaluate the price action
and formulate a way to commit capital and manage risk.
The ATM Trigger is one of the most brilliant indicators I have ever seen
and is the main component of the ATM studies. It has an uncanny ability to
find 1-2-3 and A-B-C patterns in price activity. Rick is a large proponent of
Elliott Wave and in turn, he looks for these patterns. Todd Gordon’s chapter
on Elliott Wave goes into more detail on what those patterns entail.
The following processes illustrate what I do to establish a technical bias
for the market. This is a book of process, and the reader will hopefully be
able to incorporate some, if not all, of what is being explained to help with
their trading, investments, or due diligence of a manager. Because every
market participant has different objectives, the following technical tools may
serve a different value for each person. Someone can use the same brush as
Monet, but it does not mean they can paint like him.

419
Extensions, Projections, and Symmetry
Every market carries with it idiosyncrasies embedded in its price
movement. Treasuries have a different harmony than equities, which have a
different flow than currencies, etc. This is not hard to understand when there
are different participants in each one of these individual markets. When it
comes to a very technical market like Treasuries, I believe in 100 percent
symmetrical moves, meaning as prices make a substantive move higher or
lower, a continuation of that trend will respond in an equal way. Simply
stated, if the first leg of a rally in bonds is 34 ticks, after a pullback, the next
leg higher will see a material reaction when it rallies 34 ticks as well. I also
use symmetry in percentage terms as well. Meaning if a market were to rally
7 percent over two months, then pull back, the next rally could be up 7
percent as well. When these symmetrical levels align with capital flow levels,
you have found the price level to exit and enter trades.
This “symmetry” in moves is another tool for flow traders to keep in mind
when taking on exposure. Other key levels that can generate tremendous
reactions are the Fibonacci relationships. See Figure 9.26 below.
The Fibonacci sequence is a series of numbers defined by the relation:

Fn = Fn-1 + Fn-2
0,1,1,2,3,5,8,13,21,34,55,89,144 …
The series has an interesting relationship where Fn+1 / Fn ~ 1.618 for every
value of n in the series, the Golden ratio. This value can be used to find
relationships in price activity. The market will typically find support and
extend to these Golden ratio levels.

Retracement support: 0.382, 0.618

Extension levels: (1.618)½ = 1.272, 1.618, 2.618
Joe DiNapoli’s chapter on Fibonacci talks about the importance of these
moves and can complement the previously mentioned indicators. Let us look
at an example in Figure 9.26.

420
 Figure 9.26

This chart of the ten-year note contract shows as almost perfect 100
percent projection (or 1 x 1 as John Netto references) which began with
an impulse at 132-02 and ended at 132-18. The contract pulled back to
132-10 only to see new buying interest that moved the contract to 132-
26. This level represented the same move that started at 132-02 and
paused at 132-18.
Let us look now at my personal favorite, the 1.272 “Bond” extension. I
see this overshoot occur repeatedly from 30-minute charts all the way to daily
and weekly periods. The example in Figure 9.27 below on the ten-year
contract shows an overshoot of the 100 percent symmetrical extension to the
1.272 zone.

421
 Figure 9.27

The impulse wave is from 132-10 up to 133-07, where the market then
pulled back.
By extending or projecting the impulse wave off the base at 132-23, you
can see the two expected targets. First the 100 percent target at 133-18,
and the second target at 133-26.

422
Exhaustion: DeMark Analysis
Stan Yabroff at CQG, a real student of price action, introduced me to Tom
DeMark. I have spent countless hours learning about Tom’s indicators. Tom
stumbled onto a formula which runs as deep as biology itself; the Fibonacci
sequence and its relationship to the golden mean.
I use Tom’s tools to determine if a move has come to the end of its trend.
This is important, as giving away profits from after a move has run its course
and then pulled back is painful. Therefore, having a viable way to tactically
exit positions at a highly probable level is a key component to succeeding.
If you have ever had the pleasure of listening to Tom speak, his motto is
“The trend is your friend until it’s about to end.” His TD Combo and TD
Sequential tools, which look for price exhaustion, nicely complement my
style of trading.
I look for the TD Setup that is nine consecutive closes higher/lower than
the close four price bars earlier, to show trend and short-term pause in the
market (See Figure 9.28)

423
 Figure 9.28
The setup is followed by the countdown. For a “TD Sequential” setup, it
begins counting after the setup and looks for the close of the current bar
versus the low or high two price bars earlier. For a TD Combo, the
countdown begins on the same bar as the first setup bar. It needs the close of
the next countdown bar to be higher or lower than the second bar earlier (see
Figure 9.29). It also needs to be higher than the high of the previous
countdown bar. This added restriction forces the indicator to look for a
market that is moving higher or trending rather than sideways. I think of them
as the impulse wave and the extension referenced in Elliott Wave Theory.
The idea being once the market has moved far enough in time and price, it
will stop and consolidate.

424
 Figure 9.29

Figure 9.29 shows two important concepts:

100 percent extension; and
The DeMark Setup that provided a rest in the downtrend of price.
The DeMark TD Sequential 13 exhaustion signal marking the completion
of the price movement lower. This overlays nicely with the symmetry of the
100 percent extension.

425
 Figure 9.30 Hourly Ten-Year Treasury Chart

Figure 9.30 is an hourly ten-year Treasury contract chart.

You can see the TD Setup and TD Countdown start on the same bar.
The TD Combo 13 isolated the high in the move that preceded the
market pulling back. I like to use TD Combo for intraday charts because
of the added need for the bars close to be higher than the previous
countdown bar high. This keeps the indicator from counting in a choppy
market.
ATM Trigger:
The ATM Trigger has three components:

Trend Strength bar

Fast Trigger
Slow Trigger

426
 ATM is different from every indicator I have ever used because it has no
settings. Unlike an RSI or moving average, the ATM calibrates itself to
previous price activity.

Figure 9.31 - Chart of Weekly Ten-Year Yields

The first and most powerful indicator of trend is the Trend Strength bar. It
is the horizontal bar which appears locked at the 100 level, or top of the
indicator, when in a bullish trend, or locked at the bottom of the chart (0)
when in a bearish trend (see Figure 9.31). I like to think of this part of the
indicator as the long-term trend of the chart.
The next component is the Slow Trigger, or ST. This is a different model
of trend that is more responsive than the trend strength bar. However, it is
still an indicator of intermediate trend. I use this as a counterpoint and tool to
find intermediate trend in the price activity. The ST will show a less noisy
view of the price activity.
The quick moving “oscillator” in Figure 9.31 is the Fast Trigger (FT).

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This gives the buy-and-sell locations in the direction. It bases this off the
intermediate and long-term trend. Once I have biased myself and have
decided to trade with the trend, I use the pullbacks on the FT to enter into
trades. After entering the trade I will also use the FT as a measurement of
time with regards to risk. If price does not facilitate in the direction of the FT
swing then as the FT becomes overbought I will pare down the risk and look
for another trading opportunity.
When you think about the idea of buying dips in a bull trend and selling
rallies in a bear trend, this indicator shows its true strength and is very useful.
Trade Examples: These two trades show the power of confluence in
technical analysis and fundamental views. The first is a ten-year trade from
the portfolio standpoint using the weekly interval. This is a very important
interval because it shows long-term cycles and trends in yield that are used by
banks and money managers. This specific trade was the flight to quality bid
into the US bond market as the euro was becoming more unstable.
I will then outline a trade that occurred in the fall and into the winter of
2010. The seven-year note versus the 30-year bond curve was expected to
steepen because of quantitative easing. The FED was buying securities,
driving yields lower; however, they were buying many more securities in the
five-to ten-year sector than the 30-year. This set up a bias for a “steeper
curve” driven by strength in the belly, not the long end.
Trade Example: Weekly ten-year yield chart
The first trade setup is a daily ten-year chart. In February of 2011, the
world felt good with the 2010 euro crisis out of the way. The market also felt
QE2 was fostering economic growth that put pressure on expectations for
ten-year yields. As the economy looks better, this implies the FED will need
to raise interest rates. Therefore, interest rates out the curve will rise. The
below example in Figure 9.32 will illustrate how powerful the confluence of
DeMark, ATM, and symmetry can be.

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 Figure 9.32

Point 1: Ten-year notes sold off and yields rose from January to early
February. At the high of the chart you can see the DeMark TD
Sequential 13 indicating exhaustion in the trend and an overbought
situation on the ATM Trigger.
This confluence of DeMark and ATM would give me the confidence to
cover any short and look to get long the market.
Point 2: The move in price action following the trend exhaustion and
Fast Trigger move lower brought yields down into a DeMark Setup 9.
Point 3: The market gravitates to higher yields only to see the ATM
Fast trigger become overbought. With the ST staying low on the chart,
the intermediate trend is clearly to lower yields. Also noting the recent

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 high in ten-year yields is at 3.60 percent, where the last cycle high was
at 3.77 percent. This move also stopped at the 50 percent retracement of
the February down move from 3.77 percent down to 3.37 percent.
This concept of a lower high in yields is known as a “failure to
continue.” The highs and lows in price action as the FT turns give you
very important insight to market sentiment. Here you can see the market
was unable to rally yields anywhere near the level seen in early February
of 3.78 percent. Because the FT is overbought and provides a “close
lower” signal, as well as a test of the 50 percent retracement, I would be
looking to initiate a long position on the next move lower.
Point 4: Moving from Pt 3 you should be biased long, looking for a
move down to the symmetrical extension of the Pt 1 to Pt 2 down move
(approximately, where point 4 is located). This target was touched at
3.20 percent. This is an oversold condition on the ATM Fast Trigger.
Longs are liquidated at this location and a great spot to provide liquidity
and take on long exposure.
I cannot stress enough the importance of using both fundamental and
technical information together. Great traders marry both technical indicators
and fundamental insight in order to enter and exit the market in an educated
manner. By doing this you can reduce slippage and give yourself clear levels
to take on exposure.
Example 2: 7s30s Curve Trade
This is a trade that was during the move into the QE2 trade in 2011. The
fundamental scenario is very straightforward. The Fed will be buying assets
from the seven- to ten-year part of the curve. The anticipation is for the
seven- to ten-year part of the curve to perform very well (prices rising/yields
going lower) and have the long end not appreciate as much, thereby making
the yield curve steepen. I have many people question the ability for technical
analysis to forecast the yield curve. The same price tendencies gained from
displaying a standard chart can also hold true when charting a spread (see
Figure 9.33).

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 Figure 9.33

Point 1: The price action in the curve begins to base. From there it
begins a new steepening move, or the differential between the two yields
starts rising. At this stage in the chart, it is difficult to ascertain how the
trade is going to develop.
Point 2: The yield curve stops steepening with the ATM Trigger
overbought. From here the price action relative to the movement in the
FT (Fast Trigger) is very important. With the Fast Trigger cycling lower
you would expect the curve to flatten, but it does not. At the same time,
the ST (Slow Trigger) stays high, indicating the intermediate trend

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 has shifted to bullish.
Point 3: As the Fast Trigger turns up, you go long the curve (sell the 30-
year bond and buy the seven-year note), initiating the steepening trade.
You are in the trade, and now you ask, “Where do I get out?” Look for
three things:
The market to reach an extension target
DeMark signals of exhaustion
An overbought situation on the Fast Trigger

Point 4: The curve steepens dramatically along with the cycle higher of
the ATM Fast Trigger. DeMark TD Setup 9 appears followed by a
DeMark TD Combo 13 as the spread hits the 1.272 extension of the
initial move at 216 bps. EXIT and re-evaluate. The confluence of
extension target, TD signals, and the Fast Trigger overbought is an
excellent reason to take profits.
Leg 2 of the Trade: See Figure 9.34

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 Figure 9.34 Leg 2 of Trade

Point 4: From this point, the steepening exposure you had on should
have been reduced based on the aforementioned factors. With the
confluence of DeMark Exhaustion and the ATM Trigger indicating an
overbought condition, there is no reason to stay in the trade with a high
probability of the recent steepening move consolidating or a flattening
bias coming back into the market.
Point 5: At this location in the trade, the ATM Fast Trigger is oversold
and turning up. The Slow Trigger is staying overbought, which is
indicative of a bullish intermediate trend. The trade is to enter the

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steepener with a turn of the Fast Trigger.
Point 6: Having entered the steepening trade off the Fast Trigger turn
higher, you are now looking to take profits at the end of the move. You
can see we come into DeMark exhaustion and simultaneously see an
ATM Fast Trigger overbought condition and a turn lower. Finally,
measuring the “symmetry” of the Pt3 => Pt4 magnitude and extending it
off of Pt 5, you will see the 100 percent extension target at 240 bps. This
confluence forces an exit of the trade. At one location on the chart, you
have exhaustion (DeMark), timing (ATM), and price extension
(symmetry). This is trading with the odds on your side.

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Takeaway
As I sat down to write the Fixed Income chapter for John, I wanted to
come from the perspective explaining how getting an education on investing
in the bond market using risk-based strategies can help the reader solve the
biggest challenges facing them in maximizing return per unit-of-risk. The
keys are education, technology, and discipline. There are no shortcuts.
This chapter builds a solid foundation for trading Treasury securities and
provides an understanding of how funding works in the Treasury market and
affects the rest of the global macro space. As a bond guy, it is no surprise that
I feel the whole book could have been on the bond market and how it trades.
This perspective should serve you well going forward to incorporate the
macro narrative and maximize return per unit-of-risk.
Lastly, the process of investing starts with your ability to fund a strategy,
manager, or idea and define the risk around it. You are now in a better
position to perform this task. The reader has a framework to either
incorporate aspects of a fixed income strategy into their own portfolio, invest
in a manager who trades the fixed income complex, or have a better
understanding of what things to look for when advising clients—all from a
return per UoR approach.

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CHAPTER
10

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 DiNapoli Leading Indicator
Techniques for Trading Global
Markets – Joe DiNapoli
Happenstance is a funny thing in both trading and life. My
brother, Alex, came back from a Traders Expo event in 2000
raving about a presenter named Joe DiNapoli. Alex said he
was the one speaker who stood out for his energy,
authenticity, and judicious approach. As Alex walked me
through his presentation and showed me his book, the
concepts resonated with me. I took DiNapoli’s book to China
that summer. It explained why the markets behaved the way
they did, and for once I was able to take an anticipatory
approach to my trading. It was like learning a new, beautiful
foreign language.
DiNapoli is the patriarch of Fibonacci analysis. His book
Trading with DiNapoli Levels profoundly influenced not only
my trading style, but a whole generation of hedge fund
managers, proprietary traders, and individual investors. The
information in the book is essential for creating a formidable
game plan when looking to successfully navigate the global
macro trading space.
DiNapoli has been trading for nearly 40 years and his
range of knowledge and depth of experience make him the
quintessence of a market practitioner. He has been able to
apply his robust technical methods across a range of global
macro events, including everything from bonds being priced at
18 percent, to the Dow crash in 1987, where he predicted a
drop of 500 points. He has been profitable in a range of
markets, and this chapter will provide a synopsis of his
approach.
—John Netto
DiNapoli leading indicators, or DiNapoli Levels™, are powerful tools that
allow traders, investors, and advisors to substantially increase alpha across
multiple asset classes, on multiple time frames, around the world. Having the

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ability and know-how of where and when to provide liquidity is at the core of
what makes DiNapoli Levels indispensable. Providing liquidity in this
context, however, is not the aim of my studies, but rather the key to reliable,
consistent profitability. This process is contingent upon taking an anticipatory
approach to the markets, and this necessitates the use of effective leading
indicators. You are no longer dependent on the four-letter word of trading—
hope—but rather you have a structure to act responsibly within. If short, you
know that you should exit just before predictable support. If long, you know
you should exit just before predictable resistance. If you want to get into an
up or down move, you buy before a predictable, predefined retracement.
Not knowing where these areas of support and resistance exist is akin to
flying blind. At a minimum, ignorance of the location of these levels
increases your risk appreciably. This chapter will provide an overview to help
traders understand how they can navigate the markets with relative safety. It
will provide insights that make it possible for some traders to refine their
methodologies and help investors understand more about discretionary
strategies. It will also provide insights to those whose responsibility it is to
evaluate the effectiveness of traders who use discretionary technical
strategies.
In this chapter, I will cover four leading indicators that I have developed
over 40 years of trading. I use these indicators daily. Two of the four are
Fibonacci-based. The other two use moving averages in effective and
innovative ways.
When taken within the context of my overall trading strategy, or
assimilated into your own approach, there is the real possibility to further
refine your ability as a trader. For a more comprehensive discussion on the
details of these leading indicators and how to use them in a comprehensive
plan, read Trading with DiNapoli Levels.

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Reviewing the Basics of Fibonacci Analysis
Since most traders connect me to my work with advanced Fibonacci
techniques, let’s first discuss the basics of Fibonacci analysis.
Almost every trader who has been involved in the market for any length of
time has heard that Fibonacci numbers and Fibonacci ratios can be applied to
the markets, but few know how to use them effectively. Like technical
analysis itself, Fibonacci techniques vary from brain-twisting impracticality
to the amazingly straightforward and stunningly effective. Many of the more
complicated forms of Fibonacci analysis are designed to keep the trader
tethered to the advocator of such techniques rather than to produce desired
trading results. It is assumed that, where there is complication there must be
brilliance. In fact, with regard to trading, the opposite is true. This chapter
will dispense with the mystery of the most effective advanced Fibonacci
techniques, and set you on a path of understanding that should produce strong
and replicable returns for your portfolio. The market need not be the
mysterious place it once was, if you understand Fibonacci analysis in its most
applicable form. It does not require complicated forms of wave analysis or
convoluted Gann-related timing techniques. It does require, however,
thorough, detailed, and repeated application of a series of simple rules.

439
Understanding Leading Indicators
My development of the Oscillator Predictor™ in 1982 literally changed
my trading life. It was the first time I had a reliable way to place an order
ahead of time to take profits in an existing trade.
Imagine no more waiting for moving average crossovers, broken channel
lines, or other lagging technical indicators which inevitably give back hard-
won profits. After the first time I implemented this strategy, I was hooked. If
you are an investor seeking a professional money manager, it may be
worthwhile for you to find out how much a given manager balances leading
and lagging indicators in his approach.
The Oscillator Predictor is a derivative of the Detrended Oscillator. The
Detrended Oscillator is perhaps the best Overbought/Oversold indicator on
the planet, far superior to the normalized RSI and Stochastic. While the CCI
may be as effective, the CCI is more complex. Simplicity with effectiveness
is and always has been the key to practical trading indicators, and what could
be more simple than close minus moving average? Figure 10.1 shows an
example of the Detrended Oscillator using a non-displaced, seven-period
simple moving average (MA). If you want to try a different MA, be my
guest… I have rigorously tested these parameters over three years and have
applied them for over 37 years. It is possible that a trader will come up with
superior parameters after diligent research tomorrow afternoon, but it is also
very unlikely.
Figure 10.2 is a 24-hour, continuous, non-adjusted weekly chart of the
Japanese yen/USD on Globex.
There are a few things that you should notice when looking at the
example. There are three horizontal lines—first note the zero line indicating
perfect balance. Also note the OB and OS lines showing +443 and -524
respectively.
Notice that OB and OS are not normalized to + or – 100 and are also not
symmetrical. This is a good thing. You need to be able to “see” big moves,
and markets are seldom symmetrical. Limiting and squishing your indicators
into a specified range leaves valuable information behind. You should also
notice the point labeled “extreme” (more on that later).

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 Figure 10.1 Detrended Oscillator Using a Non-displaced Seven-Period Simple
Moving Average (MA)
The OB/OS horizontal lines can be adjusted for the intended use, as can
the time frame.

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 Figure 10.2 24-hour Continuous, Non-adjusted Weekly Chart of the Japanese
Yen/USD on Globex
As good as this indicator is, however, to use it you have to sit there at your
screen and wait for the OB/OS number to be hit. The extreme point on the
chart could not be seen using this indicator either in hindsight or foresight.
You would need to be there watching while it happened in order to see it!
This makes the Detrend a coincident indicator, not a leading indicator. That’s
why I developed the Oscillator Predictor.
Through the magic of math, one can accurately postulate the price
necessary to reach historical OB/OS a period in advance. With this
information, you can place two dots, one above, one below, both in front of
the last bar. Connecting the dots historically produces a volatility band that
leads price by one bar. This makes it a true leading indicator.
With this indicator, you would have had the value of the extreme as
shown on Figure 7.2, a period in advance of market action.
Four common uses of the Oscillator Predictor are as follows:

1. Take profits when and if these price points are reached

2. Stretch™, a directional indicator combining DiNapoli Level™

442
 resistance or support with Oscillator Predictor resistance or support to
form an area of entry against the ongoing trend
3. Filter entries
4. Filter DiNapoli Level profit objective points
Even with the dramatic down move as shown on the right side of the
chart, price is reasonably contained. That’s because it is oversold. Throwback
rallies on a shorter time frame could have been sold with the use of the
additional studies that I will show you.
Understand this: the RSI, Stochastics, CCI, and the Detrend were all
capable first generation indicators for their time. The Oscillator Predictor
goes a step beyond. With the Oscillator Predictor, you need not display the
Detrend, thereby gaining valuable screen real estate.

Figure 10.3 Clear Tradable Presentation of the Continuous Non-adjusted

Weekly Chart of the Japanese Yen/USD on Globex

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Introduction to DiNapoli Levels
While the Oscillator Predictor that I developed was the most effective
trading tool I had used up until that time, all it did was whet my appetite for
more effective leading indicators. I began a diligent search for something that
could supplement this tool. Research brought me to the study of Fibonacci
analysis. The biggest issue with this study was that with all the possible ratios
and numbers, one was bound to find some set of combinations that would call
every turning point. While this could be useful as an investment advisory or
market letter, it requires backward curve fitting rather than forward market
analysis. Therefore, this approach was not useful for trading.
It took four years of research but I finally came up with a rule set that
simplified and codified this massive body of knowledge. More importantly, it
turned broad theory into a practical pair of highly effective leading indicators.
I can think of few times in my life when anything amazed me the way these
levels did. I refer to these levels are DiNapoli Levels. They seemed to control
market movement in a way that was truly awe-inspiring.
Again, for those of you who are new to the world of trading (meaning
having traded less than five years) understand this: Simplicity with
effectiveness in your method of analysis is the key to profit. Simplified and
codified Fibonacci analysis techniques means I threw away most of the
traditional aspects of the study and used what remained in new and
innovative ways.
For example, I use no Fibonacci numbers except to the extent that they are
used to develop Fibonacci retracement ratios. I do not use some of the most
popular retracement ratios. Among those ratios that I do not use are .5 and the
.79 (square root of the .618 retracement ratio). Are those ratios effective?
Yes, but not effective enough to add to the results that I am able to obtain
without them. They just cause clutter.
You want discipline? Remove clutter from your mind and your trading
approach. Focus is paramount. Speaking of focus, my focus here is trading. If
you want to learn more about the poetry, beauty, symmetry, and natural
occurrences of Fibonacci numbers and ratios in nature, a simple internet
search will turn up plenty to get you started. My job is to teach you
something practical and effective that you can apply to trading tomorrow. In
that regard, understand that the growth and the retracement of that growth can

444
be quantified with the correct tools.

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D-level Retracement
A retracement is simply a market pullback of an ongoing move. A
Fibonacci retracement is a market pullback, the extent of which is defined by
any Fibonacci ratio. D-Level retracements incorporate specific Fibonacci
ratios and supplemental techniques. I use two Fibonacci ratios:
0.382
0.618
Retracements are measured between a prominent high (Focus number F)
and reaction lows 1, 2, 3, etc. or, between a prominent low and reaction
highs.

446
Figure 10.4 Showing Basic Retracement Analysis from Both a Low and a High
Here are the equations relating to the above criteria.

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FIBNODE EQUATIONS
F3 = B - .382(B-A)
F5 = B - .618(B-A)
F3 is the 3/8 FibNode or .382 retracement
F5 is the 5/8 FibNode or .618 retracement
I call these retracements levels FibNodes™. They will exhibit support to
an ongoing up move and resistance on an ongoing down move. They are
available to you ahead of time; hence they are leading. They can lead by
months, weeks, days, hours, minutes, or seconds, depending upon the time
frame chart you are using.
When you start out with this method, you will typically use these
retracement ratios for entering a trade. You can place your limit buy-and-sell
orders ahead of time. Unless you are scalping or adjusting a previously
placed order, there is no need to act “at the market.” You can also place stop-
loss orders ahead of market action since you know where more distant
support and resistance will manifest in advance of market action. This is a
tremendous advantage when it comes to managing risk. If you are selecting a
manager who trades a discretionary strategy, you may be able to better assess
his risk management ability by finding out if he is providing liquidity, taking
liquidity, or a combination of both.
As you gain experience, you will see that retracement support can be used
for taking profits on existing short positions. Retracement resistance can be
used for taking profits on existing long positions.
By using multiple reaction lows (highs) one can develop a D-level™
series. You may have, for example, six FibNode pairs with one or two (K)
confluence areas as pictured below. Confluence is apparent if you have two
nodes created from different retracement ratios that are close in proximity. K
areas are very strong.
In Figure 7.5 a typical way to play would be to go long above the top area
of confluence while having a stop below the lower area of confluence.
Of course, the converse is true for down moves.
Creating definable risk-reward ratios is a substantial byproduct of this
liquidity-providing strategy.

448
 Figure 10.5 Retracement Analysis with Multiple Reactions
The real world, Figure 10.6 below displays a D-level series with three
reaction lows. This chart has one area of confluence. A limit order above the
area of confluence and at 139300 with a stop loss below 189850 would be a
reasonable interaction with the leading indicators depicted. If filled, this trade
would provide a high probability of gain. Note, even though the confluence
area was briefly penetrated, a well-placed stop under more distant support
kept you in the trade. Depending on the volatility and time frame, you need to
give these areas a little latitude. In this example, the brief penetration was
right on the open.

449
 Figure 10.6 (Previous Page) 120-minute Chart of the June E-mini
Figure 10.7 is also a 120-minute chart with the horizontal axis expanded
for clarity. It shows a probable outcome. We will consider profit taking after
we discuss expansion analysis.

Figure 7.7 120-minute Chart with the Horizontal Axis Expanded for Clarity
Be aware that a chart using standard Fibonacci lines with multiple reaction

450
lows is essentially incomprehensible to the knowledgeable trader. The most
important information is buried in the display. If you know little or nothing
about D-level techniques, you will not readily understand what is missing.
The fact is a lot is missing!
I developed this approach in 1985-6 and have been using it ever since, and
I could not use Figure 10.8 to trade with effectively.

Figure 10.8 120-minute Chart of the June E-mini

This chart is unclear because I cannot identify the reaction low that creates
a specific retracement and I cannot clearly distinguish between the nodes
from differing retracement levels. Additionally, standard Fibonacci studies do
not move. They are static, while D-levels are a dynamic study and are re-
computed on every change of the Focus number.
Figure 10.8 depicts the same information on the same time frame with a
clear, concise, and effective D-level presentation.

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D-level Expansion
Expansion ratios are most commonly associated with logical profit
objectives, but for more advanced users, an expansion is simply a forward or
leading area of support or resistance and can be used for entry as well as exit.
The three expansion ratios that I use are:
0.618
1.00
1.618

Figure 10.9 Expansion Analysis

OBJECTIVE POINT EQUATIONS
OBJECTIVE POINT: OP = B - A + C
CONTRACTED OBJECTIVE POINT: COP = 0.618 (B
-A) + C
EXPANDED OBJECTIVE POINT: XOP = 1.618 (B -
A) + C
The concept is straightforward in its simplest form yet unbelievably
effective if you spend sufficient time to understand the nuances.
I use three simple equations to establish logical profit objectives, where A,

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B, and C are specific points in a market move. The first objective is the
contracted objective point (COP). It utilizes the Fibonacci ratio .618:
COP = 0.618(B-A)+C
The second objective is the objective point (OP), which uses the Fibonacci
ratio 1.0:
OP = B-A+C
The third objective is the expanded objective point (XOP), which uses the
Fibonacci ratio 1.618:
XOP = 1.618(B-A)+C
This simple set of equations has allowed me to calculate major turning
points in a variety of markets, seconds, hours, days, weeks, or months ahead
of market action dependent on the time frame chart I am using.
In Figure 10.9, left chart, point A marks the beginning of an up move, B
marks the highest high of that move and C marks the lowest low following
point B.
In Figure 10.9, right chart, point A marks the beginning of a down move,
B marks the lowest low of that move, and C marks the highest high following
point B.
Once all three points have been located on a bar chart, their respective
values can be entered into the equations, and all three profit objectives can be
quickly determined.
Once you have located the three profit objectives, your strategy for taking
profits can include any combination of the objective points. You might
choose to take all of your profits at one objective point, or if you are holding
a multiple-contract or stock position, you could peel off contracts (shares of
stock) at each objective point. As you work with the concept, you will likely
develop other workable strategies.
Three targets, or logical profit objectives, can be calculated from any ABC
market swing, whether the thrust is up or down. You always use intraday
highs and lows. Forget the complication of taking two deviations from the
high/low average divided by the distance to the sun on every other full moon
except on leap year. Please, just keep it simple; use the high and the low!
There are a few high-quality software companies that I have authorized to
develop and offer software that includes my studies. To insure authenticity,
these studies are offered under my name. They are listed on my website:
http://www.fibnodes.com/software/softwarepage.asp
The details of the display are important; the points of interest must be

453
shown clearly. Having designed my studies for the rigors of my personal
trading, I can say with full confidence they are ready to handle the majority
of stresses which arise from fast and volatile markets.
If you are an investor looking for a manager who will trade with Fibonacci
levels or any other discretionary trading tools, inquire about what their
process was in selecting their trading software. Was the software provided as
part of a default package by the broker with the execution software, or is
there a specific set of analytics unique to that software? Being that most
software packages do some things well and other things not as well, also ask
what shortcomings exist in it, and if they have considered developing
proprietary trading tools.
Demanding traders will typically produce superior results. If a trader
does not have a strong software preference, it could be that he does not
have the experience to know what to look for. Presenting DiNapoli Levels
in an effective format is critical and not available in generic software.
In real-world analysis it is not often that you are paid to take a stock or
commodity, so negative numbers created from expansions are not recognized.
One of my most profitable trades of the year, in late 1998, was entering a
long position in crude oil. The COP on the monthly Figure 7.10 showed
approximately 10 USD as support. The negative values of the OP and XOP
are to be ignored. It should also be noted that this analysis does not use time
to locate profit objectives. Timing a trade is left to the MACD Predictor
discussed later in the chapter and certain other directional techniques.

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 Figure 10.10 Quarterly Continuous Chart of Crude Oil
It is possible for a move that occurs after a wave ABC formation to reach
all three objective points after experiencing a reaction at the previous profit
objective. It is also possible that the first objective could be the end of the
move.
Note that, when using logical profit objectives, significant selling will be
manifest at all three objective points in an up move, while buying will occur
at these levels in a down move. You cannot be sure of the extent of the
resulting reaction, only that the activity will occur. There’s nothing wrong
with exiting partial positions at each objective as it is met. As my father used
to tell me, “Joe, remember, a profit is not a loss.”
These objectives are particularly useful in panic markets. The 2008
financial crisis was among the most profitable times in my trading career.
When all else seems to fail, these numbers come in beautifully.
Natural occurrences lend themselves to this analysis.
Figure 10.11 is the Daily E-mini S&P at the time of the Japanese
earthquake and tsunami on March 11, 2011. It shows the expansions on the
E-mini S&P prior to event. I had resting orders at this level to buy.

455
 Figure 10.11 Daily Mini S&P Futures Continuous Chart Prior to the Japanese
Earthquake
I am not a seismologist and obviously did not know the earthquake
and tsunami were about to take place. However, the trade profited
handsomely because I had the support numbers ahead of time. See the
five-minute chart in Figure 10.12 when the disaster hit.

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 Figure 10.12 Mini S&P Futures Five-Minute chart at the Time of the Japanese
Earthquake
I was able to buy the market three times within a very short period with a
high probability expectation of gain. What gave me the courage to act in light
of such a disaster? Courage had nothing to do with it. Experience and a
robust trading plan supplant courage.
Using D-level expansion analysis, we can calculate these profit objectives
and exit accordingly. These expansions are not shown on Figure 10.12, as
they must be developed forward in time and dynamically change with market
action.
The real beauty of this analysis technique is its portability across time
frames, one-minute chart, or yearly. Take a look at the yearly chart, Figure
10.13, and then look at daily charts of gold in Figure 10.14 and Figure 10.15.
Note the reactions from the COP and OP levels.

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Figure 10.13 Yearly Gold Showing Expansions

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Figure 10.14 Weekly Gold Showing Market Reaction to the COP and OP

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 Figure 10.15 Daily Gold Showing Market Reaction to the COP and OP
Another example of the effectiveness of expansion analysis is shown in
Figure 10.16. At the October 2011 low, while everyone was bearish and the
news was horrific, we had clear and predictable COP support on the Daily
Dow. This was my best trade of 2011!

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 Figure 10.16 Dow Jones Industrial Average, Daily COP Support
If you have the knowledge and very high-quality software, you can even
apply these techniques to ultra-fast intraday moves caused by news
announcements. Fed decisions, employment reports, inflation figures, and
GDP. They are all fair game. As discussed in Chapter 14 on trading economic
numbers, being able to overlay DiNapoli Levels on top of global breaking
news makes your risk-adjusted trading profits better than they would
otherwise be. I often play news on one- and three-minute charts. But don’t
even think about it without top-notch software and ample experience.
An important rule to observe when using expansion analysis is to use
objective points primarily for exiting established positions. That way, you are
always trading with the trend of wave AB and not against it. (A strategy of
purchasing options against objective points is also acceptable, but riskier than
flowing with the trend.) After exiting a position, I usually wait for outright
entry signals before taking new positions. I seldom reverse.
Another point of importance is the universality of these profit objective
points. As long as a market is liquid, the concept works across both
geographical boundaries and artificial time boundaries (minute, daily,
monthly, etc.).
Whether you use COP, OP, or XOP as a profit objective, it is a judgment
call that takes into consideration other tools in your technical arsenal. For
example, Overbought/Oversold as defined by the Oscillator Predictor earlier
in this chapter, the strength and thrust of the move, previous length of base,

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trend in the next higher time frame, and volatility all play into the decision
process.
If you trade futures or commodities, continuous contracts must never
be price adjusted for high open interest or for any other reason. Take the
contract to expiration for the best results before rolling. Never use log scales,
and despite what you may have heard in chat rooms or by way of certain
wave theory techniques, always extend the expanded wave from point C, not
point B.

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The MACD Predictor
The MACD Predictor™ will be the easiest of my tools to teach you, but
the subtleties of this amazing tool are far more than I am able to cover in a
single chapter.
Figure 10.17 shows the 240-minute E-mini S&P futures. Detailed is the
MACD, a terrific coincident trend indicator. Coincident indicators are in step
with current market action. They do not lag. They do not lead. I feel they
were good for their day, but in the trading environment we have today, we
need to be ahead of the action, not simply in step with it.

Figure 10.17 E-mini S&P Futures 240-minute Chart

Above the MACD is the MACD Predictor (MACDP). Note that price
crossing this red line indicates a trend change. There are three such trend
changes shown on the chart. Note the price crosses the MACDP exactly
where the standard MACD crosses. What is not obvious is that the MACDP
leads by one period so you know the value of price that will create a trend
change in advance of market action. You can also gain valuable screen real

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estate by eliminating the less effective MACD from your chart altogether.
Now as a caution, there are a variety of subtleties and a wide variety of
advanced ways you can use this indicator. As a trend indicator we can simply
say that the trend is up and therefore we will buy retracements on a lower
time frame chart. We can place a valid stop as described above and take
profit at a profit objective.
See the 60-minute chart in Figure 10.18.

Figure 10.18 E-mini S&P Futures 60-minute Time Frame Combining

Expansion Retracement and MACD Predictor Studies
I have chosen a simple example that shows three retracements and no
confluence area. I have also selected an example where the retracement
values were penetrated a bit. This happens primarily when markets are
exhibiting illiquidity. Note that the entry and stop-loss retracement values
were known when the high of 133000 was made. That’s seven hours in
advance of our entry! As you can see from Figure 10.18, there was
considerable down thrust prior to the up move, and although we have a
positive 240-minute trend, it is more likely that this trend will be supported at
a deeper rather than a shallow retracement. We can choose the deepest .382
and select a stop loss beneath one of the .618 retracements as shown. The

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selection would also be based on money management considerations. These
numbers can also be used to scale both in and out of positions rather than
having a binary outcome on a single price point. Varying size at respective
entry and exit points is a terrific way to control risk. This is a key part of a
discretionary trader’s arsenal, and the use of a strategy that produces multiple
entries and exits not only allows for this tactic but encourages it.
After the entry, we can see that we’ve maintained the positive trend on the
higher time frame chart (Figure 10.17). Our stop was not hit and we are on
the way to making the COP profit objective. Prudence dictates protecting our
gains and moving the stop loss above our entry level.
If the higher time trend (240) were to break, we would exit immediately
using a limit order just below the current bid.

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Disadvantages of D-levels
I’ve provided you with a perspective on how to use the leading indicators
that I have developed, across a range of global instruments. This perspective
was constructed over 40 years, through experience, research, and repeated
application. Inherent in any discretionary trading strategy, which provides
liquidity and uses limit orders to enter the market, is the possibility to miss
trades. Key for both managers who use my leading indicators and investors
who wish to invest with those managers, understanding how managers can
work into positions if they are not filled on a given trade. Some will elect to
pass on the trade altogether, while others will pay up with either a market
order or preferably a limit order above the current offer. Typically paying up
on entry will constitute a smaller position size because definable risk has
been increased. These are both viable possibilities and the context of the
situation as well as the psychology of the trader must be taken into account
on a case-by-case basis. Using the points and insights brought forward
throughout this book will help to determine which situation warrants such
modification.
If you have a system or approach, unlike what is described here, that has
you buy stopping into strength or sell stopping into weakness, you will
definitely get a fill. Perhaps not a good fill but a fill indeed. Such an entry
typically produces a lot of heat and a low percentage of winners. Typically, a
given trader will prefer one method of entry over the other. Some managers,
however, can apply both methods and thereby potentially smooth out their
equity curve.
Ninety-five percent of my entries and exits are with limit orders placed
according to what has been discussed above. Using my approach, you will
find yourself sitting on the bids and offers with other professional liquidity
providers. You are now battling with institutions at these keys spots. This is a
good thing as you are trading on the side of smart money. You should also
realize this puts an emphasis on queue preference. Futures have advantages
over stocks since futures traders don’t have to deal with 1/1000 of a penny
flash orders inserted by high-frequency trading (HFT) programs.
It is also not uncommon for DiNapoli Levels to match up with other
inflection points and, as a result, you will be fighting for fills because you are
acting at the right price point. Properly written algorithms (algos) can and do

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sense support and resistance as it happens. Happily, your order will be in
front of them since you have the numbers to trade on before the market gets
there. Your competitor could, however, go to the market or as in the case
with stocks, front run you by a thousandth of a penny or step in front of you
by special order privileges given to HFT trading firms by the exchanges.
What can also be problematic is a market that becomes whippy and loses
its rhythm. This can be caused by unexpected news events, low volume, or
systemic threats to the exchanges like the one we saw in the Flash Crash on
May 6, 2010.
The degree of difficulty using this strategy is different depending on the
asset class being traded. Stock traders, for example, operate under a different
rule set than futures traders. The presence of algorithms in the market is
unmistakable. Recently it was reported that as high as 92 percent of volume
in a given month was attributed to various forms of algorithmic trading.19
Until this parasitical form of market participation is properly regulated, all
discretionary traders have a significant problem to deal with, as certain of
these algos are granted advantages the rest of us do not have. This sad fact
makes it incumbent on discretionary traders to understand exchange rules for
working orders and how queue preferences are constructed. Anecdotally, for
my equities trading, I have experienced HFT robots that continually step in
front of partial fills as their algos determine it is safe for them to make a 50-
microsecond presence. I have had this difficulty over and over being filled
on, say, 118 shares of a 5,000- or 10,000-share purchase, only to see “the
last,” a fraction of a cent in front of me until the selling has abated and the bid
rises, leaving my order unfilled. Some claim that these front-running robots
actually provide liquidity. Others feel it is a controversial issue. The issue is
only controversial to those who do not experience it every day. These robots
are killing liquidity by making the game harder for the real liquidity
providers to act within a market structure that now unfairly favors machines.
Furthermore, in the application of the expansion studies detailed above,
understand the process involves being able to apply context to the market
action and is open to some interpretation. With any strategy involving
discretion and interpretation, factors such as the individual’s experience and
market conditions can exacerbate one’s ability to profit. In line with this
thought, while the selection process of the ABC points shown in this chapter
is accurate and can be used as presented, there are subtleties that we simply
did not have the time to get into, and these subtleties require study and work.

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Without understanding the subtleties, getting that limit fill will be all the
more difficult.
Additionally, the proper selection and weighting of reaction points share
the same level of difficulty. Reaction points, and the FibNodes they create,
are no more equal as locations to take on exposure to the market than the
Prince of Wales and the typical sub-Saharan teenager. They both are people,
but that is where the similarity ends. Bottom line is that if you want to be as
effective as possible with this method, you will need to work at it.
As most of us have experienced, the time period between 2009 and 2012
has seen liquidity in most markets suffer markedly. If liquidity were to come
back to the markets, then the casual application of these methods will serve
you well. If not, those of us who know the subtleties will be in a much
stronger position to benefit versus those who do not.
Finally, you can implement the methods without the properly programmed
tools, but doing so is labor intensive and subject to error. Fortunately, the
tools are available and I suggest their use in all time frames, but especially if
you are trading below a 240-minute chart.
As a trader, the efficacy of these methods should become immediately
apparent as soon as you start using them. This assumes, of course, that you
have put sufficient time into understanding them and that you have capable
software to properly implement the studies.
As an investor using a manager who employs discretionary trading
strategies, you should understand as much as possible about your manager’s
approach. What is his plan for success? What tools does he use? Which
markets does he perform well in? Is he typically a liquidity provider or taker?
What time frame does he trade and how does he incorporate news? Many
large discretionary managers use some type of Fibonacci-based analysis in
their strategy. Now you have a working knowledge so that you can better
understand the efficacy of what your trading manager is doing.
My sincere hope is that this chapter brings you a greater understanding of
market action and this understanding improves your profitability as it has
with thousands of traders I have had the privilege to be in contact with over
the years.

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Notes
macd
Gerald Appel, The Moving Average Convergence-
Divergence Trading Method (New York: Signalert
Corporation).
RSI
J. Welles Wilder Jr., New Concepts in Technical Trading
Systems (Trend Research, 1978), hereafter cited
parenthetically in the text as Wilder, New Concepts.
Stochastic
George Lane, Lanes Stochastics, Technical Analysis of
Stocks and Commodities, May/June 1984.
CCI
Donald Lambert, Commodity Channel Index: Tool for
Trading Cyclic Trends, Technical Analysis of Stocks &
Commodities magazine, July/August 1983, page 120-122.
FibNodes, DiNapoli Levels, Oscillator Predictor, and D-Levels, MACD
Predictor, are trademarks of Coast Investment Software, Inc.
19 http://www.programtrading.com/faq/index.php?
action=news&newsid=56&newslang=en

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CHAPTER
11

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 Understanding Animal Spirits
Using Elliott Wave Principles –
Todd Gordon
One of the biggest challenges facing every market
participant looking to maximize return per unit-of-risk is
accurately pinpointing an exit point where their trade is no
longer viable. The problem is obvious. If one puts an exit point
too close to the action, then they risk market noise taking them
out of a trade prematurely. If the exit is too far away, then the
potential Maximum Adverse Excursion (MAE) erodes the
payout profile.
Beyond that, not having the confidence in the exit strategy
of your trading plan can lead to impulse reactions—reactions
that can have adverse results for many. Challenges like these
can cause a system appearing robust on paper to experience
only marginal gains or losing performance when executed in
real time. Therefore, having a solid technical approach is
essential for risk management and the long-term viability of a
strategy.
The Protean Strategy combines technical, fundamental,
and sentiment analysis to actively trade the macro narrative.
Above all, though, price action is the best indicator when a
macro narrative is no longer viable. Unfortunately, there are
stories of huge hedge funds pinning all risk management
protocol based solely on the exhaustive fundamental research
of a trade idea. This research empowered them to add into it
as the price went against them. Their risk management was
their “research”—their certainty based on their calculations
that the position could not go much further against them—and
adverse price movements were simply cause to increase
exposure. Then, when the narrative “surprisingly” changed
due to some unforeseen outlier event, they had a complete
risk-management disaster on their hands. It is surprising how
many firms one hears this about.

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 That is one of many reasons having an objective, rules-
based approach for both entry and exit is critical to the long-
term success of any portfolio. Todd Gordon’s application of
Elliott Wave analysis is a viable means of solving this
challenge. To this point, Todd goes well beyond locating
where an exit should be. His Elliott Wave Principles
objectively convey what macro argument is winning the
debate on a price action basis. As important, it also lets you
know what point on the charts the opposite argument is
gaining traction. This ability to determine where a trade may
be in its life cycle and what future price action can serve is a
critical part of effectively deploying your risk units and the
success of the Protean Strategy performance outlined in
Chapter 3.
Todd is going to outline his Elliott Wave Strategy in this
chapter. In the process of doing that, he will provide a
framework to the reader for how to identify, trade, and
maintain a robust payout profile.
—John Netto

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Introduction
“If it were easy…everyone would be on the World Cup.”
Since my early childhood, I have been an avid downhill skier. I grew up in
upstate New York, only a mile from the local ski resort. My early ski racing
days helped cultivate my love for the markets. One of the best parts of
competitive downhill skiing is the binary understanding of the boundaries of
the race. Failure to adhere to these rules results in being disqualified. One of
the earliest challenges in trading for me was trying to understand both the
written and unwritten rules of the markets. I needed to build a rules-based
system to answer key questions like:

What are my chances of success?

When should I get out of a trade?
Where should I take profits?
How much should I risk on this position?
While there is no overnight solution in answering the foregoing questions,
Elliott Wave Principles, EWP, provided the framework for solving these
problems. EWP’s application lays out a set of boundaries for my trades,
similar to my competitive skiing days. Knowing where to get in and what
point on the chart my trade has gone “out of bounds” was a huge turning
point in my career and a major “aha” moment.
Learning EWP is a discipline that takes time and dedication. Therefore, it
is only appropriate that I harken back to my ski racing coach, Royce
VanEvera, in Lake Placid, New York. He had a saying that has stuck with me
to this day: “If it were easy, everyone would be on the World Cup.” Think of
committing the time to adopt and implement Elliott Wave Principles into
your investment process as analogous to training for the World Cup of
Skiing. This chapter is structured to help you do just that, without the
prospect of any bodily harm.

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Four Lessons From Early Trading Days
Many of our investment styles, including how much risk we take, our
philosophy, velocity of trades, etc. are greatly determined by both our
personality and experiences. To have a better understanding of how I evolved
into my preferred style of market analysis and trade formation, I’m going to
give you a brief background of how my trading career has taken shape over
the years.
In 2001, coming from the cold of the right coast, I accepted my first job
out of college as a proprietary trader on the left coast, in San Diego,
California. I learned to trade stocks on a prop desk from Dave Floyd, who
then introduced me to John Netto. The office strategy was to track the S&P
futures pit on both a price chart as well as an audio feed from pits of Chicago.
We would then scalp in and out of listed stocks using the S&P futures pit as a
leading indicator.
For example, if an institutional paper order in the pit was driving price
action, we would align our day trades based on that direction as the NYSE
specialist adjusted his market in reaction to the move in the stock indexes. I
did not realize it at that time, but I learned four important skills from short-
term scalping listed stocks with the S&P futures that I still use to this day:

1. Read the tape

2. Understand correlated markets
3. Track market energy
4. Filter external information

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1. Read the Tape
During that time of such hyper-trading, I studied virtually every uptick
and downtick of the stock indexes as well as the major Dow stocks. Over the
years of watching markets tick, I started to learn that markets have
personality traits. Those personality traits can be seen in the shorter time
frames—they are the ebbs and flows of a market which are usually
considered simply “noise” by most financial media commentators who do not
understand how markets work. (Disclosure: many of those financial media
commentators are my friends from my two years as a cast member on the FX
show Money in Motion, and I know many others from guest appearances on
shows before and after our regular show.)
Those ebbs and flows, which so many dismiss as noise, are the markets
actually giving you a look inside what really makes her tick. Ignore her
subtleties at your peril! Essentially, this is “tape reading,” and it is a required
skill for traders and investors of any time frame.
Another important lesson I learned that I still use to this day is the concept
of market interplay. With the computerization of trading markets and
networking on hyper-fast Internet connections, information flow of
fundamentally correlated markets is communicated in milliseconds. This
allows the interplay of fundamentally related markets to be observed on the
price charts on the smallest of time frames.

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2. Understand Correlated Markets
Selecting an exit strategy should entail the three-dimensionality of
using price action in other markets to select a viable exit point. The
interplay of related markets can serve as a confirming indicator to your
trading market of choice, or it can be a major hindrance. Sometimes the
best trading setups or investments can be doomed because a related market is
not in a confirming position. Taking these ancillary factors into corroborating
futures price action is the process of intermarket analysis, and comprises a
large portion of how I trade the markets.
Intermarket analysis has a few components to it. The first is how the
markets have correlated until this point in time, or historical correlation. The
second, and more important factor, is how they will correlate going forward.
There are both technical and fundamental aspects to this, and the Elliott
Wave Principle (EWP) does a great job of revealing the technical side.

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3. Track Market Energy
Most market participants are aware that the current volatility regime plays
a huge factor in how much opportunity exists for price discovery. I learned
from my early days how critical it is to be cognizant of the rhythm and
energy of a market. Realized volatility is something I track to help quantify
this.
In my formative years as a prop trader, I listened to a broadcast from the
S&P pit that included the general noise levels from the mass of pit traders. As
prices advanced and paused, I would listen to the inflection in the voice of
Ben Lichtenstein, a broadcaster in the S&P futures pit. It became second
nature to associate which price action would accompany certain intonations
in his voice and how that correlated with overall market behavior. Paying
attention to market energy is critical when assessing the likelihood of future
market direction.

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4. Filtering Information in Your Network
Most of us have a trading network we use to gather information. How we
distill this information is very important. I have both a virtual network and a
physical one. I am inundated with market information from TV, newspapers,
social media, and my trading colleagues. Some of it is valuable, while most
of it is not. The ability to quickly receive, filter, and interpret external market
information that might impact your position is an important skill as a trader
and investor.
The network I use consists of a range of sources. Understanding which
source can be relied on based on their skillset is very important when making
a final determination of how to execute.
In summary, the four key lessons I learned from “life on the one-minute
charts” was how to read the tape, understand correlated markets, assess
market energy, and filter information in my network. These would prove
valuable building blocks and lead to incorporating Elliott Wave Principles.

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Plan Your Trade, Trade Your Plan
During my move back to the East Coast in 2004, I received a memorable
phone call just outside Las Vegas. My focus quickly shifted from the empty
desert terrain to a charismatic voice emanating through my Motorola flip
phone. It was Mark Galant, and this call would change my life.
At 200 words per minute I heard, “Hey, guy, this Mark Galant, CEO at
Forex.com. We received your résumé and would like to talk to you.”
Forex.com was a startup forex company looking for a technical analyst and a
training course instructor. The call lasted 20 minutes and ensured the
remaining 3,000 miles on the road trip would be filled with great alacrity
over the future.
I began writing a daily trading report published on the client-trading
platform known as Strategy of the Day, or SOTD. SOTD was designed as a
daily research piece rooted in technical analysis with a light fundamental
overlay that would feature daily trade strategies. Considering my trading
background, my goal was to formulate precise and actionable trade strategies
that met the following criteria:

1. Applied across a variety of liquid asset classes

2. Generated regular signals in an interval I could execute in
3. Performed equally well with longs and shorts
I wanted to feature technical setups that included precise entries, stop
losses, and viable profit levels. It was important to have an actionable,
transparent game plan that would help traders understand how to
navigate the markets while concurrently providing a quality trade setup
that monitored risk.

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Searching for the Holy Grail
From my early trading days in San Diego, I had a decent feel for where
the market was headed in the next 15-30 minutes, but that presented an issue
with SOTD readers. To produce SOTD I had to do the following:

1. Capture two or more charts;

2. Annotate them with relevant technical analysis;
3. Write out the text of the report; and
4. Publish on the multiple trading platforms in the US, Russia, Asia, and
Europe.
Then, clients around the world actually had to read the report and take
action. All of this within a 30-minute window. Logistically this proved nearly
impossible for clients to monetize the information in SOTD. I needed to give
people more lead time.
I began following two specific research reports put out by analysts from
UBS and Morgan Stanley Investment Banks: James Chorek of UBS and
Andrew Baptiste of Morgan Stanley. Both analysts relied heavily on
something known as the “Wave Principle” and both seemed to be routinely
calling market turning points that few others in the markets were calling.
Most importantly, they were doing it hours and days before the actual turn.
They were doing it with these crazy letters and numbers that belonged to the
Elliott Wave Principle.
I had heard of the Elliott Wave Principle but never really studied it, so I
dove in. I read and consumed everything I could and contacted Jim directly. I
spent an hour or two with Jim Chorek on the phone discussing Elliott Wave
on more than a dozen occasions. He was an authority in the methodology,
having worked with Robert Prechter Jr. directly in the currency division at
Elliott Wave International.

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My Aha Moment
Jim was my first true Elliott Wave mentor. Andrew Baptiste was a major
influence as well. They recommended I read Elliott Wave Principle by Robert
Prechter. If you have ever read this book, I’m sure you would agree it’s as
difficult as any college calculus textbook. However, for the first time—after
scouring through piles of trading books searching for the grail—I had several
“aha” moments. I thought back to Royce, my ski coach in Lake Placid: If it
were easy, everyone would be on the World Cup.
Mark Galant, the former CEO of Forex.com and my boss, is a fan of the
Elliott Wave Principle. His former employer, Paul Tudor Jones, was a
practitioner of the methodology. If you’ve ever read Market Wizards by Jack
Schwager, Paul Tudor Jones writes “Elliott Wave Theory allows one to create
incredibly favorable risk/reward opportunities. That is the same reason I
attribute a lot of my own success to the Elliott Wave approach.”
As I adapted Elliott Wave Principle into my daily research at Forex.com,
Mark started to ask where I thought various markets were going based on the
wave count. This coincided with my daily readership growth and
overwhelmingly positive feedback.

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Surfing Basics with Elliott Wave
Elliott Wave is a theory that was created by R.N. Elliot in the first half of
the 20th century. Elliott was an accountant by nature and with his professional
skills he produced a methodology that helped traders “account” for various
trend and corrective market phases. It wasn’t until he got sick in the latter
part of life in the 1930s and ’40s that he made the greatest strides in the
methodology.
The methodology is rooted in Dow Theory (Charles Dow), which
identifies the tendency for markets to trend in three separate phases. First is
the accumulation phase, next is the public participation phrase, and third is
the distribution phase. (See Figure 11.1)

Figure 11.1 The Three Phases of Elliott Wave Pattern

Elliott took the basic three-trend model and broke it down into much
greater detail to help traders and investors understand intricacies of price
patterns never before seen. He went beyond just identifying the three trend
phases of a market and began to study the corrective phases in a great deal of
detail as well. Elliott began labeling each wave of a complete trend with the
numbers 1-5 (see Figure 11.2).
It is a set of rules and guidelines to interpret mass-market psychology

482
in reaction to fundamental / geopolitical events predicated upon
underlying price action. Most importantly, it is a technical methodology
and a true leading indicator of what might happen at some point in the
future.
We will go much further in-depth in the specifics of Elliott Wave Theory
below.

Figure 11.2 Psychology Behind Each Phase of Five Wave Elliott Pattern
Using Elliott Wave I was able to forecast markets with a higher degree of
accuracy, and more importantly offer the proper lead time for clients to read
and take action on the trade alert. I continued to follow the work of Elliott
Wave authorities, including Jim Martens, head of FX research at Elliott
Wave. The two Jims, Andrew, and Mark provided an overwhelming amount
of support along my Elliott journey, and I would not be where I am today
without their help.

483
Application
The application of Elliott, much like that of trading, requires a hybrid
approach. It is a combination of art and science. In Elliott Wave there are
specific structural rules and mathematical relationships that cannot be broken.
There are also tendencies, guidelines, and subjective pattern recognition skills
that happen for those who develop by opening your creative mind.
The skills to successfully implement EWP must be acquired over time by
training your eyes to see the patterns, and putting in enough time in the
markets to gain the experience to recognize familiar situations. Like any
worthwhile activity, you will not master it in a few short hours or days.
Anything with any value requires a plan, hard work, and perseverance. If you
are going to be successful in this game, you must love the process and not
just the end goal of making money.
Let us begin focusing on the process of maximizing returns per unit-of-
risk using the Elliott Wave Principle.
It is important to begin with the scientific aspect of Elliott Wave. These
are a few of the rules and mathematical certainties of Elliott Wave so you can
begin counting and surfing the waves!
Rule 1 – A complete market trend is comprised of five waves: three
trending waves and two intervening corrective waves. Many casual market
observers understand the aforementioned rule of Elliott Wave. However, it is
the interpretation of these waves that has sparked so much misunderstanding
about EWP and generated lots of controversy over its efficacy.
Each of the five waves is accompanied by psychological, technical, and
fundamental characteristics.

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 Figure 11.3 Basic Five-wave Elliott Pattern
Wave 1 – Following an extended decline, the fundamentals of the market
are very poor. Investors are fully bearish this market, and those wanting to
exit any long positions have already done so, as have short-sellers wanting to
move into new positions. The market begins to rise as there is very little
selling interest left. So prices begin to rise in Wave 1.
As Wave 1 advances, the highly complacent bears believe this is nothing
but a short-term correction in the well-established downtrend.
Wave 2 – As the first wave tops out and begins to head lower, those
complacent bears kick their feet up on the desk with an “I told you so” look
on their faces. The fundamental picture of the underlying market is still poor,
but the small uptick in price action has improved the mood of a select few.
As Wave 2 approaches the Wave 1 low, selling pressure suddenly evaporates
and price pauses.
Suddenly, wondering why prices are pausing near the lows, greed kicks in
and buyers come to market. Those buyers are shorts covering their positions
and brave souls looking to scoop up cheap longs, and price starts to rise.
Wave 3 – Complacent shorts begin to take notice of a rise in price. When
the highs of the first wave are exceeded, buy stop losses start to trigger as
short sellers are stopped out in droves. This brings in the momentum longs.
Only after price has been moving higher in the early stages of a third wave
does the financial media attribute a reason why prices have begun to move
higher.

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 The market climbs the wall of worry as short sellers enter a position to
then stop themselves out. An increasing number of buyers pile into Wave 3
as the underlying fundamentals of the market under study begin to improve.
Eventually the buying pressure abates and the market goes into consolidation
to take a breather after a massive move.
Wave 4 – Fourth waves are characterized by a long and sideways, choppy
corrective structure that is often a battle between bulls and bears. The bears
are longs taking profits on any advance toward the highs, along with bold
short sellers. The bulls are represented by a combination of short sellers
taking profits and new longs coming to market, on any move toward the
lows.
Wave 4 tends to be long and drawn out, as the fundamental picture has
vastly improved but most traders and investors who desire to participate on
the long side of the market have already done so. Eventually the
consolidation ends and we break out one more time in a feeble rally riddled
with divergence in line with the prior trend.
Wave 5 – In fifth waves, investors are extremely optimistic and bullish of
the underlying market, even to a greater extent than they were in the third
wave position. The issue is buying interest in this late stage of the game is
scare. “The early bird gets the worm” is applicable to the markets, and the
early birds have been invested for some time. Only after the fundamental
picture appears nearly flawless—on the surface, of course—is when the late-
coming, unknowing, amateur investors begin to come to market. Beneath the
surface the cracks in the foundation of the strong fundamental story are
starting to show. Of course it will take some time for those stories to circulate
through the markets, but they are there. It’s the combination of late-coming,
low-volume, amateur longs positions, along with a fundamental story that’s
seen its best day does the five-wave advance prepare for a three-wave
correction to start the process all over again.
The Motive Pattern – A completed five-wave sequence is known as a
motive wave. Motive wave is synonymous with “trend.” A motive wave is
any wave that advances the trend of one larger degree. A quick and easy way
to identify the trend of the market is to simply look for a five-wave advance
as described above. If you can spot more than two five-wave trends on a
single chart (see Figure 11.3), the trend “of one larger degree” is likely up,
and you want to align yourself with the direction of that trend until there is
overwhelming evidence to trade against the trend. Before we get too far along

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with the concept of multiple degrees of trend, let’s work on how to identify a
motive wave on one degree.
Here are the rules of the motive wave.

Wave 2 never retraces more than 100 percent of Wave 1.

Wave 4 never retraces more than 100 percent of Wave 3.
Wave 3 always travels beyond the end of Wave 1. The goal of an
impulse is to make progress, and these rules ensure that progress is
made.

Figure 11.4 Rules for Each Wave of EW Pattern

Have you ever managed to establish a long trade at the absolute high price
of a move? Alternatively, have you ever sold a market at the absolute low
before it sharply reversed? The answer is most likely “yes” as we have all
done it. If you are in the vast majority of people who have done this, chances
are you identified the end of a five-wave Elliott structure without even
knowing it. Take this S&P 500 E-mini futures chart on the two-hour period.
You can see the five-wave advance clearly labeled (see Figure 11.5).

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 Figure 11.5 Labeling Five-wave Advance
Now, here is an irrefutable, inevitable constant in the markets as viewed
through the lens of Elliott Wave. After every complete five-wave motive
you can expect at least a three-wave correction. It could turn into
something more than just a three-wave correction, but it must at least unfold
into a three-wave correction. For a trader / investor looking to control risk
and maximize reward, this is an incredibly important and useful truth.
With the very basic knowledge of a completed five-wave advance, you
could quite possibly never buy the top, or sell the bottom, of a market
again. At this point you are probably thinking: Great, but in which time

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frame should I be looking at for these five-wave structures? The answer is on
any interval. Turning back to our S&P futures chart, this can apply to any
period.
In this case the S&P futures completed a five-wave rally and retraced in a
three-wave corrective selloff. (See Figure 11.6)

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 Figure 11.6 – E-mini S&P 500
I am sure you see the fives and threes, but how exactly do they all fit
together? As we’ve said all trends are comprised of five waves. Three of
those waves are smaller degree trend waves, and the other two are smaller
degree corrective waves. Take the following three chart examples to drive
home my point. After every complete five-wave motive wave, you can expect
at least a three-wave correction.
On the weekly chart of Lennar (see Figure 11.7) we saw a five-wave rally
to the high in early 2011, followed by a three-wave corrective decline toward
the end of 2011. Notice the five-wave rally was labeled as a higher degree

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circle Wave 1, and the three-wave correction was labeled as a higher degree
circle Wave 2.

Figure 11.7 – Lennar Weekly Chart (2011)

In the spring of 2012, Lennar gathered itself for another five-wave rally in
circle wave 3 (see Figure 11.8), followed again by a three-wave corrective
decline in circle wave 4. Noticing a pattern here? You should, as markets are
highly patterned, which is exactly what helps us to predict future market
direction, providing an opportunity to gain alpha!

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Figure 11.8 – Lennar Weekly Chart (2012–2013)

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 Figure 11.9 – Lennar Weekly Chart (2013–2014)
To drive the point home, the five-wave motive advances in parentheses,
along with the three-wave corrective declines in the charts of LEN, are
completing waves at a higher degree. Let’s move out to a bigger picture view
of the same chart to help pull it together.
You will notice that at the time I captured this chart, I was predicting LEN
to moving higher in circle Wave 5. Specifically, I have us rallying in Wave 3
of higher degree circle 5, and in fact I was carrying a position in Lennar
based on this analysis while writing this chapter in 2014. I wrote this chapter
in real time and used “out-of-sample” trade results to add a greater level of

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authenticity. I was long a debit vertical spread to take advantage of the fifth
wave rally into the $50.00 area. I bought the May ’14 36 calls and sold the
May ’14 50 calls on December 20, 2013 for a cost of $4.05. By buying at-
the-money calls and selling out-of-the-money calls above to create the
spread, this caps my risk, but also caps my reward.
Why cap the reward if I am so confident of the analysis? Because the
wave count says we have a final fifth wave rally into the $50.00 area before
the markets reverses, with at least a three-wave correction, which could turn
into something more (see Figure 11.10). It just depends on what is happening
at higher degrees of trend.

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 Figure 11.10
This concept of multiple degrees of market trend according to the Elliott
Wave Theory may seem daunting at first. The originator of Elliott Wave
theory, Ralph Nelson Elliott, was an accountant by profession, so we can, of
course, see influences from his training here. The semantics of Elliott
Labels are universal and analogous to the metric system. This allows
practitioners of Elliott Wave to be able to communicate in a common
language with the format of the Elliott label used on the chart. As you
progress in your understanding of Elliott Wave, you will get more
comfortable with concepts of multiple degrees of trends. If you have ever

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heard Elliott as being “fractal,” this is exactly what they are describing—
Elliott Waves nested within Elliott Waves.
Now that we have a basic understanding of how to identify a motive wave
and how to label various degrees of market trend, we will introduce the two
kinds of motive waves. The motive wave category is comprised of motive
impulse waves and motive diagonal waves.
If you recall the actual fundamental and psychological characteristics of
each of the five waves earlier in the chapter, you will remember the third
wave is the result of a massive fundamental recovery that sees widespread
participation in the rallying market. This characteristic helps to explain the
key difference between motive impulse waves and motive diagonal waves.
There are a few key differences between a motive impulse and a motive
diagonal.
The first key difference is where you would expect an impulse and
diagonal to occur. The next difference is the interaction between the second
wave and the fourth wave within the motive that determines if it’s an impulse
or diagonal. Finally, the structure of the five waves that make up a complete
motive wave differ.

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The Motive Impulse
Identifying where we are in a given price cycle is very important in
maximizing return per unit-of-risk. Being able to distinguish between
different wave types allows the trader to create realistic risk/reward
ratios and assess the viability of a particular position.
An impulse motive wave is the traditional trend wave that most people
refer to when describing the rules of Elliott Wave. The impulse can occur in
Waves 1, 3, and 5. But here’s the key—the third wave must only be a motive
impulse. There are three simple rules that must be followed to correctly
identify an impulse motive:

Figure 11.12 – Motive Impulse Pattern

A completed motive wave comprised of impulse waves in the first, third,
and fifth wave position will look like the following:

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Figure 11.13 – Motive Wave

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The Diagonal
The other kind of motive wave is the diagonal. A diagonal is an incredibly
useful and very effective kind of trend. Diagonals often take the shape of
consolidating, wedge-shaped patterns that are still effecting price change.
They are more commonly referred to as pennants or rising wedges (see
Figure 11.13). Elliott Theory helps us to quantify these elementary technical
patterns by assigning rules and guidelines to them to first help identify them,
and secondly help us pinpoint our location in the higher degree trends.
Diagonals take on a consolidating and almost hesitant shape as the health of
the underlying trend is very weak. In the case of a diagonal in the first wave
position, it suggests a trend is still immature and in its infancy. Essentially the
new trend is taking some getting underway and does not yet have enough
strength to trace out a clean impulse structure.
In the case of a Wave-5 diagonal, a well-established trend is quickly
deteriorating and highly prone to a sharp price reversal as buyers (in the case
of an uptrend) are extremely tired and about to be overcome by sellers.
Here is the basic form of a diagonal in Figure 11.14. You will notice that
when you connect the highs and lows with a trend line and extend the trend
line out into the future, eventually those two trend lines will meet, illustrating
the consolidating shape of this pattern.

Figure 11.14
If you were to dive further into the diagonal and look at the structure of
each of the five waves, you will notice a key difference compared to an
impulse; all waves subdivide into three-wave structures.

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 Figure 11.15
The rules and guidelines of the diagonal are as follows.

Figure 11.16
As I said above in Figure 11.16, the key to diagonals is where they occur
in a motive wave. Put most simply, they occur in only the first wave and the
last wave. They can never occur in a middle wave, such as a third wave. The

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model below shows a complete motive wave with diagonals in the first- and
fifth-wave position, and an impulse in the third-wave position.

Figure 11.17
Another difference between motive impulse and motive diagonal is the
structure of the smaller degree first, third, and fifth waves that make up the
motive wave. In a motive impulse, the member trend Waves 1, 3, and 5 are
often smaller-degree motive impulse waves. Again, as we have said above,
the third wave MUST be a motive impulse that sees no overlap of the
member Waves 2 and 4. Contrast that to a diagonal, where you will see three-
wave structures throughout, including the smaller-degree third wave.
Let’s pull this together. The chart below (see Figure 11.18) compares the
two kinds of motive wave waves. There are key differences between an
impulse and a diagonal:
1) A diagonal requires Waves 2 and 4 overlap, while an impulse
does not allow for it.
2) A diagonal can occur in the first and fifth wave of a motive,
but never in the third wave. An impulse can occur in the first and
fifth wave of a motive, but must occur in the third wave.
3) The first, third, and fifth waves of diagonal have three-wave

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 sub-structures, while the third wave of an impulse must be an
impulse.

Figure 11.18
So pulling this back to the real world, how does this help you effectively
manage positions and minimize risk? Let us tie it back to our Lennar trade. I
went long a vertical call spread established on December 20, 2013 for a cost
of $4.05. The closing price of the stock that day was $37.38 and the closing
price on the day of this writing, March 6, 2014, is $39.39. So far the result of
the trade has been encouraging, or has it?
I established the trade in December, 2013 within the context that a fifth-
wave rally was coming. If you look back at our diagonal vs. impulse
comparison chart, I think you will agree with me that in early March of 2014,
we are likely in an ending diagonal. That will have an impact on how I
handle the exit of this trade.
If the ongoing fifth-wave rally were subdividing into a clean five-wave
impulse, I would be much more comfortable holding the position closer to
expiration as the trade is demonstrating an underlying strength. Instead, the
structure of the underlying rally is riddled with overlap and three-wave
advances. If this in fact is an ending diagonal, I want be on high alert that a
sharp and swift reversal could come after a final C-wave rally of higher-
degree Wave 5, and I need to protect my profits. Better yet, I might look to

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establish counter-trend positions as ending diagonals often set up spectacular
reversals.

Figure 11.19
At this point, it is important to step back on the academics and specifics of
Elliott Wave. It’s instructive to approach it as a living, breathing, and cross-
market analysis tool. Let’s further examine this Lennar trade with a concept
that I mentioned earlier in the chapter, intermarket analysis.

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Reducing Subjectivity of Elliott with Intermarket
Analysis
Intermarket analysis is a key component of my trading today, a technique
I learned early in my career as a stock trader following the correlated S&P
500 futures. Intermarket analysis helps to reduce some of the inherent
subjectivity of Elliott Wave by looking at the Elliott Wave counts of
correlated markets.
As John Netto highlighted in Chapter 5, the Netto Number shows how
markets are performing, on both a return per UoR basis and relative to each
other. The Netto Number Dashboard is a great starting point when looking at
intermarket analysis to see which markets are performing well and poorly on
a return per UoR basis. Figure 11.20 below shows an example of what US
Equity Index markets have the highest and lowest Netto Numbers as
identified in the UoR column. For this situation, all US Equity markets are
down on the day, with the NASDAQ 100 performing the worst relatively and
midcaps performing the best relatively.
Based on the Netto Number Dashboard, I can quickly run EWP scans and
see how this compares with these markets’ respective wave counts. This
gives me great multidimensional analysis when combining different
analytics. I can apply these to the different asset classes and immediately
know what sectors to focus on.

Figure 11.20 UoR Dashboard

Correlation is defined as “a statistical relationship between two random
variables or two sets of data,” according to Wikipedia. Personally, I take a
slightly less academic approach to determining market correlation, than
crunching data. I simply rely on a fundamental and economic relationship
that should occur, and then confirm that it is in fact happening by overlaying

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the markets under study using charting software to find similar price
movements.
Continuing on with our Lennar example, a home building company,
which can be highly prone to a change in interest rates. In January and
February of 2014, there was a decent move up in longer-dated Treasuries.
Assets that benefit from a risk-aversion sentiment were on the rise from soft
US data at a time when the Federal Reserve had begun tapering asset
purchases. Markets were now backing up expectations the Fed was going to
move to a more restrictive monetary policy stance.
As bond markets are rallying, the corresponding bond yields are falling.
Lower interest rates tend to be good for housing stocks. Using an intermarket
overlay, we can determine if that is in fact the case (see Figure 11.21).

Figure 11.21
Looking at the overlay of 30-year US bond futures and Lennar stock in
Figure 11.21, we can see the correlation since May 2013 has been solid, as
they have tracked each other quite well. However, look closely at the
relationship of these two markets relative to the Oct ’13 high. Lennar has
broken above the October ’13, whereas 30-year bond futures have not broken
above and are actually looking to form a double top.

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 Let us move over to the chart of the 30-year US bond futures. Our current
preferred count shows that the 2014 rally might be the final leg of a Wave 4
correction, and we’re set to move lower in Wave 5.

Figure 11.22
If bond futures do not have the strength to push above the late 2013 high,
bond yields may have reached a low and could be gearing up for a rally (see
Figure 11.22 above). If that is the case, the Lennar rally may be on borrowed
time at this point, as rising yields can act as a headwind for growth in the
housing industry.
Combining everything we’ve done here with 30-year bonds and Lennar,
we see bonds seem to be struggling with the 135’17 high that held through
2013, while Lennar is struggling with the May 18, 2013 high $44.48. In other
words, they are both at resistance. Does that instantly mean sell? Of course
not.
From a process standpoint, what are some factors that lead me to believe
this technical resistance will hold?
1) Lennar is likely in a final fifth-wave rally from a motive
impulse that began in 2010
2) The ongoing Wave 5 in Lennar is a likely an ending diagonal

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pattern suggesting a sharp reversal is imminent.
3) Bonds have yet to break above the highs set in H2 of 2013,
whereas Lennar has exceeded the H2 of 2013 highs. I view bonds
as a more dynamic and economically sensitive market compared to
equities.
4) I sold the Lennar long call vertical spread on February 6,
2014 for $6.50, then sold again on February 25 for $6.50. Missed
the run-up to $44.50, but that was very close to the top (see Figure
11.23).

Figure 11.23

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Corrective Waves
Familiarizing oneself with corrective waves is another key tool in
assessing the current state of the markets, and therefore what the potential
future performance of one’s trades may be in that type of market
environment. Corrective waves accomplish a goal just as the name implies;
they serve to interrupt or correct an ongoing trend. This is a key concept that
all traders must understand. Trading can be encapsulated into the following
phrase:
“Trading is nothing but trying to buy weakness in rising
markets, and sell strength in falling markets.” —John Netto
I heard Mr. Netto use this some years ago. It serves as a great reminder of
how important it is to keep things as simple as possible when building an
effective strategy. It is a wonderful saying that neatly and accurately conveys
exactly what we are trying to do in the markets.
The following section will outline some of the price dynamics that occur
during various types of the corrections according to the Elliott Wave theory.
Projecting the end of corrections with a decent degree of accuracy is a very
important skill a trader must acquire. Once a correction to a larger-degree
trend terminates, that larger-degree trend is about to re-emerge and a large
profit opportunity exists.

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The Basics of Corrections
Corrections usually take on a simple A-B-C structure and must retrace a
portion of the prior motive wave. They are labeled with letters, and waves 2,
4, and B are corrections.

Figure 11.24
The rules of this correction do not let this move go below the origin.
In either case, you have a risk-defined trade and are expecting a five-
wave move down.
One specific kind of correction I would like to focus on here is the “flat
correction.” A flat has the following characteristics:

Wave A – breaks down into a “3”

Wave B – rallies back to, or through, the origin of Wave A and fails.
Also breaks down into a “3”
Wave C – sells off to low of A-wave and usually through in a five-wave
subdivision. The pattern is now complete and a new motive wave rally is
expected.

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 Figure 11.25
Let us apply this to our case study of the US 30-year bond chart and zoom
in on the wave 4 in early 2014 (see Figure 11.26). On January 7, I was
operating under the assumption the approach to the lows in late 2013 was not
a motive wave to a new low, but a B-wave of a larger-degree flat correction.
At that time, I bought TLT Jan 18 2014 101.0 Calls for $1.99.

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 Figure 11.26
Since then I have exited half of the position on the way up and continue to
hold the other half.

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 Figure 11.27
The current rally from early January 2014 can be placed in a C-wave
position of a higher-degree corrective flat pattern (see Figure 11.27). It is
very common for the C-wave of a flat pattern to reach the termination of the
A-wave level. In this case, it is the same point as the origin of the B-wave. If
our wave count is correct, bonds might only have a final run up toward
135.00 before the rally may be considered complete from a technical
perspective. Fundamentally speaking, it is always difficult to say what the
catalyst for the selloff may be, but EWP is anticipatory and the fundamental
causes of a move will usually reveal themselves well after the actual trend
change lower in Wave 5 has occurred.
If our analysis is, in fact, correct and bond prices are nearing a top and
bond yields a bottom, rallying US bonds yields will hurt my LEN position,
kicking the ending diagonal wave count into gear and signaling a sharp
reversal is at hand. As of February 27, 2014 I exited all of my long TLT and
long LEN positions based on the analysis presented in prior pages.
Elliott Wave, Fibonacci, and intermarket analysis are my bread-and-butter

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methodologies to analyze market trends, sentiments, and market
relationships. A side note about Fibonacci. Due to space restraints in this
chapter, I have not had the opportunity to give Fibonacci the attention it
deserves, as it is an integral component of Elliott Wave analysis. However, a
highly reputable author and trader, Joe DiNapoli, thoroughly covered this
area in the previous chapter.
I place greater emphasis on certain Fibonacci ratios based on which wave
we are throughout the lifecycle of rally or selloff. Elliott Wave is a road map
of the journey price will likely take to get to your destination. Fibonacci is the
key at the bottom of the map telling you how many miles an inch on the map
actually represents.
Combining the two methodologies, you have a road map of the twists and
turns a market may take on the way to your potential objective. In addition,
as any good navigator will do, Fibonacci can outline approximately how long
each twist and turn should last.
The practicality of the foregoing knowledge is quite powerful when
maximizing return per UoR. If one has an edge in determining HOW price
will get to your objective, and WHEN it should arrive at your objective, then
positioning and executing become much easier. The price and time
component of Fibonacci in the context of Elliott Wave is crucial to traders,
especially those traders who are long options and exposed to theta. However,
it is not only for those who invest and trade options; it is for all traders and
investors. If you have a working game plan of when to enter a trade and when
to exit, you can minimize the opportunity costs associated with wasting
capital. After all, time is money.

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Risk Management
A trading methodology based in technical, fundamental, or a combination
of the two is only as useful to a trader as the quality of the risk control
mechanisms included in the methodology. When it comes to Elliott Wave,
Fibonacci, and intermarket analysis, there are two ways to approach risk
management for each individual trade or investment. I break them up and
refer to them as “Wave Count Stops” and “Bar Pattern Stops.”

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Wave Count Stops
This stop loss is placed at a level that invalidates the Elliott wave count of
the pattern you are trading.
Let’s circle back and apply the Wave Count Stops to our bond chart and
the pending wave-4 corrective reversal. If we believe, a Wave 4 reversal is
coming and there exists a good opportunity to move into bond shorts, it’s
essential to identify a specific level to place a stop loss.
One of the basic rules of the impulse wave is that a fourth wave cannot
enter the territory of a second wave. If it does, then the trade plan is invalid
and there is no reason for you to stay in the trade. When your plan goes
wrong, you must immediately get out to protect capital. In the TLT chart (see
Figure 11.28) that wave-2 origin, or wave count invalidation, is $114.75. If
you want to establish short positions in the TLT based on the traditional
Wave Count Stop, you would place your stop loss a few pennies above this
level.
There are positives and negatives to this approach. I have bulleted the
complete list below. The main positive is you are using a larger stop loss,
thus reducing the risk of the market prematurely shaking you out of the
position. The main negative aspect is the stop-loss size is quite large relative
to the potential reward, which is simply a wave-5 decline toward 100.
When a trader uses this kind of stop, you will find the following dynamics
at work:

Less frequent trades based on an idea—usually one

Larger stop losses
Less favorable risk-reward ratio
Stop loss is known ahead of time

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Figure 11.28 Using the wave count as the stop

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Bar Pattern Stops
The other style of risk management I employ is called “Bar Pattern
Stops.” This technique includes a collection of reversal bar patterns formed
from open, high, low, close bar patterns, as well as specific candlestick
reversal patterns to find two and three bar patterns that suggest a reversal is
happening at that particular moment. The approach here is to identify a
specific zone where the corrective wave should reverse and then scan for
those specific reversal bar patterns in that zone. The technique for
determining where the reversal should occur is based on more advanced
Elliott Wave and Fibonacci analysis that we conduct on our site.
Essentially the idea here is to trade more frequently with tighter stop
losses within the predetermined zone that is ideal for a corrective completion.
This is geared for the more active trader who has the time and desire to
micromanage the trade. Here are the pros and cons.

This stop loss is placed as a level that invalidates the bar pattern you are
trading
More frequent trades
Smaller stop losses
More favorable risk-reward ratio
Stop loss can be approximated ahead of time with ATR
Often buying into strength, selling into weakness
On the chart below, the Bar Pattern Stop technique is being used. You will
notice the first horizontal shaded zone. This is known as the reversal zone
and is calculated based on the ideal Wave 4 beginning and ending price and
time. Again, this is based on more advanced technical analysis.
The second shaded zone is what we call the continuation zone. Using
Figure 11.29 below, this is the zone that we expect wave 5 to travel within.
In that zone the WaveTrader system will scan for bar and candlestick patterns
highlighting opportunities to add to existing positions. The reversal and
continuation zone trade signals are packaged up and available in a plugin
module known as the “WaveTrader.” This plugin module is available on our
site www.tradinganalysis.com, and it allows you to scan for these setups.

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Figure 11.29 Using the Bar As the Stop

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Art Of The Trade
The final component of trading with Elliott Wave and intermarket
analysis, which is the most important aspect of trading, is account, risk, and
trade management. I call it the ART of the Trade. I will break it down into the
three key components: Account, Risk, Trade

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Account
When it comes to trading, I highly recommend you trade an account size
that is appropriate for your risk tolerance. Trading an account too small will
likely create three dangerous occurrences:
1) Percentage swings that are too large relative to your account
size within the guidelines of proper risk management
2) Excessive psychological stress during the trading process that
will impact your decision-making process
3) When you do follow a proper risk profile, the number of
trading units / lots available will often be one, which limits your
profit potential, or even zero, which prevents you from
participating in the trade.
Do not let your ego get in the way and eliminate your availability of
multiple lots. Twenty mini-option contracts will produce the exact same
profit as two regular-sized option contracts. In fact, I would argue trading
more of the smaller contracts allows you to dampen volatility and ease the
pressure that comes with large changes in the concentration of your position.
The ability to scale out of a winning trade at several price points may produce
a smoother equity curve in the end as compared to only having the option of
scaling out one or two price points with larger contracts.

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Risk
What are your goals in trading? Newer traders focus on the reward of
trading, while professional traders focus on the risk. We have developed a
risk management system that, if followed, will drastically shorten the
traditionally long, expensive, and possible career-ending learning curve of
trading. If you follow it, you will be managing risk like a professional in a
relatively short period.
Before you make your first trade, you need to decide what your goals are
in trading. To say you simply want to make money is NOT a goal. Goals
need to be specific and defined to make them attainable. Are you here to
smooth out the volatile returns of buy-and-hold investing in hopes of making
a 15 percent return? Alternatively, are you here to aggressively speculate with
outsized percentage swings targeting a 100 percent return? More than likely
you will fall somewhere in the middle. With that in mind please identify
yourself with one of the following three risk profiles. Or, come up with your
own risk profile:

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Determine Your Risk Profile
Risk Profile #1 – Aggressive – outsized percentage swings are desired
with the hopes of aggressive capital appreciation. On a per-trade basis
you are comfortable risking:
Tier 1 – Risk 8 percent of total capital
Tier 2 – Risk 7 percent of total capital
Tier 3 – Risk 6 percent of total capital
Tier 4 – Risk 5 percent of total capital
Risk Profile #2 – Moderate – average percentage swings are desired
with the hopes of capital appreciation that far outpaces traditional buy-
and-hold investing. On a per-trade basis you are comfortable risking:
Tier 1 – Risk 6 percent of total capital
Tier 2 – Risk 5 percent of total capital
Tier 3 – Risk 4 percent of total capital
Tier 4 – Risk 3 percent of total capital
Risk Profile #3 – Conservative – moderate percentage swings are
desired with the hopes of capital appreciation that smooth out the
inherent volatility of traditional buy-and-hold investing. On a per-trade
basis you are comfortable risking:
Tier 1 – Risk 4 percent of total capital
Tier 2 – Risk 3 percent of total capital
Tier 3 – Risk 2 percent of total capital
Tier 4 – Risk 1 percent of total capital

522
Trade
Now that you have your risk profile determined, we need to get into the
four “tiers” of trades that you see in the risk profile section above. A tier is a
very important component to our trading methodology. A trade tier helps
quantify your conviction in the quality of a trade setup within the context of
the overall market conditions. Sometimes markets are trading in a lethargic,
choppy, and wandering manner and your conviction in a trade is less; thus,
you’ll use a lower tier ranking in a trade. Other times markets are dynamic,
fluid, and trading with a high degree of volatility. These are ideal trading
conditions and your chances of making money in a trade are increased; thus,
you want to be more aggressive in terms of a higher percentage risk.

Tier 1 – The highest conviction trade we have. Essentially the planets

are aligned on this trade and we are prepared to risk a significant amount
of capital.
Tier 2 – A very high conviction trade that seeks to aggressively position
within ideal trading conditions for maximum gain.
Tier 3 – A trade size that is only moderately aggressive and is used for
trades that are slightly better than your everyday trade.
Tier 4 – Your everyday, average trade size that is used to “probe” the
market with minimal exposure.
Use all of your tools to assess the quality of a trade setup, which then
points to the appropriate position size. When the markets are trading high
energy, responding well to your analysis, and you are in a good frame of
mind, step up and go for the throat with a Tier 1 or 2 trade. When the markets
are a bit out of sync, perhaps you are out of sync or distracted; trade a smaller
Tier 4 or don’t trade at all.

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Objections of Elliott Wave and Challenging Market
Conditions
As with any strategy, understanding what regimes will struggle to produce
alpha is a responsible and balanced approach to successfully implementing
the strategy. As I have shown you EWP in this chapter, markets with great
rhythm, energy, and momentum will typically see this strategy perform well.
Markets with poor rhythm and low energy are historically very
challenging for EWP Strategies, as there is a tendency to see key
inflection points undercut with no follow-through. This leads to being
stopped out of positions when there was, in fact, not a change in control of
the market.
Further to this, corrections in price are how EWP determines and
quantifies risk and reward. Without corrective price moves, it is hard to
accurately determine where to place your stops and manage risk.
When looking for vulnerabilities in using EWP, there is a temporal aspect
as well. Currencies may be very choppy on a weekly or monthly interval but
on an hourly or daily may be showing great energy. Therefore, the regime
temporal analysis I do plays a big factor in not only what markets I trade but
what time frame they are traded.
The second biggest challenge to this strategy is the opportunity for
misinterpretation. Specifically, the famous joke is if you were to put ten
Elliott Wave analysts in a room, you would get 12 different wave counts.
While EWP has a solid set of rules, there are also qualitative aspects. A
number of market participants misunderstand Elliott Wave Principles and, as
a result, do not fully realize their value in helping maximize return per unit-
of-risk.

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Conclusion
One of the hardest things to do in the markets is determine at what point a
trade is no longer valid. By using the Elliott Wave Principles shared in this
chapter, you have a technical framework for accomplishing this. These key
principles shared techniques for identifying where we are in an Elliott Wave
Cycle, the psychology behind each wave count, entry methods, exit methods,
risk management techniques, and detailed intermarket analysis to make
investment decisions more multidimensional.
The chapter also incorporated an implementation aspect by covering the
decisions I make before entering a trade based on my account size, risk
tolerance, and level of confidence in a position. Lastly, I covered the regimes
and market environments in which I have experienced greater success as well
as struggles in when incorporating these techniques.
As a final word, it has taken me years to assimilate the techniques of EWP
into my process and has been well worth the effort and time. The paradox of
EWP is that because there is some art, it creates misinterpretation and
opportunity at the same time. Therefore, celebrate these nuances as blessings.
In the end, it takes dedication and passion to excel in most endeavors.
Trading and EWP are no exceptions. I invite you to see my passion in the
services I provide my clients through www.tradinganalysis.com.

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CHAPTER
12

526
Using Options to Trade the
Macro Narrative – Neil Azous

527
Introduction
Neil Azous, the founder of Rareview Macro, is an options
artist whose creativity and vision would inspire the most
iconic of the Renaissance greats. His palette consists of both
qualitative and quantitative colors that uniquely brush across
the canvas of his model portfolio. I have been fortunate
enough to see Neil in action in one of his clinics on how to use
the three-dimensionality provided by options to structure risk
around key macro themes and I have learned a lot from the
experience. For those not fortunate enough to see him in
person, you can follow him in real-time through his tweets
(@neilazous) and in the pages of the market-leading
newsletter, Sight Beyond Sight, that Neil writes every day.
My relationship with Neil has been an inspiration for
refining and developing many aspects of the UoR™ Process.
Whenever I read his insights, talk with him about the market,
or watch him present, he sets a new benchmark for all of us. It
is no exaggeration to say I have had to raise my own game a
lot to make sure I am pulling my weight in this collaboration.
In my opinion, Sight Beyond Sight sets the gold standard
for all financial newsletters. Neil’s rich Wall Street
background—Goldman Sachs, Donaldson Lufkin & Jenrette,
and UBS Investment Bank—and his unique ability to see the
angles that elude everyone else are just two of the reasons for
his much-deserved success. Working harder than anyone else I
know in this industry doesn’t do any harm either.
Lastly, Neil and I share a similar overriding philosophy—
that is, investing is a game of inches. This core principle is
what drives Neil to fight for every basis point and challenge
conventional wisdom in every aspect of his research and
investment insight. By having Neil contribute to this chapter, it
is my hope that you will learn not only different ways to use
options but also how to weave their versatility into the overall
macro narrative.
Take a look at some examples of Neil’s work, set out

528
below. They will give you a flavor of his research, and
introduce some core investing concepts.
—John Netto

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Introduction to Neil Azous
I am the founder and managing member of Rareview Macro, an advisory
firm to some of the world’s most influential investors and the publisher of the
daily newsletter Sight Beyond Sight®.
I have close to two decades of experience across the financial markets and
am recognized as a thought leader in global macro investing.
The best way to describe me is that I am agnostic to the region, asset class,
and cash or derivatives instruments. The same goes for whether it’s
economics, policy, strategy, fundamental, or technical analysis.
On Wall Street, my career included roles at UBS Investment Bank and
Donaldson Lufkin & Jenrette, where my responsibilities comprised of trading
derivatives, hedging solutions, asset allocation, and fundamental securities
analysis.
I began my career at Goldman Sachs in Fixed Income, after completing
both the firm’s Analyst and Associate training programs, widely
acknowledged as the preeminent and most coveted learning ground for
undergraduate and graduate students.
I completed graduate level coursework for a MS in Real Estate at New
York University and received my BA in Business Administration from the
University of Washington, where I am a member of the University of
Washington Bothell Board of Advisors and was the recipient of the Bothell
Business School 2013 Distinguished Undergraduate Alumnus Award.

530
Introduction to Sight Beyond Sight
The 20-second elevator pitch of Sight Beyond Sight® goes something like
this:

1. Focus on the three pillars of global macro: economics, strategy, and

policy;
2. The reach is global, multi-asset, and includes both cash and derivatives
products;
3. Incorporates many elements of investment disciplines: fundamental,
technical, systematic, and quantitative;
4. Tracks five to ten of the major short- and intermediate-term themes in
global macro investing;
5. Applies portfolio construction, risk management, and idea generation on
those five to ten themes with a sole focus on either making or saving
you money; and
6. Has the highest level of transparency and accountability in newsletter
writing, i.e., every idea is time-stamped in real-time, a full write-up is
included, and there is a predefined game plan for gains and losses.
When you sign up for Sight Beyond Sight®, you will receive:

Four editions per week;

Actionable trading ideas across regions and asset classes using both cash
and derivative instruments;
A predefined risk management process for gains and losses on each
trading idea;
The most transparent model portfolio in newsletter writing;
Our proprietary risk-adjusted return monitor covering over 150
investment relationships globally;
A list of our top overnight observations from banks, think tanks, news,
and social media;
Immediate access to all the valuable archived editions.
A typical profile of a Sight Beyond Sight® subscriber is:

An institutional investor who is forward-looking and interested in

531
portfolio construction, risk management, and idea generation;
An investment advisor who does not have a large budget to pay for
numerous independent services providers (ISPs), including private think
tanks or sell-side bank research;
A family office looking for an information edge or needs to monitor the
secondary markets alongside their real estate and private equity holdings
closely;
A self-directed investor who wants to have the same level of access to
market intelligence and trade ideas that institutional investors have;
Executives at corporations and non-investment related personnel at
money managers looking for a daily tear sheet to follow the markets
alongside their day jobs.

532
Model Portfolio: Our Philosophy, Process, and Sample
Positioning
Before diving in, it is important to tell you our philosophy on global
macro investing.
This philosophy dovetails right into the second most asked question when
it comes to allocating to an alternative manager:

1. How do you make money?

2. Is your process repeatable? ß this is the question
3. How do you manage risk?
Repeatability and the type of alpha creation—ex-ante vs. ex-post—a
global macro discretionary manager generates can be a challenge for
investors to understand.
While deciphering the tea leaves of global macro is an art developed over
time, not purchased in an online tutorial, in an age of high correlations a more
robust approach to portfolio construction and risk management is required.
A more robust approach ranges from a) limiting directionality to b) adding
a rules-based discipline to c) being able to demonstrate managing a product
with a drawdown liquidity provision to d) running a business.
By making the art less abstract through a process and framework, you can
increase the odds of repeatability and the amount of “ex-post” alpha
generation.
Below we provide a visualization of this.

533
 Figure 12.1 – Traditional Macro Manager vs. Rareview Macro
Returning to the #1 most asked question — How do you make money? –
here are our answer and an illustration.
We think about portfolio construction and capital allocation in terms of
seven return streams.
Our philosophy is rooted in the idea that combining a series of
independent bets in proportion to an expected Sharpe ratio and uncorrelated
sources of return produces superior risk-adjusted results over time.

534
 Figure 12.2 – Rareview Macro Approach
So what has this model portfolio produced over the last three years?
Highlights include:

150-200 trades per year;

An average holding period of ~50 days;
Almost zero correlation to the S&P 500 and the major macro fund
benchmarks;
A single-digit annualized standard deviation or realized volatility;
Significant inverse-to-low downside capture when the markets are
down;
A hit ratio between 52-55 percent with an average profit ratio of ~2.5
percent.

535
The Use of Options
So now that you have a basic understanding of how or where we try to
generate positive P&L in the model portfolio and our philosophy—whether
global macro investing is repeatable or not— lets add all the current strategies
we have presented in Sight Beyond Sight® in 2016 to the above illustration.
See below.
Figure 12.3 is the model portfolio on March 11, 2016.

Figure 12.3 – Rareview Model Portfolio on March 11, 2016

As you can see, as of March 2016, we have deployed strategies in six of
our seven return streams, including a heavy emphasis on using options.
Successful options trading requires both mathematical rigor and ability to
put events into a wider context. The style I have developed to trade options
embraces both the versatility these instruments provide combined with a
unique narrative of each specific event.
In this chapter, I am going to provide you with my philosophy on options
trading, how I categorize trades, a template for how to apply trades, and also
set out some examples that show how to put these techniques into practice.
How we view options trading.
Firstly, we break options trading down into two buckets: 1) the trade-off
between buying versus selling an option, and 2) event-driven macro trading.
Our philosophy for the trade-off between buying versus selling an option
goes something like this:
When you sell an option, you win three out of four times. When you buy

536
an option, you lose three out of four times.
Here is what we mean by that in real life:
You sell a $100 strike call option at $1.00 on ABC stock when it is trading
at $100.

If the stock moves down, you win.

If the stock stays in the same place, you win.
If the stock moves up but does not go higher than $101, you win.
If the stock moves up above $101, you lose.
You buy a $100 strike call option for $1.00 on ABC stock when it is
trading at $100.

If the stock moves down, you lose.

If the stock stays in the same place, you lose.
If the stock moves up but does not go higher than $101, you lose.
If the stock moves up above $101, you win.
As you can clearly see, when you sell options the probability of success
(i.e., 75 percent) is significantly higher than when you buy one (25 percent).
Put another way, collecting option premium is a powerful exercise when it’s
repeated over and over.
Our philosophy for event-driven macro trading goes something like this:
When it comes to event-driven trading, before an event occurs you have to
determine the probability—or risk premium—the market is assigning to that
event happening in the future. For example, if an asset price has declined by
10 percent before a major event, you would likely think that the probability
of a negative event has increased.
However, when the odds become asymmetric—such as the market pricing
in an 80 percent chance, or 5 to 1 odds, for something occurring—we will
look to play those odds all day long.
Why? Because when the odds become that skewed against an event
occurring if you were already “long” those probabilities through an options
structure, the risk-to-reward ratio of the event happening is now no longer in
your favor. Meaning that you could lose $5 for every $1 that you would make
if it did happen.
In that instance, we would take the other side of the trade by selling an
option, as our risk-to-reward ratio would be very opportunistic.
Additionally, we would benefit if perceptions change about the likelihood

537
of that outcome, even if the market only reprices the probabilities to just a 60
percent chance, down from 80 percent, for this event to occur. It does not
always have to be about large moves, as there is a lot of money to be made on
only 20 percent changes in probabilities as well.
The goal overall is to “systematically” identify these asymmetric-type
setups and wait for the market to reprice the probabilities in line with our
options process. As we said earlier, selling an option is a powerful exercise
when it’s repeated over and over. But doing so with asymmetry is even more
powerful, as it provides an extra layer of protection and can enhance
performance. That is the real edge we seek out each day.
Conversely, if the market were pricing the probability of an event
occurring at 5 to 1 against, meaning that it is a 20 percent probability, then
we would look to place those types of bets through a long options position.
At that point, all we would need is for the market to shift back toward a
profile that is more balanced, and our payoff could be two or three times our
money. For example, if the 20 percent probability were to move up to 50
percent—or an equal probability of something occurring—then our payoff
would be 2.5 times our money.
You can see how placing some of these types of bets can be highly
profitable. If your scenario analysis is superior to others in the marketplace,
you would need only two of these bets to pay off to double your money.
These types of scenarios are especially true in US interest rate products
because the scenarios are easily quantifiable, which we will show you in
greater detail below.
Additionally, when buying an option, you can define your risk to the
amount of premium that you are willing to lose. Knowing your premium
outlay is critical to recognize because in global macro investing when you
add up all the potential event-driven situations, there are thousands each year.
By defining your risk up front for each potential outcome, your staying power
year-over-year increases significantly.
Below we give two examples of how to apply the trade-off between
selling versus buying an option to a euro (EUR/USD) and S&P 500 (SPY)
strategy, and one example of our event-driven macro trading philosophy for
how to appply options to an FOMC meeting (Eurodollars).

538
Fundamental: EUR/USD Risk Premium Strategy –
Originally Published on October 25, 2015
Over the last month, during the US dollar correction, we added a
significant long US dollar position in the model portfolio. Being long on
the US dollar was our highest conviction view and still is.
To put our level of conviction in context, we spent 3 percent of the
model portfolio NAV in premium, or 1 percent each on long-term call
options (i.e., March/April 2016), against the world’s three funding
currencies—euro (EUR), Japanese yen (JPY), and Swiss franc (CHF).
Additionally, we went long on the US dollar relative to the offshore
Chinese yuan (CNH) in the spot market.
Between the option strike notional in EUR/USD, USD/JPY,
USD/CHF and spot position in USD/CNH, the total is $1 billion of long
US dollar exposure or 3.33x the model portfolio NAV. If the options
were to expire worthless next spring and the spot position hit our stop-
loss level, we would lose ~4 percent.
If you adjust for the delta in the call options and combine that
exposure with the spot position, the total US dollar notional is ~$350
million or 1.2x the model portfolio NAV. Delta-adjusting the entire
portfolio is a more real-time representation.
On last Friday, we added to this view through a new tactical options
position.
While the risk is not free, there was no option premium outlay to
structure an iron condor on the euro (EUR/USD), and that makes it
attractive following the large move that has already occurred.
The trade matrix, including a predefined game plan for gains and
losses, is below for your reference. There is also a breakeven graph
illustrating the potential risk-reward profile.
Trade 1
Leg 1: Long 1x EUR/USD 12/11/15 1.07 put
Leg 2: Short 2x EUR/USD 12/11/15 1.05 put
Trade 2
Leg 1: Long 1x EUR/USD 12/11/15 1.13 call
Leg 2: Short 2x EUR/USD 12/11/15 1.15 call
Cost: ~zero (we received a net CREDIT!)

539
 Downside Breakeven: 1.07-1.03 (start losing money
below 1.03, sweet spot 1.05)
Upside Breakeven: 1.13-1.17 (start losing money above
1.17, sweet spot 1.15 or recent two-month high)
We profit on these options if the EUR/USD trades anywhere inside
the green pyramids pictured below.
We lose nothing but the time we spent watching this position if the
EUR/USD never trades on the inside of the pyramids and just sits in the
middle of the two.
We only lose money if the EUR/USD trades on the outside (i.e., far
left and right) of these pyramids.

Figure 12.4 – EUR/USD Options Payoff

Source: Bloomberg
So how do we think about this risk profile and why did we choose
this expiration date and these exact option strikes?
Regarding the risk profile, a seven “big Figure” move in the
EUR/USD cross is exactly 1.9 standard deviations over the trade’s time
horizon (45 days). Given that 98 percent of all market moves occur
within two standard deviations, we’re comfortable assuming those odds.
Sidebar: If we blew through the downside breakeven of
1.03 in the EUR/USD for some unknown reason, we are very
long the 1.05 strike put option as a core position as mentioned
above, in exponentially larger size. Put another way, if the
EUR/USD is trading below 1.03, it would be a very high-
quality problem, especially considering it would likely help
our long US dollar position vs. JPY, CHF, and CNH as well.
The expiration date is very important to this trade.
We explain why this is the case in more detail below. But the only
scenario where the euro is trading above our breakeven of 1.17 is if the
ECB does not ease policy on December 3 to the extent that is being

540
priced into the market now, and the FOMC pushes back the idea of an
interest rate hike occurring in the next 12 months.
Although we will not know both outcomes definitively until the
actual meetings—December 3 for the ECB and December 16 for the Fed
—our risk is partially mitigated because this option expires before the
second meeting on December 11.
Here’s how we fundamentally came up with the strikes on either
side.
Given that ECB President Mario Draghi has consistently surprised
relative to the market consensus, our view is that a further 10 bps cut of
the deposit rate into even deeper negative territory is probably fairly
high.
Currently, the market is discounting a 10 bps cut for the December
meeting. If the ECB were to cut the deposit rate by 20 bps (i.e., to -0.40
percent), and marginally increase its QE program, lowering the two-year
German Schatz yield by another 10 bps, then fundamentally the interest
rate differential would indicate the EUR/USD will decline to 1.062. The
decline assumes the probability of an interest rate hike at the December
FOMC meeting is at 50/50—an increase from the current 40 percent.
Looking solely at the US dollar leg of currency cross, we estimate
that for every 10 percent probability change of a December interest rate
hike, and a 5 bps change in the one-year slope of rates (i.e., the path of
rate hikes over the next 12 months), that equates to ~70 pips in the
EUR/USD cross.
On a short-term basis, we would also note that the correlation
between the two-year interest rate spread between the US and Europe
and the EUR/USD has been exceptionally high for the month of
October.
Regarding the upside scenario.
If the ECB only cuts interest rates by what the market is discounting
—a -10 bps cut to -.30 percent—and the Fed Chair Janet Yellen’s
commentary is dovish in the month of November, then the EUR/USD
should trade back up to the higher end of the 1.13 – 1.15 range. Chair
Yellen is not currently scheduled to speak after the October FOMC
meeting, although plenty of her lieutenants will do so.
Regarding the US interest rate market, it is unlikely that it will price
a rate hike in December at less than 1-in-3 odds unless we hear an

541
explicit dovish communication from Janet Yellen. Given that the
probability for an interest rate hike in 2015 is 40 percent, or near 1 in 3,
the downside is limited in that regard.
Additionally, if the Fed communicates that it will use the balance
sheet to tighten policy next year—they have not seemed to make this
cognitive leap yet—then this will also be supportive for the US dollar, as
under the current policy the Fed intends to reinvest any maturing
Treasury issues next year.
In conclusion, for a trade that is highly scalable, this is a very good
risk profile, given that you don’t have to spend any money up front to
express your view. For example, if you put on $100mm x $200mm for
free and the EUR/USD either closes at 1.05 or 1.15, you make $2mm.

Figure 12.5 – New Position (EUR/USD) Details, Thesis, and Plan

542
Fundamental: Directional Short S&P 500 –
Originally Published November 3, 2015
We believe strongly in accountability and transparency. We have
now written the following four bearish editions of Sight Beyond Sight
on US equities.

1. The October 13, 2015 issue focused on the corporate financing

gap moving into a significant deficit and how corporations and
sovereign wealth funds (SWF)—the two largest buyers of equities,
or hedge funds—the short-term swing vote for equities would not
be supportive of the fourth quarter positive seasonal view.
2. The October 25, 2015 issue focused on the lack of market
confirmation by small-caps, credit, crude oil, etc. or anything tied
to inflation, growth, or tighter financial conditions.
3. The October 28, 2015 issue focused on
transportation/retail/small-cap underperformance, and narrow
equity market leadership.
4. The October 29, 2015 issue focused on the valuation of the S&P
500 and how both the Federal Reserve and stronger US dollar
would be a headwind in the future.
We should stress that all four of those notes were simply opinions.
The only actual position along the way was to get incrementally short of
the S&P 500 at 2003 (avg. prices 1983, 2003, 2023), starting on October
7, and cover that short position for 2030.50 on October 20. Put another
way, from a position standpoint we lost money only during that 1.3
percent move higher and held onto it for nine days.
In that October 29th edition, we said we were “itching” to get short of
the S&P 500 once again. We were just waiting for a new entry point.
Yesterday, right into what we view as a blow-off top, we satisfied
that itch and got short of the S&P 500, but in a very measured way.
The trade matrix, including a predefined game plan for gains and
losses, is below for your reference.
While we appreciate all of the arguments we outlined to you in those
four editions, it’s time to take a break from the traditional methods of

543
generating investment ideas. So let’s stop the “paralysis by analysis” and
let some simple statistical observations drive the trading process,
especially the entry point or timing. Put another way, let’s now put all
the stuff we sketched out into motion.
Firstly, let’s identify a top in the market where we are just flat-out
wrong. See the chart on the right of the S&P 500 on a “quarterly” basis.
The highest traded price over the last three-quarters is clustered
around the range between 2130 and 2134. Based on yesterday’s closing
price, the stop-loss is ~1.5 percent above current prices.
We believe this is the level that most are now using in their portfolio
construction if they are looking to get short of the S&P 500, including
ourselves.

Figure 12.6 – S&P 500 Quarterly OHLC Chart

Secondly, the S&P 500 closed ~122 points above the 50-day moving
average yesterday, which is a very rare feat indeed. Or to put it
quantitatively, the S&P 500 is trading 6.2 standard deviations away from
its 50-day moving average. We would note that at its worst levels in
August, a similar divergence was witnessed on the downside, which
sparked a sizable short-term rally.

544
 In looking for a meaningful data set of past events, we identified this:
Over the last 20 years the S&P 500 has only closed 80 points above its
50-day moving average seven times. Last Friday was the seventh. Not
including last Friday’s occurrence, in five of the previous six
occurrences, the S&P 500 retested its 50-day moving average within six
to 16 days later on average. That puts the November 20th options
expiration in play for a similar mean reversion for the seventh
occurrence.
Thirdly, the S&P 500 is trading more than two z-scores above its 50-
day average price, which is also indicative that it is trading at an extreme
level in the short term. It goes without saying that it is very rare to see it
do so on the upside, rather than the downside.

Figure 12.7 – S&P 500 50-Day Z-Score

In that spirit, when the S&P 500 cash index was trading up at 2103
near the very highs of the day yesterday, we bought 10,000 of the SPY
November 20th expiry 204-201 strike put option spread for $0.30 to
open.
Again, we realize we have explained in four editions why we are
bearish the S&P 500, and we have noted that we were unsuccessful in

545
our last attempt at being outright short the index. So we want to be clear
about our level of conviction today as there is a big difference between
an opinion and a position.
We spent only 10 bps of the NAV on a three-week position with a
defined risk profile that in theory would capture the mean reversion back
toward the 50-day moving average.
If that event materializes, the payout would be 10 to 1 on the
premium we outlaid or add 1 percent to the model portfolio NAV.
If that event does not materialize, all we did is waste more ink and
lose 10 bps on a second attempt at shorting the S&P 500.

Figure 12.8 – New Position (S&P 500) Details, Thesis, and Plan

546
Event-Driven: Eurodollar Strategies for the
December 2015 FOMC Meeting – Originally
Published on December 5, 2015
The beauty of using US interest rate options in Eurodollar futures,
the most liquid and deep market in the world, is that you can digitally
recreate a structure depending on how you think a variety of scenarios
play out.
Put another way, due to the quantifiable nature of interest rates, you
know the exact price a specific forward interest rate will trade depending
upon certain scenarios playing out.
For example, if you think that the Federal Reserve may raise interest
rates six times in a given year, whereas the market is only pricing in
three, you can locate a structure that will give you a defined risk “bet”
on what that outcome will be.
In this case, the market may assign a 12 percent probability of the
Fed raising rates six times, but you think it might be closer to 50
percent. If your scenario-analysis is correct, it would be a 400 percent
payoff on your bet.
Additionally, when we can identify what these probabilities are,
when one gets so low, where the payoff is more than 8 to 1, you can
place some of these asymmetric bets where only 1 in 4 would be
required to pay off to double your money.
Moreover, even if you did not realize the full payoff, but only half of
it, then it would still equate to a 400 percent payoff on your bet.
Leading up to the December 2015 FOMC meeting, we identified
some different structures that would pay off depending upon how a
variety of scenarios would play out at the meeting. For example, how
could we profit based upon whether or not the Fed raised rates at the
meeting?
Strategy #1 – No Hike Trade: The Fed does not hike interest rates
in December.
Trade: Buy the January 15, 2016 expiry 99.50 call on the
March 2016 Eurodollar future (EDH6) for 0.75 ticks. The
payout is ~12:1 if the Fed does not raise interest rates.

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 Rationale: It seems “impossible” that the Fed would not
hike, given that the market is pricing in the “certainty” of a
move at the moment. It may not be the right one at this point
because if the Fed did not hike, it would be even more extreme
than the ECB moves last week regarding PnL destruction, but
this is now one of the cheapest and most asymmetric hedges in
the marketplace. We have currently deployed this strategy in
the model portfolio as a book overlay.
Strategy #2 – One and Done Trade: The Fed says that it is hiking
once, and is then on hold for quite some time. This outcome would
colloquially be referred to as “one and done.”
Trade: Buy the March 11, 2016 expiry 99.00-99.25 mid-
curve call options spread on the March 2017 Eurodollar future
(EDH7) for about three ticks. The payout ratio is 8:1.
Rationale: The market is currently pricing this outcome as
“almost certainly not.” In probability terms, the odds of “one
and done” occurring is being priced in the market as a ~15
percent probability at the moment. The payout would be
asymmetric if the Fed made such a signal.
Strategy #3 – Pace Trade: The Fed says after it raises rates in
December that the pace of interest rate increases will be gradual and is
data dependent moving forward.
Trade: Buy the January 15, 2016 expiry 98.75-98.625 mid-
curve put options 1x2 ratio spread on the March 2017
Eurodollar future (EDH7) for about one tick. The payout ratio
is 12.5:1.
Rationale: The market is currently pricing the odds of four
rate increases next year at about “even odds.” If the Fed raises
rates and says that it is data dependent, then the market will
need to price in the ~66 percent probability of an interest rate
increase at every quarter over the next 12 months.
Strategy #4 – Next Meeting Trade: The Fed agrees with what the
market is pricing in— that is, each quarterly meeting is live and there is
roughly a 66 percent probability of a move at each of these meetings.
Trade: Buy the March 14, 2016 expiry 99.375-99.25 put
option 1x2 ratio spread on the March 2016 Eurodollar future
(EDH6) for about three ticks. The payout ratio is currently

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 greater than 4:1.
Rationale: The trade would be betting on the market, or
Fed signaling that an interest rate hike in March is a certain
outcome.
Those are just a few examples of the tradeoffs between selling and
buying an options, and event-driven macro trading strategies Sight
Beyond Sight sets out every day.

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Conclusion
Circumstances in global macro change all the time, and the opportunities
change with them.
Trades such as the ones sketched out above require hard work and drilling
down into the data. What you have to be aware of every single day is that
what worked today won’t necessarily work tomorrow. But if you can evolve
every single day, when you get those trades right, they are well worth it.
The key to all of this is to have a process that ties everything together each
day.
For us, our process is writing Sight Beyond Sight®.
By tracking each market theme, having flexibility across many return
streams, and using options strategies to exploit opportunities or inefficiencies,
we can recreate digitally our scenario analysis through a structure that has the
most asymmetric outcome.

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CHAPTER
13

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 “Dirty Arbitrage” Spread
Trading Asset Classes Around
the World – Patrick
Hemminger
One of many exciting aspects of creating The Global
Macro Edge is the chance to delve further into the strategies
which have helped the contributing authors become so
successful through their influence on the risk-based
performance outlined in Chapter 3. The idea of basing trades
around relationships is something that has been hit early and
often. Jason Roney from Chapter 4 incorporates relationships
into overall market strength. His mentor, Bill McKenna, has
used his ability to understand the dynamics between a
plurality of markets to identify trading opportunities, and Neil
Azous uses the three-dimensionality of options to trade the
relationships in volatility, time decay, and directionality
around the macro narrative.
Patrick and I met in 2002 and he was the catalyst for my
first visit to Chicago during an amazing summer time to be a
futures trader. Looking back nostalgically at those cherished
markets, trading a VIX above 60 still gives me goose bumps.
Over the years, I have seen Patrick embrace a trading
approach that seeks hard-to-define out relationships between
highly correlated products in similar asset classes that are
hard to define. These relationships are difficult to calibrate
because barriers like trading hours, time zones, currency
differentials, product measurement, exchange requirements,
and other aspects can complicate the process of trying to
measure accurately all of the factors in the relationship.
Whereas some see it as a nuisance, Patrick sees getting
“dirty” as a great way to maximize return per unit-of-risk. He
is a relative value trader with a twist.

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 In 2009, we were part of a Eurex Roadshow in Chicago
and New York City, which offered us the opportunity to
present on behalf of The European Derivatives Exchange to a
variety of proprietary trading shops and market-making firms.
This opportunity to present in front of our industry peers was
a special moment in our careers.
Spread trading, or relative value trading, has a tremendous
amount of appeal in not only the hedge fund world, but for any
investor seeking to maximize return per UoR across multiple
asset classes. This chapter will outline in further detail what
an investor will need to be aware of when looking to invest in
these strategies.
The creativity, fortitude, and granularity of market
understanding that comes from successful spread trading can
have tremendous benefits for those who can incorporate part
or all of this into a global portfolio.
—John Netto
When I think of the inherent benefits of spread trading, it brings me back
to two very specific points in my journey as a trader. When I began my
journey in the financial markets in 2001, my first job was as a proprietary
equity trader in a small office north of Denver, Colorado. The main strategy
of the office was directional momentum trading stocks listed on NASDAQ.
As a new trader, I was required to attend internal trading classes, led by our
fearless leader, which in reality held no value. He was much better at
promoting than trading.
From all of the classes we attended, one point quickly became clear. None
of the young traders had any idea what was going on as the NASDAQ 100
was limit down day after day. I was happy to have my first trading job and I
worked two part-time jobs outside of market hours to support my wife and
two young sons.
A few months later, the guru owner of this trading shop sold the firm and I
was left with nothing but fond memories and two part-time jobs. As fate
would have it, this would turn out to be an inflection point in my career.
A managing director at this firm went out on his own and invited me to
trade with him and his team (after much perseverance on my part). I was
introduced to equity pairs and statistical arbitrage trading. In one fell swoop, I
had found my passion. Although I could not properly explain what a standard

553
deviation represented, they told me to sell at +2 standard deviations and buy
at -2 standard deviations. This seemed easy enough.
As I became more comfortable with the strategy, I began to explore
different, more creative ways to look at relationships. Most importantly, this
new style of trading gave me time to watch the trade evolve, and it freed up
my mind to explore different ways to analyze the financial markets. I no
longer had to watch every single tick of the market to determine my success
or failure. The following information, stories, and analysis techniques can be
traced back to a small office in Denver, Colorado, just off I25. I humbly offer
a sincere thank you to Richard and Scott for giving me a start.

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I. What Is Spread Trading?
Relationship-driven trading is often referred to as spreading, pairs trading,
stat arb, and hedging. I generally refer to it as spreading. Relationship-driven
trading has always been an intuitive pursuit for me. Relationships are a part
of the very fiber of who we are. We seek them out in one way or another,
whether in person or online. The formal definition for spreading is
combining two or more different products or assets into one tradable
asset. Spreads come in two broad categories, exchange guaranteed and
synthetic, also referred to as “implied.” As spreading has become more
mainstream, exchanges have thrown their hat in the ring and have begun
offering guaranteed spreads.
Guaranteed spreads remove all execution risk as the exchange spread
engine manages the leg execution. Implied spreads are user generated and
require more sophisticated execution software to combine products that may
trade on different exchanges. We will expand on these subjects later. The
main concept to grasp in spreading is that you focus your risk and exposure
on the relative value between the products, rather than placing your risk on
the outright direction of one product or asset.
The ability to combine any two markets and make a tradable spread is
very powerful. That power opens your mind to the many possibilities that
exist to accomplish the main goals of an asset manager:
1) Maximizing return per unit-of-risk.
2) Diversify return streams through exposure to non-correlated
products.
3) Reduce risk by minimizing the impact of systemic exposure.

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Intra-Commodity Spread
An intra-commodity spread consists of futures contracts of a single
commodity, but of different months. Consider a spread consisting of WTI
Crude Oil December 2013 minus WTI Crude Oil January 2014, also referred
to in CQG as CLES1Z13 or a one-month calendar spread. As of August 13,
2013, Crude Oil December 2013 closed at $103.53 and Crude Oil January
2014 closed at $102.16. This equates to a spread of $1.37, December minus
January. Let’s briefly get into what that $1.37 represents.
The difference in price arguably represents the combination of risk
premium, insurance costs, freight costs, and interest costs.

Figure 13.1 Crude Oil December 2013 Minus WTI Crude Oil January 2014

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Inter-Commodity Spread
An inter-commodity spread consists of the purchase of one futures
contract and the simultaneous sale of a different, but related, futures contract.
Think of a spread consisting of Crude Oil December 2013 minus Heating Oil
December 2013, also referred to as a crack spread with the following symbol
in CQG, HOECLEZ13. As of August 13, 2013, Crude Oil December 2013
closed at $103.53 and Heating Oil December 2013 closed at $3.0485.
First, you will notice that the contracts are priced differently. Crude oil is
priced in US dollars per barrel and heating oil is priced in US dollars per
gallon. A factor will be needed to equate the price of heating oil in barrels,
rather than gallons. You will also notice that both contracts are of the same
delivery month. There are 42 gallons in one barrel of crude oil, so we will use
a factor of 42 to determine the crack spread or refining margin. If we take the
heating oil price of $3.0485 and multiply it by 42 we get $128.037, rounded
up to the nearest .01, $128.04. We then subtract the crude oil price of $103.53
from the heating oil conversion price of $128.04 and we get a crack spread
price of $24.51.
Let us briefly get into what the $24.51 price represents. $24.51 is the price
at which December Crude Oil can be cracked and refined into heating oil, or
simply put, a refiner’s margin. This is a generic price for the crack as
logistics, financing, insurance, and most importantly the quality of the crude
oil input affect the crack spread price.

557
Figure 13.2 Crude Oil December 2013 Minus Heating Oil December 2013

558
Implied Spreads
Implied spreads begin the process of getting “dirty.” The next type of
spread discussed is an increasingly important part of properly diversifying a
portfolio and creating non-correlated streams of exposure: the implied spread.
Implied spreads are user-generated spreads that come in three different
flavors:

Intra-Exchange
Inter-Exchange
Cross Asset
An intra-exchange spread is comprised of related products located at the
same exchange, whereas an inter-exchange spread is made up of products
located at different exchanges. The main attribute of an implied spread is that
the user is manually creating a spread synthetically by combining
products that are not formally offered as a spread by an exchange. In a
world where sophisticated technology exists, the combinations are bountiful.
As we get deeper into this chapter, we will discuss in more detail the
parameters and inputs to create an implied spread, as well as how to mitigate
execution risk.
Finally, let us discuss cross-asset spreads. This type of spread consists of
product combinations that cross asset types. For example, Treasury basis
trading between ten-year cash notes and ten-year note futures. One asset is a
cheapest-to-deliver cash note government security, and the other is a
derivative of the government security. Some examples of the different flavors
of cross-asset spreads are cash Treasury versus Treasury future; cash
currency versus currency future; future versus exchange-traded fund (ETF);
and future versus equity stock.
There are some rules of implied spreads that are immutable. The first one
being when it comes to pricing and trading an implied spread, one is only
limited by one’s ability to adapt, innovate, and control risk. Each individual
trader has a unique way of building and analyzing spreads. Traders are
usually influenced by the shop where they learned the skill, their individual
experiences, and research into a strategy.
I view implied spread ratios through two different lenses: the contract
trading ratio and the analysis ratio. The contract trading ratio is the amount of

559
contract A versus the amount of contract B, to represent a true relative value
relationship and mitigate residual, outright exposure.

Figure 13.3 Global Equity Index Relative Value Ratio Table

Residual exposure can be a dangerous side effect of implied or synthetic
spreading. It is difficult to perfectly match the dollar amount of contract A to
the dollar amount of contract B and reduce residual exposures. The exposure
can significantly increase volatility when relative-value spreads are held for
long periods of time. There are times when traders purposefully take on
residual exposure to increase the profit potential of a specific aspect of the
spread or investment theme. Factors to reduce residual exposures are
discussed later in this chapter.
The analysis ratio uses parameters such as contract value, currency
denomination, and volatility to determine factors used to “normalize” the
price characteristics of the spread. The number of factors involved in
creating an implied spread make it unlikely that any two traders will be
looking at the same exact pricing structure for the same spread. This is
just one of the factors that create the basic function of the market, bringing
together buyers and sellers to determine price.
One issue facing implied spread traders as opposed to exchange-based
spread traders is the potential repercussion of high initial and maintenance
margins, as trading implied spreads can be a margin-intensive strategy. A
long ES (E-mini S&P 500) versus short DAX position is a classic example.
ES is traded on the Chicago Mercantile Exchange (CME) and DAX is traded
at the Eurex Exchange. When trading between two separate exchanges, there

560
is no cross-margining relief. This means one needs to post margin on each
position, which at the time of this writing is $4,500 USD and €2,190 EUR,
respectively. Exchanges offer intra-exchange cross-margining relief when
spreading products on the same exchange.
If you are trading ten-year note futures (TY) versus 30-year bond futures
(US), or the NoB (Notes over Bonds) spread, the CME offers cross-margin
relief taking into account the inherent hedged position. There is no cross-
margin relief for a ten-year note future vs. a German Bund future. The two
products are similar and exhibit a high historical correlation coefficient, but
are traded on two separate exchanges.
The process of integrating strategies like this one to create a more capital
efficient portfolio is an option for an investor with the right infrastructure.
Blending a non-correlated, low-margin strategy can be a great way to
effectively invest a portfolio. Throughout The Global Macro Edge, an
approach to analyze both systematic and structural aspects of alpha
generation is constant.

561
Types of Spreads
A defining feature of spreads is the way in which we calculate them. Let
us quickly overview the options.
Absolute Difference – A spread expressed in the most popular manner,
by subtracting the value of Asset 2 from Asset 1. These spreads can take on
positive and negative values.
Ratio – A spread expressed by dividing Asset 1 by Asset 2. A popular
ratio spread is the Gold/Silver ratio. As of July 20, 2012, August Gold is
1333.9 and September Silver is 20.295, which gives us a ratio value of
1333.9/20.295 = 65.72. Simply, it would take almost 66 ounces of silver to
purchase one ounce of gold.
Basis Point Difference – A spread expressed by determining each
product’s percent change from a specific benchmark. Depending on your
approach and time frame, this can be calculated using previous day’s close,
previous year’s close, or previous bar close. I use year-to-date percent
changes.

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How Does Spreading Differ from Hedging?
As demonstrated by the London Whale Trade with JP Morgan in 2012,
the answer to this question can be quite complex. For instance, a producer or
end user of a commodity goes into the markets to mitigate adverse price
moves, as they need to sell or buy product at market. One is considered a
hedger if one utilizes derivatives as a risk management tool to protect oneself
from adverse moves in the market.
The wheat farmer sells futures contracts to mitigate downside movement
in wheat, while the baker buys futures contracts to protect against upside
movement in wheat. Both the farmer and baker are able to plan and manage
expectations by taking on positions in the market to protect their interests.
I am writing this chapter from the perspective of a speculator. I utilize
multiple analytics to identify areas of value that offer optimal opportunity to
maximize return per UoR. As part of my approach, I choose to focus on
relative-value opportunities that require hedges to properly express my
investment theme. My approach to spread trading aims to mitigate risk,
reduce volatility, and create non-correlated product exposure for
diversification. In general, I speculate on the relationship of at least two
related assets and position myself to benefit from that movement.
Fund managers of all types utilize hedging techniques to protect gains and
mitigate the risk of a profitable position becoming less or not profitable at all.
Is the fund manager a speculator or hedger? Is following one’s trading plan a
hedge or speculation? There is no easy answer to those questions. The
majority of speculative traders offset risk in some manner. A few examples of
speculative hedged positions are as follows:

1. Spreads – Positions made up of multiple contracts or assets

2. Futures/Options/Stocks/Bonds/Currency
3. Covered Calls – Option position along with Equity Stock
4. Convertible Arbitrage – Simultaneous execution of Corporate Bonds vs
Equity Stock
5. Merger Arbitrage – Simultaneous execution of two merging companies

563
II. Benefits and Risks of Spread Trading
When I first began trading equity pairs, my creative juices really began to
flow. The biotech sector caught my eye due to the number of companies in
the sector and the uncertainty of future company profits that, for all intents
and purposes, were in the hands of the FDA. My goal was to begin capturing
short-term profits in pairs of biotech stocks, generated from the inherent
volatility. My first foray was in the following pair, IDEC Pharmaceuticals
versus PDLI Pharmaceuticals. This pair exhibited a high degree of volatility,
mainly due to IDEC. I liked the volatile ranges each stock exhibited and there
was a high correlation at the time.
I decided to look at the spread not based on absolute differentials, but on
net change difference, calculated from the previous day’s close. As soon as
the net change difference between these stocks deviated to a level +/- $1.50
from the 0 point, I would start positioning aggressively. I made money almost
every day, while experiencing some losses along the way. I was feeling like a
trader. Learning how to trade out of divergent pairs “behaving badly”
was an “aha” moment for me in my career. My mistakes provided the
greatest opportunities for learning. I learned how to shift exposure, trade out
of bad positions, and make the most of opportunities. This specific time in
my life, along with the gents on my desk, would ultimately shape my trading
career going forward. Thanks, Rich; you know who you are.

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Speculative Risk
One of the most obvious benefits of spread trading is that you do not have
to be concerned with absolute price movement of the broader market; you are
only concerned with how product 1 relates to product 2. This provides the
trader some time to analyze the position and the parameters involved.
My old partner would often say, “Let’s put that trade on the back burner
and let it simmer.” These spread trades allow us the opportunity to profit
whether the market is rising or falling, although prospects seem to be more
plentiful during higher volatility periods, in my experience. Spreading can be
especially helpful in dampening volatility, tracking money flows, and
identifying relative performance relationships within asset classes. One thing
remains no matter what your approach: you still have to be right to make
money.

565
Execution Risk
The analysis, both quantitative and qualitative, can seem like the easy
part, now that we have to execute a position. If a juicy edge has been
identified, you need to ask yourself a question. Is the opportunity an outright
exchange guaranteed spread (for example, a Wheat Calendar Spread) or is it
an implied spread? The answer to this question decides your next course of
action. If we are dealing with an exchange guaranteed spread, simply enter
limit and/or market orders, just as you would an outright market. However, if
an opportunity is discovered between two assets, traded on two separate
exchanges (an implied spread), execution risk is a major factor and needs to
be managed.
Sophisticated technology is utilized to mitigate the leg risk associated with
synthetic or implied spreads. This is accomplished by executing with an auto-
spreader. The auto-spreader works active limit orders on one or both assets,
also commonly known as the legs of a spread. On execution of one of the
legs, the auto-spreader attempts to simultaneously execute the second leg to
complete the spread.

566
 Figure 13.4 E-mini S&P vs. DAX Implied Spread Ladder
Execution risk is paramount at this point, and successful execution of an
implied spread strategy can hang on the balance of milliseconds. Implied
spreads are not guaranteed a successful execution, and spread legs can
be missed. A missed leg of a spread occurs when the first leg of your spread
is executed but the second leg cannot be executed. Prices shifted too quickly
and the specific implied spread price determined by the trader cannot be

567
executed at the current independent asset prices. Now, you have outright
exposure, also known as a mis-hedge, getting legged, or a multitude of other
vulgar words spreaders have come up with to describe this unfortunate event.
It is vitally important for investors to inquire with managers about what risk
management metrics are in place to deal with mis-hedges. Execution risk is a
viable source of risk that cannot be ignored. It is pertinent for managers to
have a coherent plan that addresses this source of risk. Investor
acknowledgment of this risk source displays a sophistication and builds
credibility of the investor when in discussions with the manager.
Below are some of the ways to utilize auto-spreader technology to
mitigate execution risk:

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Decide Which Leg to Work
In most cases, I only work one leg and most often default to working the
more illiquid product. For example, I work the FTSE 100 leg when trading
the ES versus FTSE 100 spread. What if both legs are equally liquid?
Determine where your spread engine server is co-located and work the leg
closest in proximity to that server.

569
Hedge Order Logic
Third-party trading platforms, like CQG, offer auto-spreader functionality
and provide parameters that allow the trader to customize how the hedge
order is executed. Figure 13.5 shows a list of the main hedge order
management parameter options. I spread on CQG and this is part of the logic.

570
 Figure 13.5 of CQG Spreader Parameters
As Figure 13.5 illustrates, there are a number of customizable options as

571
part of the CQG spreader. I can choose whether the hedge order is sent as
limit or market.
Pay Up Ticks – User defines how many ticks through the market to send
the hedge order.
Minimum Size Increment – Monitors bids and offers of hedge leg to
determine a user’s specified minimum to send the order. Helps ensure the
amount needed for execution is available.
Trailing Limit Order – A limit order that trails the bid or offer of the
incomplete product. The order can trail by time increments or tick
increments, depending on user.

572
Finding Great Trades Through Relative Performance
and Money Flows
Monitoring and trading spreads can be a highly effective way to measure
relative performance and track money flows between products of the same
asset class. When Japan was hit with the tragic earthquakes on March 11 of
2011, major shifts and dislocations occurred in the equity index asset class.
As global markets reacted to the earthquake news, the equity index futures
moved rather sharply to the downside. Because the earthquake occurred at
the beginning of the London session, global equity indexes were under
pressure, but European indexes were hit harder.
The equity index strategy I implement begins with creating a benchmark. I
will discuss the notion of benchmarking later in the chapter. I use the S&P
500 as the benchmark of the strategy and compare all global indexes to it, to
better understand relative performance. As stated earlier, European indexes
were selling off harder than the S&P 500, which made sense as it was the
London session.
I initially began selling the E-mini S&P 500 and buying the DAX, at a 3-
by-1 ratio (meaning buying three E-minis S&P 500 for every one DAX
contract I sold), because the DAX was experiencing relatively more
downside pressure during the sell-off. The DAX was not only
underperforming the S&P 500, it also performed weaker compared to its
European brethren, the FTSE 100, Euro Stoxx 50, and CAC 40, thus making
it show up on one of my screening alerts.
I began scaling in with smaller size on Friday, March 11. The spread
continued to chop around with an upward trend during the London hours.
When I create an implied spread between the S&P 500 and the DAX, the
DAX is analyzed as the second asset, so as it sells off, the spread rallies.
When the US session opened at 8:30 AM CST, the spread spent most of the
day trading to the upside, or seeing the S&P 500 outperform the DAX on a
relative basis.
The DAX futures continued to experience a greater degree of selling in
relation to all other indexes in my universe, save for the Nikkei 225. For
obvious reasons, I did not want exposure in the Nikkei 225. As I was building
a core position, short the ES versus DAX spread, there were some
opportunities to tactically trade and finance my position around the core

573
position I was building. This is an important facet to my strategy and one of
the parameters John Netto uses when looking to incorporate something into
his Protean approach.
Taking advantage of the opportunity to trade short-term positions around a
long-term core position adds value to the strategy in a number of ways:

May improve the average price of the core position

Can help reduce volatility
Keeps you intimately involved in the rhythm of the trade, which can
improve your ability to gain “transactional value”
Over the weekend, I conducted some top-down fundamental analysis,
reviewed the import/export relationship between Japan and Germany, and
conferred with regional experts over potential policy responses. I did not find
any meaningful economic relationship that would cause the DAX to decouple
when compared to other US and EU equity indexes.
When Europe opened Monday, March 14, 2011, the spread continued to
trade to the upside, or against me, as the DAX continued to underperform the
S&P 500. Based on my weekend research, interpretation of the market action,
and money management policy, I was able to use this opportunity to add a
few more units, thereby increasing my short S&P 500 and long DAX
exposure. My patience and discipline would be rewarded.
Following this morning burst, the spread pulled back to the downside and
I finally had my first real opportunity to take some profits from short-term
positions and move some inventory.
Moving inventory is an important concept to grasp. Traders need to
realize the maximum size they are comfortable trading and attempt to stay
within those bounds. When a trader respects his or her size limits, it allows
the trader to think and react to market movement in a more impartial manner.
Thoughts, ideas, and suggestions become a lot less logical when a trader is
taking losses and has too much of a position. Moving inventory is important
for the psyche.
I liken most situations in life to baseball. Focus on hitting singles. I keep a
Rod Carew baseball card on my desk to remind me to hit singles. To move
inventory requires strategy. Play small ball. Bunt. Steal. Sacrifice. Move
runners around the bases. Moving inventory on both winning and losing
positions opens up my mind to think more clearly.
The relief movement in the ES versus DAX spread was short-lived. When

574
the US markets opened, the trade rallied slightly but did not make new highs
on the daily chart. I felt good as I was able to move some inventory and buy
back some spread positions (see Figure 13.6), which provided the dry
powder I knew I would need to see this trade through.
As US markets closed on Monday the 14th, the spread sold off
considerably, benefitting my position, and I lowered my exposure. My
thought process was to keep some exposure, as I felt the markets could really
revert to its historical norms.
After London markets opened on March 15, the DAX was hit hard with
selling right out of the gates, helping the S&P 500 to outperform the DAX
again. I was selling the spread once again at much higher levels. I knew I
wanted to be in this position longer term because there were no other stimuli
I was aware of which confirmed such a knee-jerk reaction. But looking at the
position objectively, I began to lose some confidence as I was approaching
my average holding time of three days.

575
 Figure 13.6 E-mini S&P 500 vs. DAX Spread Entries During Japan
Earthquake
When markets opened in London on March 16, the underperformance of
the DAX continued in comparison to the E-mini S&P 500 and the spread
began making new highs. This new round of selling in the DAX caused me to
feel extremely confused and I began taking a more defensive posture.
The divergence peaked at a ~600 basis point differential on March 16.
This was a huge differential and provided some confidence that I was

576
positioned right, but we all know how the saying goes: “The markets can stay
irrational longer than I can stay solvent.”
Beginning on March 17, the spread began to break back down in an
orderly fashion and presented opportunities to scale out of the trade over the
following seven trading sessions (see Figure 13.7). The trade eventually
yielded a respectable risk-adjusted return. This is a fine example of how
being aware of an asset class’s relative performance, as well as historical
basis point differentials, paved the way to a great trade that ultimately made
up the majority of the alpha I generated in March of 2011.

Figure 13.7 E-mini S&P vs. DAX Spread Exits During Japan Earthquake
The pursuit of tracking money flows falls on every spread trader’s screen.
It is the GPS of future market movement and if you listen close enough, it
may guide you into the turning points as well. As money moves, it leaves
footprints. In 2008, when markets were really spooked, the relationship
between cash Treasuries and Treasury futures was significantly distorted as
investors ran to the actual cash products, leaving futures to lag and try to
catch up. As you recall in Chapter 9 with Bill Glenn, this topic is covered
with much specificity.
My next spread trade example occurred in January 2011. Spain and
Portugal experienced successful short-term Treasury auctions at relatively
high interest rate levels. The sentiment to these results was positive as
broader European equity indexes such as the EURO STOXX 50 and DAX

577
significantly outperformed global indexes to the upside. The execution plan
for me was to strategically sell the strength in the EUROSTOXX 50 and
spread that versus long E-mini S&P 500.
The S&P 500/EURO STOXX 50 spread had been in a nice uptrend over
the previous months, meaning the S&P 500 had been outperforming its
European sister. I believed this news was an opportunity to bid into the
relative weakness of this spread and provide opportunity, as the longer-term
challenges for Europe would persist.
I entered the trade by selling one Euro Stoxx 50 futures contract for every
one E-mini S&P 500 contract I bought. As I began to position myself, this
spread had no interest in reverting back to higher price levels from the
morning. I liked the exposure long term, but my concern was that I would get
too much inventory too quickly and be in a compromising position.
I had some long days and weeks in January and early February of 2011,
and I fought the market and tried to move some inventory at advantageous
levels. As the spread continued to work against me, coinciding with investor
enthusiasm over Europe increasing, the S&P 500 performed very poorly
compared to the Euro Stoxx 50 (see Figure 13.8). I initiated my risk
management protocols and incrementally reduced risk 10 percent of the
position at a time. The reality was this spread was not coming back anytime
soon.
When I got down to 50 percent of the max position I had on, the spread
appeared to have bottomed out. I was confident the trade I was expecting to
happen weeks earlier was now beginning to manifest itself. Although I had
taken losses as I reduced my exposure, I still had a decent-sized position. But
more importantly, I created some dry powder that I could strategically utilize
should the trade move back in my favor. The longer-term S&P 500 strength
did reemerge and the spread started to move back in my favor. I
systematically increased my size as the position went back in my favor,
adhering to my risk protocols. The spread headed back to levels seen before
the successful Spanish and Portugal auctions and provided opportunity for
those to benefit who provided liquidity on the longer-term trend.
What did I learn? First, I discovered I can be really stubborn. I held onto
this trade well past my average hold time of three to five trading days. The
total time horizon for the trade was five weeks. I made the position personal
and just could not understand how the successful auctions were positive
news, as longer-term challenges in Europe were unsolved. The market

578
eventually went in the direction of my position. However, it was much longer
than I imagined and really tested my will. I also learned the impact of
“opportunity cost.” Managing the exposure consumed my every thought and
prevented me from moving into other inter-market relationships for potential
profit. All of that time, stress, and emotion for a small loss exacted a greater
toll on resources outside the monetary ones.

Figure 13.8 E-mini S&P vs. EuroStoxx 50 Spread Position Management

During Spain/Portugal Auctions of 2011

579
III. Identifying Spread Relationships

Benchmarking
One of the very first steps in identifying potential relationships in a spread
is to know all the products and players in a specific asset class. When
breaking down an equity index futures asset class, every trader is aware of
the E-mini S&P 500. There are many other regional representations:

North America: E-mini Dow, NASDAQ, Mini Russell 2000

Europe: DAX, Cac 40, FTSE 100 and EuroStoxx 50
Asia Pacific: the Nikkei 225, Hang Sang, Kospi, and the S&P ASX 200
in Australia
Now that we know the “players,” I begin by selecting a benchmark
product of the asset class. I do this as a way to study the relationship of the
indexes in comparison to one index. It makes analysis easier and more
intuitive, while also assisting in easily recognizing relationships not paired
with the benchmark. Of the above listed futures products, I designate the
E-mini S&P 500 as the benchmark. On any given day, I can look at the
basis point percent change of each index and make a quick assessment of
which index is outperforming, how it relates back to the E-mini S&P 500,
and what the outperformance means. It pays to do your homework and be
prepared by knowing what each index represents and how many constituents
make up the index. If the mini Russell 2000 is leading the E-mini S&P 500 to
the downside, it may mean we are experiencing a cycle of “risk-off,” as
investors shed their exposure to small-cap stocks, which are deemed more
risky than large-cap stocks. One of the key drivers from 2010–2012 was the
sovereign debt theme in Europe, which prominently impacted equity index
relationship trades. Markets hung on every word coming out of Germany, the
ECB, and multiple ECB governors. This altered the dynamics for those
spreading US versus EU equity index spread trades

580
Liquidity
Another main factor in determining products to investigate for
relationship-based trading is liquidity. I define liquidity as the degree to
which an asset may be bought and sold without causing significant movement
in the respective asset.
With the advent of algorithmic trading, quantitative analysis, complex
software, and powerful hardware, periods of illiquidity can present challenges
to effectively executing a strategy. Execution specialists provide competitive
execution services to decrease market impact, minimize information leak, and
decrease overall execution costs. Therefore, it is incumbent upon traders who
are active in these markets to go beyond a cursory examination of just
looking at the inside bid and offer to determine a product’s true liquidity.
Average daily trading volume and open interest are widely available
market statistics that can assist you in determining true liquidity. My favorite
equity index spread is E-mini S&P 500 versus FTSE 100. I always work the
FTSE side of the trade because the size on the bid and offer is lighter in
comparison. However, as of this writing, the FTSE 100 trades about 80,000
contracts a day, more than enough to do some real size.
Liquidity can also be affected by the product’s term structure. Most
commodity futures that require delivery, transportation, and storage have a
robust term structure or chain of futures that mature and expire at different
dates in future. When it comes to financial futures such as equity index
futures, Treasury futures, or currency futures, the majority of the traded
volume and open interest will occur in the front contract or front option.
However, when you look at a product like crude oil, corn, or live cattle, the
total product volume will spread out amongst multiple expirations on the
curve or term structure (see Figure 13.9).

581
 Figure 13.9 WTI Crude Oil Forward Curve
The volume on the deferred contracts or expirations provides spread
traders with opportunities to speculate on market movement that may not be
attributable to current market conditions. For example, in the summer of
2012, the grain markets experienced drought conditions in the Midwest not
seen since 1988. The dry conditions directly affected the bushel-per-acre
yields, propelling corn and soybeans to all-time high prices.
What most do not immediately consider is the effect this will have on
contracts of live cattle. As grain (feedstock) prices increase, the probability of
livestock farmers sending the current herd to slaughter increases due to the
increased cost of feeding the herd, which directly impacts margins. However,
the deferred expirations, six months and more, will not experience the same
degree of selling and will exhibit relative strength. The increased feedstock
cost of the grain can be embedded in the price of future dated cattle, which
drives the over-performance of the future cattle prices. Keep in mind, the
further you go out on the curve (term structure), liquidity begins to become
an issue that can impact position sizing, exit strategies, and overall
profitability. The following chart displays this negatively correlated

582
relationship. Figure 13.10 shows live cattle prices in blue and corn prices in
red. As you can see, as the price of corn decreases, the price of live cattle
increases and vice versa as corn prices evolve to the upside.

Figure 13.10 Flat Price Cattle and Corn Price Relationship

583
Trading Hours and Time Cycles
As markets have gone more global, products are opening earlier and
closing later, with many trading 20 hours per day. Time cycles are a very
important part of my approach to the markets. While watching the equity
index markets during the London session, one can usually expect the
European-based index futures to exhibit leadership and set the tone for the
day, which I define as beta.
Intuitively, the European cash equities, the constituents of the indexes, are
open and the performance of those stocks is determining the index levels. If
the E-mini S&P 500 price action is leading the European indexes during the
London session, there is likely an opportunity. Situations like this may create
a dynamic where the European indexes “catch up” to the E-mini S&P 500 or
the E-mini trades back in line with the European indexes. The price discovery
journey is agnostic to where the eventual profit is sourced. Meaning, it does
not matter if the profit is derived from Asset A, Asset B, or a combination of
both. Our main goal is to profit. Often, I will have family and friends ask,
“How did the Dow do today?” Sometimes I do not even know, but I can tell
them exactly how the Dow performed relative to the DAX.
Awareness of the specific opening and closing trading hours is an
essential component to successfully trading multiple markets. Managers who
trade internationally must have an aspect that anticipates what markets are
leading and which markets will soon be leading. Along with this, the
difference between the futures and cash equivalents in terms of trading hours
is also essential. The opening and closing times of the constituents or when a
pit opens and closes. Please reference Appendix I in the back of the book for
an example of international market hours.
These extremely important factors can create a lot of stress if you enter
trades during times of illiquidity or are unaware the European cash equities
close at 10:30 AM CST. These two examples will have a major impact on
execution costs and lead/lag aspects of your spread trade.
The economic earnings calendar has been mentioned throughout this
book. An awareness of key events taking place in Europe or Asia is an
essential component to understanding what markets may be driving the trade.
I keep a current running G-7 calendar and spend a lot of prep time staying on
top of key earnings releases from major index components.

584
 The globalization of financial and commodity markets has brought with it
the need to have a comprehensive plan to provide desk coverage, which takes
into account the different opening and closing times of these products. If you
do not plan ahead, you could find yourself stuck overnight in a European
grain contract that closes nearly three hours earlier than its US equivalent
grain contract. When trading US versus European financial and commodity
spreads, pay close attention to the holiday schedule as well.
Boxing Day is a classic example. The British observe Boxing Day as a
bank holiday. A spread position of E-mini S&P 500 versus FTSE 100 will
most likely only be half trading with US markets open and London markets
closed. This can be problematic, as the composition of your exposure may
shift dramatically. You are really exposed as US markets will trade and
perform while your FTSE contract is closed. Getting caught in this type of
position can pose risk management issues.
US and EU holidays offer opportunities for managers to rest, relax, and
recapture mental and emotional capital, which is essential to generating
alpha. There are serious repercussions if you do not protect your
psychological capital.
The expiration specifications of the markets in question need to be at the
top of one’s mind when considering time cycles. European financial futures
do not roll in the same capacity as their US cousins. US financial futures
usually roll over a one- to two-week period prior to the contract expiring.
European futures tend to roll over two to three days and even then, the
majority of the roll occurs on the expiration date. As markets become more
“globalized,” the roll personalities of the products ebb and flow, just like a
market. If you do not know how products roll, it can be a very stressful
situation that costs you financially and mentally, and presents an opportunity
cost. For investors looking to allocate to spread trading strategies, understand
the manager’s strategy or philosophy toward rolling positions, as this can
help save some potential heartache.

585
Basic Quantitative Measures
Most outside observers to spread trading may think the process of
understanding how the markets relate to each other requires sophisticated,
high-end quantitative strategies. Surprisingly, the most robust strategies
involve three key qualities:

1. A qualitative understanding of the global macro environment

2. Microstructures of the markets being traded
3. Application of a handful of common technical analysis methods
This keeps the decision making fairly straightforward and congruent with
the basic question posed by traders, investors, and financial advisors: Is this
strategy scalable and repeatable? Below are some preliminary statistical
properties I use to analyze products to potentially spread.

586
Correlation Coefficient
Correlation is a measure of the strength and direction of the linear
relationship between two variables that is defined in terms of the covariance
{or the degree in which the returns move in tandem) of the variables divided
by their standard deviations, or the measure of dispersion from the mean.
Correlation measures the strength of the relationship between two products.
Do two stocks move up and down together? Does one stock move up and the
other moves down? Or do they not move together at all?
Correlation is the first statistical measure I utilize to find out if there is any
relationship between the two products I would like to spread. If a spread does
not exhibit a correlation coefficient greater .70, on a scale of -1 to +1, I will
likely not consider it as a possible spread trade, However, other trading
opportunities may exist outside of this strategy. I typically use multiple look-
back periods on a daily chart to calculate the correlation coefficient. Figure
13.11 displays the correlation of E-mini S&P 500 versus the DAX. The look-
back periods I use are 100, 50, and 20. This gives me a realistic view as to
how the correlation between two products has evolved from a longer-term to
short-term perspective. As you can see, the short-term correlation in red has
broken down to nearly 20 percent due to the under-performance of the E-mini
S&P 500, relative to the DAX. Both of the longer-term periods, green and
blue, are still showing robust correlation values above 87 percent.

587
Figure 13.11 E-mini S&P and DAX Correlation Chart

588
Cointegration
If two or more time series are individually integrated, but some linear
combination of them has a lower order of integration, then the series are said
to be cointegrated. Let’s simplify this last statement. For the layman and
those familiarizing yourself with the metrics of spread trading, on a scale of
0–100 percent, the higher the confidence level, the great potential the pair has
of reverting and oscillating around a mean. Cointegration confidence is
extremely useful in deciding if the pair moves together and wants to converge
back to a mean or more normal price relationship. This provides confidence
that you can trade this pair from a mean-reversion perspective. If two stocks
are simply correlated—when one goes up, the other goes up—the pair may
never really diverge from a normal state and provide a trading opportunity.
Being aware of these two basic but important factors can save you time
and mental energy by helping you focus on pairs that diverge and exhibit a
statistical tendency to converge as well.

589
Volatility Path
Volatility path is how many times a spread moves from top to bottom in
its daily range. In other words if the spread has an average range of 14 ticks
and trades from high to low three times a day versus six times a day, this is
noteworthy information. John Netto expounded about this in Chapter 5 in the
“Opportunity Ratio.” This is a key aspect in looking into both the underlying
products and their respective spreads for trading opportunities. Understanding
the path dependency of the spread along with its penchant to move within
that range is critical to assessing the overall profitability of that spread.

590
IV. Constructing a Spread Trade
Constructing, selecting, and building spreads is both an art and science.
As mentioned earlier, spreads come in different flavors: intra-commodity,
inter-commodity, and implied. Most of the regulated futures exchanges offer
guaranteed spreads on intra-commodities. These “calendar spreads” have
grown in popularity with the exchanges now offering inter-commodity
spreads, such as corn versus wheat or heating oil Crack spreads (see Figures
13.12 and 13.13).
These “guaranteed” spreads remove execution risk and guarantee you a
spread price. In most cases, market makers are on the other side of your
execution as the guaranteed execution offers them an arbitrage by working
the individual legs versus the guaranteed spread. Think of it as a convenience
tax, which saves you mental energy and the opportunity cost involved in
focusing on a missed leg. Gaining access to exchange guaranteed spreads
does not require the use of high-end technology like an auto-spreader. Simply
requesting the product with your firm’s risk manager and front-end system
should give you quick access to exchange guaranteed spreads.

Figure 13.12 Corn vs. Wheat Inter-Commodity Spread

591
 Figure 13.13 Heating Oil vs. WTI Crude Oil Crack Intra-Commodity Spread
The discussion of implied spreads between products not offered as
guaranteed and trading on separate exchanges becomes slightly more
interesting. I have found that interesting topics in the global financial markets
tend to lead to opportunities to create alpha.
Implied spreads are inherently the “dirtiest” of all spreads. When you are
combining products with different trading hours, execution venues, and
capital requirements, edge is found for those willing to peer down the hole
into the abyss. Individual contract specifications will differ as to:

the absolute price

point value
currency
contract size
pricing unit
tick size
daily price limits
expiration
contract months
The main specifications we focus on for constructing a spread are absolute
price, point value, and currency. With the addition of historical volatility, we
can utilize these factors to construct an implied spread between two similar
futures contracts that are not offered as guaranteed spreads or are located on
separate exchanges. The main focus when creating an implied spread is to

592
“equalize” the notional value of each of the contracts.

593
Example of E-mini S & P 500 / DAX
Let us walk through an example: E-mini S&P 500 versus DAX spread.
Approaching your spread trading with a “benchmark” product is important.
When spreading equity indexes, I use the E-mini S&P 500 as the benchmark
from which to measure the performance of all other equity index markets. I
suggest setting up a spreadsheet, like the one in Figure 13.14, that will allow
you to set up a matrix of products and compare them to the benchmark. These
are the factors I use to create spreads in order: price, point value, and
currency. These three factors lead us to calculating the contract’s notional
value.

Figure 13.14 Global Equity Index Ratio Matrix

Creating relationships is a very personal endeavor. Most traders I’ve
worked with utilize historical volatility in some facet when creating the
formula as a factor—to what magnitude is a personal preference.
I find the most exciting and edge-filled spread relationships exist between
contracts that are denominated in different currencies and/or contract
specifications, thus making them a little “dirty” or problematic to manage. As
one might expect, my main market exposure from 2008–2011 consisted
specifically of US futures contracts versus European futures contracts. My
primary focus in 2012 and 2013 shifted to commodity term structure
relationships, with a secondary focus on equity index spreads. I closely
monitor US versus EU Treasury and commodity relationships as well. In the
spirit of full disclosure, I have avoided equity index spreads that are US
versus US and EU versus EU. The subtle nuances between intra-country
index contracts make trading them slightly more challenging from the

594
beginning of 2011 until 2015. When trading “dirty” spreads, I mainly try to
focus on the US versus EU dynamic.
Determining capital flows between big-cap value stocks and small-cap
stocks is very difficult and requires precision timing that has proved
challenging. I have experienced trading DAX versus CAC 40 is a proxy trade
on the macroeconomic performance of one European nation versus the other,
rather than statistical measures such as correlation and cointegration.

595
V. Fundamental Strategies of Spread Trading
The final aspect of this chapter discusses strategies and approaches to
identifying and applying risk to relationship-driven opportunities.

596
The Driver of the Bus, Capital Flows
The proverbial “bus” is the opportunity in the market that all traders are
trying to identify. Every bus needs a driver. Being aware of who is driving
that bus, or what the macro narrative is, can assist you greatly in your timing.
Arguably, the most important factors concerning relationship-driven
trading is the flow of capital. Speculative capital flows determine why Pepsi
outpaces Coke. Capital flows can provide additional color into a broad
market rally by identifying if small-cap stocks are leading or lagging large-
cap stocks. The trail of a money manager switching the portfolio’s long
equity exposure from US dollar denominated stocks to GBP denominated
stocks can be described by capital flows.
Capital flow is the driver of the speculative bus. Why is this important? If
the spread is diverging due to everyday ebbs and flows, it becomes much
easier to stick your neck out and gain contrarian/mean reverting exposure.
However, if there are real institutional capital flows behind the divergence,
blindly fading a spread can lead to excruciating pain and significant
opportunity cost.
The following are two simple observations and approaches I use when
spreading:
1) I try my best to exhibit some patience, reading volumes and
analyzing the individual legs of the spread, trying to identify an
extreme level to fade.
2) I wait for the spread to revert slightly, missing the
opportunity to catch the top or bottom and enter the trade in the
direction of the overall trend of the capital flows, in a trend-
following fashion.
It can be difficult to be patient in the markets as oftentimes the best
entries come without the benefit of confirmation. I imagine the lion
hunting for food. The lion cannot afford to chase every animal that comes
across its line of vision; the lion would waste energy and tire quickly. In our
world this is referred to as “opportunity cost.” The lion hides in the tall grass
and waits patiently for the weakest prey. The lion pounces quickly and
aggressively to provide the greatest probability of catching tonight’s dinner
and expending the least amount of energy.
The final point on capital flows is that they encompass a majority of the

597
reason spreads move. Speculative capital flows in and out of specific assets
for many reasons, including:

Country-Specific Risks – Monetary policy, interest rate risk, currency

risk, regulatory risk, tax considerations
Supply/Demand – Weather conditions, production interruptions, union
strikes, logistical/transportation issues
Sector – Product demand, wealth creation/destruction, demographics,
company specific fundamentals

598
Not All Positions Are Created Equally
At its most basic level, strategy is most concerned with external market
forces and how you can position your portfolio to exploit the inefficiencies
related to those forces. Choosing the correct market position is vitally
important to the overall strategy in relation to the risk-reward metrics a
manager is attempting to achieve. If a portfolio manager feels that US
equities are frothy and overvalued in relation to current market fundamentals,
the best position might not be directly in equities. There are many ways to
position for a directional move in equities:
1) Short Equities
2) Long Equity Put Options and/or Put Spreads
3) Long Treasuries / Short Yields
4) Long Treasury Call Options and/or Call Spreads
Each of these positions has very specific personality in relation to
volatility and risk-reward metrics. The best risk-to-reward position may be a
second or third derivative of the actual speculative position in question.
If weather conditions represent the risk of a drought in the Midwest,
simply going long corn, soybeans, and/or wheat may not represent the
greatest inefficiency in the agricultural sector, relative to the risk profile of
those flat price assets. By digging deeper, you will notice that cattle
producers come under great pressure when facing increased feed costs,
especially if proper hedging strategies have not been put in place.
A greater inefficiency and risk-to-reward trade could be represented in
being short front contracts of the live cattle term structure, and being long
back contracts. Cattle farmers will inherently sell off their current herd as
feedstock prices rise, which has an immediate impact on margins. The
backdated futures have time to adjust prices to the premium feedstock prices.
The combined action of selling the front herd and absorbing future price
increases may push live cattle spreads down. This dual type of price action
was readily present during the summer drought of 2012 and exacerbated the
selloff in live cattle spreads.
If you do some comparative analysis between the two opportunities, you
can immediately derive the dollar value of each opportunity. The corn
experienced a move up from approximately $5.00 to just shy of $8.00, which
equates to $15,000 for one contract. In comparison, the live cattle December

599
versus June spread exhibited a move down from $1.00 to -$5.00, which
equates to $2,400 for one spread. You could easily deduce that you should
have been long corn, based on dollar value comparisons only. My investment
thesis challenges that notion by stating that the cattle spread exhibited a much
different return per unit-of-risk, along with a historically reliable seasonal
pattern. First, historical volatility in corn increased 37 percent over the mid-
June to mid-August time frame. The volatility of the live cattle December
versus June intra-commodity spread actually decreased 35 percent. During
the same interval, corn does not exhibit a seasonal pattern with high
reliability, representing only a 40 percent probability of success.
The live cattle exhibits a highly reliable seasonal pattern over the summer
and represents a probability of success. What this adds up to is a liquid way
to create exposure to corn, while potentially reducing risk and increasing
probability. While each situation is nuanced and has no guarantee of
repeating itself, it is worth looking at these analogues for context should a
similar situation arise again.

600
Figure 13.15 December Corn Prices – Summer of 2012 Drought

601
Figure 13.16 Live Cattle Dec 2012, Jun 2013 Inter-Commodity Spread –
Summer 2012 Drought

602
The “Technically Quantitative” Approach to Analysis
Analyzing the markets, whether flat price strategies or spread strategies,
comes in many different flavors. These simplistic approaches have always
worked best for me, as they are easier to execute, do not cause analysis
paralysis, and are simpler to communicate with investors. My approach is
technically based, with a dose of simple quantitative analysis, as well as an
awareness of the macro narrative.
The globalization of markets requires traders constantly monitor what is
happening in all markets. Grain and livestock traders need to be aware of
major economic releases and Fed statements. These data points may
profoundly influence currency markets, which directly relate to the margins
and marketability of global grain and livestock trade. Weather patterns that
affect grains in Argentina will dramatically affect the performance of grain
prices in the Black Sea region of Eastern Europe. Economic issues in Greece
affect the price of copper, which bleeds into Chinese demand and price
discovery in US denominated futures contracts. I tend to build an investment
thesis driven by historical probabilities, technical factors, and finally
fundamental data points.
Standard deviation analysis is a prominent part of spread traders’ arsenal
of techniques. Keeping things simple has been a tenet of my life. When it
comes to being an athlete, simple and fundamentally focused training usually
provides the greatest opportunities for gains. Major League baseball players
can be found taking thousands of swings using a tee. A very simple drill that
allows the hitter to focus on a specific part of his swing. The same can be said
for analyzing the markets.
I generally keep my analytics simple and utilize Bollinger Bands as a way
to get a first glimpse of market performance, distribution, and momentum in
relation to recent price patterns. My first introduction to statistical arbitrage
came early in my career when trading equity pairs. I would sell +2.5 standard
deviations and buy -2.5 standard deviations in highly correlated pairs such as
KLA Tencor (KLAC) and Novellus Systems (NVLS). You might think, easy
enough for 2001.
Quantitative analysis and the associated strategies have quickly matured
and are dominated by PhDs, engineers, and computer programmers. I had the
great fortune to spend a few years with some livestock traders who

603
introduced me to a trick. This involved utilizing Bollinger Bands as more of
an indication of momentum, not just distribution.
Momentum is an end product of capital flows. Figure 13.17 is an
example of how you can use Bollinger Bands to gauge momentum. The red
lines are +1 and -1 standard deviations. As you can see, the Euro FX broke
out of a pattern and was above the +1 standard deviation, which can be
referred to as upper momentum or “up mo.” This particular market
consolidated for ten trading days, above the breakout level, and closed below
upper momentum twice as the market tried to whipsaw the weak longs. When
the market finally resumed its trend higher, it closed above up mo for seven
consecutive days.
That is a nice example of capital flows, and the same dynamics take place
in spread markets. I continue to be very grateful for that knowledge and
experience. Thanks, Bob, Paul, and Trevor.

604
Figure 13.17 Euro FX Currency Trend-follow, Momentum Example

605
Every Opportunity Has Its Cost
When analyzing opportunities, it is pertinent to identify the resources you
have access to and generate your approaches based on what is available.
Resources can include:

technology infrastructure
execution platforms
connectivity
asset class availability
human capital
investment capital
Opportunity cost is such an important theme to recognize in speculation
and macro trading. There is no greater frustration than when you call the
direction of a market but don’t monetize the prognostication. This can happen
due to poor timing, excessive position sizing, or the pain associated with the
unrealized loss of an early entry that compels you to exit the position before
you can profit. Of course, I have personally experienced this after exiting my
position, it starts its march in the direction I had hoped.
Do not focus your time and efforts researching strategies or
approaches you do not have the proper resources to execute. This
distracts you from finding opportunities you can seize and take advantage of.
Do not focus on building arbitrage strategies that are reliant on speed of
execution if you do not have the proper budget to support the technology
infrastructure, high-speed connectivity, and human capital to build and
maintain custom software. Your endeavor will likely be fruitless, frustrating,
and extremely costly.

606
Speculative Hedging
Spreading markets is not specific to relative-value traders only. Let’s look
at an example where spreading becomes a way to hedge a position you may
not want to part ways with, but is due for a short-term move adverse to your
current position.
An example was a trade from October 2012 when I was long the Oct 2012
Natural Gas contract, looking for a three- to five-day spike. The entry was
from $2.80 on a technical pattern and the market moved my way soon after
execution. Over the next two days, Oct Natural Gas traded up to $3.05, a
quick $0.25 cent gain. I sold back some of the inventory I had accumulated,
unwinding 50 percent of my position. The natural gas market looked tired on
the fourth day, as it tested the highs and started to sell down. I still wanted
some long exposure for another three- to five-day move to test some
resistance at $3.135.
I decided to hedge my long exposure by selling the Nov Natural Gas
contract, thus making my position long the Oct-Nov calendar spread from a
price of $-0.12, which was the price of the spread when I initiated the
November sell (see Figure 13.18 and 13.19). The natural gas market did in
fact pull back, breaking through a short-term support point. I exited the
spread trade and was able to preserve 80 percent of my profits in the Oct
Natural Gas contract as it pulled back $0.15, while the Oct-Nov calendar
spread only pulled back $0.05. I gave back $0.05 of my $0.25 profit in
natural gas for an opportunity to make $0.10 more. I strategically risked one
for the potential profit of two and booked a $0.20 profit. This was a great
return per UoR.

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Figure 13.18 Natural Gas October Flat Price Position Example

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 Figure 13.19 Natural Gas October, November Inter-Commodity Spread
Position Hedge Example
While in a training class at my first trading position in Chicago back in
2003, one of the founders of the group spoke to our ten-person class. He was
a 25-year veteran of the Chicago trading pits, and he imparted on the eager
students an important nugget of wisdom. He shared with us the many stories
of outright, flat price traders who come into the market, make big money, and
eventually either burn out or go broke. He imparted on us that “spreaders
may not be as sexy and flashy as the outright traders, but they build long
careers with more consistent P&Ls.” What appealed to me most about
spreading, or relative-value trading, is the time and flexibility it gives you.
Successful spreaders navigate the “minefield” of the markets with creativity
and develop a relationship with the markets that allows them to “feel” their
way through volatile markets, slow markets, range bound markets, and
trending markets.
This chapter has explored multiple aspects to use relationship trading to

609
maximize return per UoR. However, this chapter should not be considered a
complete compilation. The process of incorporating relationship trading into
one’s portfolio can help investors build a portfolio of risk-based, non-
correlated, liquid trading strategies.
The key is understanding what metrics influence each of those respective
strategies. With relative-value trading, factors such as manager experience,
geography, volatility, currency differentials, execution risk, and capital
efficiency are all important inputs that need to be judiciously considered
before committing capital to this strategy. I encourage you to investigate the
markets and the many creative types of exposure you can create by not being
afraid to get a little “dirty.”

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CHAPTER
14

611
Mean Reversion Strategies –
The Trend Isn’t Always Your
Friend

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Introduction
As the creator of the Protean Strategy, it has always been my goal to
incorporate as many profitable, non-correlated, risk-controlled strategies as
possible. This means developing relationships in my network with those who
specialize in how specific strategies work. Robb Ross, who is the managing
principal of White Indian Trading, a commodity trading advisor, is an
integral part of my process.
If there is one individual who busts the myth that “Money always find its
most efficient home,” it is probably Robb Ross. As we went to press in 2016,
Mr. Ross’s CTA had well under $10 million in assets under management,
despite compiling many years of impressive risk-adjusted returns and a
plethora of nominations from Barclay Hedge for his money management
prowess. Here, institutional investors’ loss is my gain and this phenomenon
serves as yet another example of the sheer inefficiency of capital markets. As
noted throughout The Global Macro Edge, I pride myself on my
independence from the Wall Street establishment, which would try to tell me
how and with whom to collaborate. If I had been forced to listen, I never
would have had a relationship with Mr. Ross, who is a prime example of why
using your own process to identify value can be so richly rewarding.
This chapter will outline the key tenets to developing a successful mean
reversion strategy, which includes numerous lessons I have learned from my
collaboration with Mr. Ross. While I cannot divulge the proprietary specifics
of the strategies Mr. Ross uses for his clients, I will outline the major factors
to consider in the construction process. As has been the theme consistently
throughout The Global Macro Edge, mean-reversion strategies (really, all
strategies), when combined with a strong macro discretionary overlay may
see a significant improvement in return per UoR. Therefore, as you read this
chapter, try not only to absorb the technical aspects of how these strategies
may improve your process, but also think about how to blend them with your
knowledge of the macro narrative.

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UoR Strategy Grid
As I have touched on when explaining the UoR Strategy Grid,
understanding what markets a strategy works well in and the underlying
macro narrative in each asset class are huge factors in computing the Regime
Profitability Factor, or RPF. In the UoR Strategy Grid in Figure 14.1 below
(the same one I shared in Chapter 8), a score of 18 for mean reversion
strategies in fixed income implies a low return per UoR. Similarly, a score of
41 in the equities has a somewhat higher chance of success but will not be
worth allocating any meaningful capital.
Even the most basic of technical trading systems, such as a simple moving
average crossover, can be very powerful when properly contextualized with
the right regime. Therefore, when I model the Regime Profitability Factor
that drives the scoring of the UoR Strategy Grid, having a rich understanding
of both the strategy and the market environment gives me greater confidence
in its success.
By explaining what the key inputs are in a good mean-reversion strategy,
you will be able to start to construct your own UoR Strategy grid based on
the specific strategies you create. If you are an investor looking at investing
in a fund that runs a mean-reversion strategy, or any other kind of strategy,
then you can ask them about their RPF methodology to see how they account
for different market regimes.

Figure 14.1

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Overview of Mean Reversion Strategies
By definition, mean reversion strategies work on the idea that prices ebb
and flow around a certain area, generally reflecting all the information in the
market. Therefore, any major movement in price, particularly to an extreme,
represents an opportunity to take on exposure opposite to this move, with the
expectation that the market will move back toward its original levels (i.e.,
revert to its mean). As a result, mean-reversion strategies tend to outperform
in markets that are choppy or counter-trending and underperform in markets
with follow-through and momentum. Hence, this is why there is a strong
inverse correlation in performance between mean reversion and trend-
following or momentum strategies.
Mean-reversion strategies are applied by a range of market participants
across many asset classes in the active management investment community.
Using a very generic example, if the S&P 500 is trading at 2150, with a low
of 2100 and a high 2200 over the previous three months, then a mean-
reversion strategy may look to short the S&P 500 at the 2200 price level, or
the high end of that range. The idea being the market is range bound and has
a greater probability of returning to 2150 than to rally to 2250.
Given the above example and descriptions offered up so far, it does not
take much to realize that markets that are trending very strongly and going
through a repricing can cause significant P&L duress to many mean-
reversion strategies in the same way choppy markets may crush trend-
followers.
Figure 14.2 below shows through the Bloomberg Backtester how four
“off-the-shelf” mean-reversion strategies fared in the S&P 500 over a 24-
month period in 2014 and 2015. The top pane is the chart of the S&P 500 in
Figure 14.2. The middle pane is an equity curve of each of the strategies, and
the last pane is a single equity curve of the cumulative profit and loss. The
period outlined in this was a notoriously choppy time for a number of risk
assets as realized volatility compressed and many markets struggled to find a
rhythm. During this period, these particular mean-reversion strategies did
well.
This data in Figure 14.2 can be exported to Excel from Bloomberg, or
dynamically imported in Excel from Bloomberg using the Bloomberg plug-
in. From there you can combine the results and see more complex analytics

615
such as the Sharpe ratio, correlations, and Netto Number to measure return
per unit-of-risk. The chart helps visualize why the right mean-reversion
strategies can be such an effective balance in a portfolio.

Figure 14.2
Mean-reversion strategies are closely related to a number of relative-value
strategies outlined in the previous chapter and operate under a very similar
philosophy. As you learned in that discussion, many relative-value traders
will use mean-reversion analysis in determining their trades. The key
difference is that whereas a mean-reversion strategy may take on risk in an
individual market, relative-value strategies are executed with at least two
products. Applying mean reversion to a relative-value strategy is a good way

616
to stay agnostic as to market direction or trend—it simply posits that,
regardless of the markets, certain products should bear a fairly constant
relationship to one another, so that a shift in that relationship should be
followed by a snap back to the mean.
Let’s say that a relationship exists between corn futures prices and wheat
futures prices, since consumers can sometimes substitute one for another. If
the price of wheat suddenly soars relative to corn, a mean-reversion approach
to the relative-value trade would be to sell wheat and buy corn, with the
expectation that the gap between wheat and corn will start to creep back to
average (either by wheat prices dropping, corn prices rising, or some
combination of the two as buyers switch from wheat to corn).
Currency trades—which are always, of necessity, relative-value trades—
also use a similar relative-value mean-reversion logic. For instance, the
Australian dollar (the “Aussie”) and New Zealand dollar (the “Kiwi”) are
often thought to hold a fairly steady relationship to one another, since they
bear similar geographic risks, have similar trade partners, and tend to
compete in exporting similar goods (though Australia is somewhat more
oriented toward hard commodities compared to New Zealand’s soft
commodities). Thus, if some move increases the value of Aussie dollar to the
Kiwi, so that it goes from 1.1 Kiwis to an Aussie to 1.2 Kiwis to an Aussie
(that is, AUD/NZD goes from 1.1 to 1.2), then a currency trader may buy the
now relatively cheaper Kiwis and sell the now relatively pricier Aussies with
the expectation that the relationship will revert.

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Benefits of Mean-Reversion Strategies
There are three main benefits from actively running mean-reversion
strategies. The first of these is non-correlation to other strategies. The less
correlated my strategies are, the more I can leverage my portfolio. The
second benefit is mean-reversion strategies have a natural “liquidity-
providing” aspect built into them. This exists because of their penchant for
selling at extreme highs and buying at extreme lows. The last benefit is
getting immediate feedback of the regime message by having access to my
P&L. By being able to see how mean-reversion strategies are performing,
there are knock-on benefits to other aspects of my trading.

618
Non-Correlation
Beyond the natural benefits of portfolio diversification, the preponderance
of trend-following and momentum strategies used in the active management
investment community places even greater emphasis for having a portion of
your portfolio allocated to strategies that are inversely correlated. Mean-
reversion and relative-value strategies carry with them this potential.
Referencing back to Figure 14.1, we see how successful a handful of off-the-
shelf mean-reversion strategies performed over a two-year period on the S&P
500. During this time, many trend-following systems were suffering
tremendous P&L duress. Those investors who were diversified based on
strategy, asset class, and macro themes probably saw a better Netto Number
on their investments.

619
Providing Liquidity
Having a set of strategies in a portfolio that have a natural liquidity-
providing role is an important part of maximizing return per UoR. Mean-
reversion strategies generally operate under the assumption that extreme price
moves higher will ultimately revert lower and vice versa. Therefore, by
taking positions at these extremes you are putting in place strategies that may
benefit from the natural premia received for providing liquidity. Depending
on the execution methodology you take and how you structure the trades
(e.g., by selling puts on down moves, or selling calls on up moves) you may
also benefit from the volatility crush that happens as well. An example would
be if the S&P 500 sells down 5 percent over a three-day period. This may
generate a buy signal based on an oversold reading in your system. You sell
at-the-money puts that have seen an uptick in implied volatility. If the market
does recover, the move will not only see a gain from your delta exposure but
may also see the implied volatility component in the option price go down as
well.

620
P&L Attribution
I assess a market regime in many ways. One of those is comparing the
P&L attribution of the strategies in the UoR strategy grid. This is very
instructive as seeing the performance of mean-reversion strategies across
different asset classes provides another level of analytical value. For example,
if mean-reversion strategies in FX are generating a better return per UoR than
mean-reversion strategies in fixed income, this may tip me off to a change in
the risk appetite of global portfolio managers. This extra level of analysis
helps me stay flexible and aware of factors that may not be easily noticed
using traditional price analytics.

621
Challenges / Environment for Underperformance
As sexy as it may be to talk about how much money a strategy can make, I
find it far more instructive to understand where a strategy struggles. In my
years of playing No Limit Texas Hold’em in Las Vegas, the single most
important factor in my success was the ability to make a big laydown, or fold
when I was beat. The asymmetrical nature of No Limit means that even if
you win eight hands in a row, you can lose all of your chips if you are
confronted with that Yahtzee scenario. A scenario that puts you to the test to
call all of your chips when you may be beat. It is a mathematical certainty
that if you play poker or are in the markets for long enough, you will be
confronted with these difficult decisions.
Therefore, the more intimate we can become with the people we are
playing against, or regimes we are trading, the better chance we stand to
make that critical “laydown” and preserve our risk units. Specifically, in the
case of mean-reversion strategies, I see two overarching challenges. The first
is using the strategy in a period where the market is going through a
repricing. The second challenge is how one manages risk. I will expand on
how these two factors can constrain one’s success.

622
Challenge 1 – Regime Shift / Market Repricing
Buying low and selling high has a certain reverence for those who are of
the mean-reversion ilk. Unfortunately, when markets go through a repricing
or regime shift, buying low can mean selling out even lower, while selling
high may mean buying it back much higher. These occur because of a market
regime shift or repricing of assets. As explained earlier, mean-reversion
strategies operate under the premise that the current price range is a fair
reflection of value. Therefore, any substantive move in price is likely noise
and offers an opportunity to provide liquidity and wait for the market to
return to its price range, thereby yielding a profit for the investor. However,
when there is a catalyst such as a policy decision from a central bank,
earnings surprise, or exogenous event, the factors that went into computing
those price ranges may no longer be viable.
Therefore, the first challenge when running a mean-reversion strategy is
how well you can assess the macro landscape to understand if we are going
through a market repricing. If you or the manager has a solid handle on this
factor, then lowering the exposure of your strategy can help minimize losses
in environments that are not conducive, and increase exposure in
environments that are. It is easier said than done and the first thing to
examine when either investing in a strategy or running it manually.

623
Challenge 2 — Risk and Money Management
There are two general philosophies when it comes to managing risk
around mean-reversion strategies. The first is that the outsized move in the
market creating either an overbought or oversold condition has created an
opportunity to provide liquidity and take on a trade with a positive expected
return. If the market were to continue moving in this direction, then it makes
sense to just exit the trade and take a loss based on a predefined risk strategy.
The second philosophy is that if the market provided value to fade the
move at one level, and it continues in this extreme, then there is even more
value. As a result, one should pyramid into the position even further, taking
on more exposure as a reflection of the potential opportunity for profit.
Philosophy 1 – S&P 500 becomes overbought and triggers a sell signal
entry at 2200 for one unit. Target 2150, stop loss at 2250. It rallies to 2250
and stops out for a loss of 50 points.
Philosophy 2 – S&P 500 becomes overbought and triggers a sell signal
entry at 2200. Target 2150, add two additional units at 2250. It rallies to 2250
and the manager adds two more units. Should it rally another 50 points to
2300, the manager would short four more units as a reflection of how
extremely overbought it has become.
As you can see from the above risk-management methodologies, both
have some merit and both require you to have tackled the first challenge of
understanding the regime. Philosophy 1 typically has a smoother equity curve
and less fat tails, while Philosophy 2 can have you sized larger at more
market extremes. Both have drawbacks and benefits. If you, or the manager
you are investing with, do not have an ability to understand when the market
is going through a repricing or regime shift, then a risk-management
philosophy resembling the first strategy is probably more appropriate.
At the very least, if understanding the macro narrative is not yet your skill
set, it may be worth considering some type of risk-defined entry like options
or option spreads. This may help protect against the tail risk of pyramiding
positions. As someone who professes incrementalism, there is always the
possibility of combining the two in an effort to smooth your equity curve. I
will elaborate on this more in the “Execution” section in this chapter.
Figure 14.3 below illustrates an example of the EUR/USD currency going
through a reprice in Fall 2014. As shown using some vanilla mean-reversion

624
strategies in the Bloomberg Backtester, there was significant P&L duress as
the euro repriced 12 big figures lower against the US dollar over a 10-week
period.
This sharp decline was shown only using a standard position size in this
backtesting model. If one had incorporated Philosophy 2 of pyramiding their
positions, the P&L duress would have been even more extreme. Again, there
are benefits and drawbacks to both philosophies; however, during periods of
extreme momentum and dislocation, the allocation dynamics of the strategy
have a profound impact on its return per UoR.

625
Figure 14.3

626
Key Inputs to a Mean-Reversion Strategy
There are an array of inputs I use when creating mean-reversion strategies.
I will use this section of the chapter to explain the philosophy behind the six
biggest inputs. I will also explain the things to consider when creating your
own mean-reversion system. Those inputs are as follows:

Implied Volatility
Time Frame
Technical Indicators
Sentiment Indicators
Inflection Points
Elliott Wave
To add to the richness of the chapter, I have also asked volatility-trading
expert Darrell Martin, president of Apex Investing, to contribute content as
well. As I will explain in this chapter, one can use many technical indicators
in creating a mean-reversion strategy. However, there is not one more
important than implied volatility. Darrell Martin, a longtime colleague of
mine, has instructed many on how to incorporate implied volatility readings
into their trading process. He will share some of his secrets and techniques
for incorporating the most important input of all.

627
Implied Volatility
I begin with implied volatility because if we are in a regime that sees
mean-reversion strategies perform well on a return per UoR basis, then we
should not trade outside the implied volatility bands. As a simple example, if
the At-The-Money (ATM) Straddle on the S&P 500 is trading at 30 points for
the next week, then we should be contained within that 30-point range as a
result. If the S&P 500 is trading at 1950, then a move to 1980 is about as high
as it should close by the end of the week and 1920 should be the lower bound
in this period. You can use those ranges as a barometer of where to enter
positions and how far trades may travel in your favor. Conversely, markets
that are going through a major regime shift or reprice could move well
beyond the levels suggested by the ATM Straddle. Knowing no other
indicator outside of the implied volatility levels, you can construct some
devastating mean-reversion systems.

628
Implied Volatility – The Keystone for Mean-
Reversion Strategies
By Darrell Martin
There are four primary segments to trading analysis which together
make up what I have termed Diagnostic Trading. Those four segments
are: Fundamentals (financial statements and news), Technicals (anything
on a chart including price action), Seasonal Patterns, and Statistics. The
goal of Diagnostic Trading is to be one step ahead of the market by
looking at ways other people look at the markets, finding confluence,
and then being able to be on the other side of trades supplying the
liquidity to those entering and exiting. I would dare to say that the one
missing element from a majority of all traders is statistics. The traders
may have their average win/loss, risk reward, largest loss, largest gain,
max drawdown, and/or even a standard deviation showing historical
movement. The problem with all these statistics is they are based on past
performance, and we all know past performance is not an indicator of
future results. One specific statistic that is missing is a statistical
measurement I have termed Diagnostic Deviation Levels based on
implied volatility. This is the expected movement levels based on the
underlying market’s expected movement within a given period of time.
When you enter a trend, how do you know if you’re getting in too late
and the market is about to reverse? Or, if you have entered a trade, how
do you know when the market is reaching an exhaustion point? How do
you know this beyond indicators that can lag, a standard deviation band
of some type, intuition, or support resistance lines drawn on a chart? The
only clear answer I have found that works on a consistent basis is
Diagnostic Deviation Levels based on implied volatility.
Implied volatility is rather simple. It means “implied” expected
volatility “movement.” So implied volatility simply means expected
movement. The key here is whose expected movement? Is it your
expected movement, Goldman Sachs, a newsletter, or is it an objective
collection average of expected movement? Implied volatility is a
number extracted by a variety of formulas from the pricing of options.
Options are based on market demand and expectations and uncertainty
as to market volatility. The more uncertainty of larger moves, the higher

629
the implied volatility. For example, you will see an increase in implied
volatility increasing the price of options in the few weeks leading up to a
stocks earnings release. Then once the earnings have been released and
the big or not so big movement has happened then the implied volatility
will drop as there is less uncertainty about that stock moving drastically,
and the options will become cheaper. This is often referred to as a
volatility crush. You may have noticed the statements the options will
become more expensive and less expensive based on implied volatility.
Option pricing again is based on this uncertainty. So another way to put
implied volatility: it is everyone saying how much they think the
underlying market will move in a given period of time and putting their
money where their mouth is. Implied volatility is not about what
happened; it’s about what the market “all participants” think regarding
how far the market will move.
Implied volatility impacts the option Greek vega. Vega is the change
in an option price based on a 1 percent change in implied volatility.
Vega typically has more impact on option pricing than any other Greek
in the options market. The market can move drastically in the opposite
direction of your option, and you could profit or even lose when the
market moves in your favor depending on how much implied volatility
changes. It is ultimately the premium often used to hedge long or short
positions similar to insurance. The higher the implied volatility, the
greater the perceived uncertainty and greater premium one must pay for
insurance in that market. The lower the implied volatility, the less
perceived risk there is in the market. For options traders, it is an
essential piece of information along with strike price, time until
expiration, and current price of the underlying market. Given the deep
importance of this indicator, huge segments of market professionals
have invested tremendous resources into building better implied
volatility models. The stronger the model you have, the better you can
assess value and opportunity in the market. These models influence
everything from the prices of millions of options on a daily basis to how
much risk is appropriate in a portfolio.
Given the depth, analysis, and liquidity of these markets, there is a lot
that we can use by simply understanding the message they are
conveying. Therefore, even if you cannot build your own implied
volatility model, by simply understanding how implied volatility is

630
priced, you can provide a framework for where the market is likely
headed. Once you determine this, you can build an array of strategies
around this. For the purposes of building a mean-reversion strategy, and
even when to tighten stops and take profit when trading, Diagnostic
Deviation implied volatility levels are the most essential component.
Ideally, you need to have a deviation model that ties something into
its objective which is separate from you and your opinions. This allows
you to have proper expectations. This essential deviation model MUST
also use implied volatility of the underlying market.
An example of a model is using an ATM straddle and adding
together the extrinsic value of the premium of the two options. So if the
premium, on GOOG options that expire in three days, was 5.00 on the
call and 6.00 on the put side then the premium combination would be
$11.00 for an 11-point expected move on GOOG over the next three
days. So the expectation is the market will move up 11 points, down 11
points, or another key factor that is part of the Diagnostic Deviation
model is moving 11 points from high to low. So it may move down three
points, then back up 11 points from the low over the next three days.
This is a simple method to give you the idea of an expected move on
an options market between the day you are looking at it and expiration.
Once you log these numbers, make sure to make note of them on your
chart or otherwise. This is a simple, rudimentary method of how to use
the premium from options to obtain an expected move. If the model you
use does not have the implied volatility built in, it will not be an
effective deviation model for you to use in your trading. Please note that
standard deviation models are based on historical volatility and therefore
are not effective deviation models to use when trading.
Diagnostic Deviations levels require two proprietary formulas where
the implied volatility is extracted out of the underlying options market
for each specific market over a period of several months. This
information is then put together and entered into a unique deviation
formula, which leads the trader to know what the market expects for that
particular market to move. Unlike standard deviation models, instead of
looking backward, Diagnostic Deviations levels are looking forward.
Having an objective expectation of movement that is derived from
market expectations—which is implied volatility, versus historical
movement, which is historical volatility—allows you to know when you

631
should start tightening your stops and to know what your realistic profit
targets should be. You can obtain deviation levels for free at
Apexinvesting.com for over 22,000 markets.
Implied volatility is huge in calculating an accurate level of
expectation of movement. Everybody wants whatever they invest in to
go to the moon, but how far is it really going to go? The best way to
know that is to find out what the market says, because the market is
usually right. By using Diagnostic Deviations based on implied
volatility, you can see the expected movement for each market. Here is
an example showing a portion of a day’s Diagnostic Deviations levels:
(Diagnostic Deviations http://screencast.com/t/pLLgoeYqgDr)

Figure 14.4
The previous day’s settlement price is in the middle column, giving

632
you reference whether the market may move up or down. Looking
across the top of the chart, you can see the deviation levels moving from
0.5 to 3 with positive on the right side and negative on the left. Listed
down the left side is the name of each represented market. On the far
right side, you will notice for each market how many pips/ticks/points it
has to move for one deviation and for 0.5 deviation. The amount is then
added or subtracted from the settlement price to arrive at the
corresponding deviation levels.
Knowing the potential movement a market may make for the day can
be used with all types of trades or strategies you may want to do. It helps
you set up proper expectations and know when to tighten your stops, and
lets you know when you should be cautious when going long on a short
trade or short on a long trade.
Statistically speaking, I have found that there’s about a 70 percent
chance that the market will break out of a +/-0.5 deviation level. Often,
it will hit +/-1 deviation with a 32 percent chance that it will go beyond
that. There is only a 5 percent chance that it will break out of +/-2
deviation level and only .5 percent chance that it will break out of +/-3
level. Knowing these facts enables you to set realistic profit targets. If
you were to continuously set the +/-3 deviation level for your take profit
target, it might never get filled and you would be wondering what you
were doing wrong! A trader who can get a half to a whole deviation
level consistently can make a great living trading. Look at the following
chart.

633
 Figure 14.5
(USDCHF http://screencast.com/t/QUnrI37K)
This is a chart of USDCHF. You can see that the Diagnostic
Deviations levels are already plotted on this chart for easy reference. If
you were trading this market you could see that throughout the night,
this market had already dropped almost one and a half deviation levels.
At 8:30 ET, when it dropped down and touched the -1 deviation level,
that would have been a signal to you that this market was probably
going to stop going down. If you were in a short trade, you would know
to get out. If you were considering going long, you would look for
confirmation to enter your trade.
As a market hits a deviation level, that can be your signal for a
potential reversal. The following chart shows US SmallCap 2000 (ICE
E-mini Russell 2000.)

634
 Figure 14.6
(TF Potential Reversal)
The market opens at 7:30 ET, and trading is between settlement and
+0.5 deviation until it hits that level. At that point, it reverses. By
knowing that particular Diagnostic Deviations level, you can be alert for
a potential reversal.
Another advantage to being aware of Diagnostic Deviations levels is
that they can help you to be sensitive to upcoming news. Even if you
don’t trade news releases, it is important to know that the news can have
an impact on your trading day.
This chart shows how several news releases influenced trading on the
GBP/USD, even if it was not for a very long amount of time. If you
were in a trade at that time, it would have probably been enough
movement to stop you out.

635
 Figure 14.7
(GBPUSD)
The market had been choppy, but as the news came out at 8:30 ET, it
caused a .5 deviation spike. It quickly retraced. Hopefully, you were
sensitive that such a news release could cause such a spike in your
trading day. The Diagnostic Deviations could also signal that the
movement caused by the news release might mean that the market has
gone as high or low as it is going to go for that day and you can trade
accordingly.
I calculate these levels daily after market close and post them that
same evening for reference for the next day. They are remarkably
accurate and aid many traders because they are based on implied
volatility. Traders use them in conjunction with various strategies. It is
interesting to see how the levels vary from day to day when plotted on
the charts.
(AUDUSD dev adjustment)

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 Figure 14.8
This chart shows how AUD/USD settlement was 0.7624 the previous
day and the corresponding Diagnostic Deviations levels. The next day,
settlement was 0.7591 and shows those respective levels. The movement
on the chart is continually shown, but the levels allow you to adjust your
trading expectations for each day using an objective approach based on
the underlying implied volatility.
Using implied volatility is important as an objective measurement of
expected movement that factors into future market expectations. Relying
on past market movement does not tell you what will be happening in
the market today or in the future. Going forward instead of looking
backward gives traders a reliable model to use when used in
combination with a confirmation of price action for proper expectations
of market movement on mean-reversal entry strategies and for when to
exit said strategies.
—Darrell Martin

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Time Frame / Temporal
After implied volatility, the second key input in a mean-reversion strategy
is the periodicity you choose. There are benefits and drawbacks of running
your strategy on varying periods. For example, by running a mean-reversion
strategy on a weekly basis, you may find that a particular market is more
responsive and has a higher return per UoR; however, the frequency of
signals and risk associated with that period can be problematic. Whereas, if
you work off a specified tick chart or hourly chart, then you may run into
consistency problems as markets enter times of varying liquidity. As Jason
Roney impressed upon me and outlines in Chapter 4, one can also
compartmentalize the market into three different geographical segments:
Asia, Europe, and US. It’s possible that during the US session, your mean-
reversion strategies work well, but during the Asian session, they may
struggle as markets suddenly start trending. These are just some of the ways
temporal analysis can be incorporated into a good mean-reversion system.

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Asset Class
Different asset classes carry with them different personalities. For
example, the specifics of what drives the US equity market are different than
what drives the G7 currency markets. These nuances can account for why not
only an asset class may perform well for a strategy but also the behavior of
individual products themselves. For example, the S&P 500 may respond
differently to oversold conditions than does the NASDAQ 100, and these
subtleties can explain how well a strategy may perform. Therefore, I try to do
as much factor and regime analysis as possible in building out a mean-
reversion strategy.

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Inflection Points
Identifying key prices is another key input in creating a robust mean-
reversion strategy. My last book, One Shot – One Kill Trading: Precision
Trading Through the Use of Technical Analysis, gives a great primer on how
I develop and trade around inflection points. Specifically, I like to use areas
like Support Turned To Resistance (STTR), Resistance Turned To Support
(RTTS), key pivot highs and lows, and Fibonacci levels. I will elaborate more
on this in the Execution section of this chapter.

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Technical Indicators
Running a strategy that looks for markets that have become overbought or
oversold requires that you have some quantitative indicator to measure this.
Standard tools used in the industry for this range from stochastics, Williams
percentR, Commodity Channel Index, and the McClellan Oscillator. As you
saw in Figure 14.1, even the most basic of these indicators applied in the
right regime can produce lucrative results. Therefore, while I want to create
the most robust technical factors giving me the best chance of making money,
your regime assessment will likely play the biggest role in your profitability.
I have integrated two indicators into my mean-reversion systems. Those
proprietary indicators are the Trend Reversal Index (TRI) and Joe DiNapoli’s
DeTrended Oscillator. DiNapoli, author of Chapter 10 and creator of the
DeTrended Oscillator, has one of the most dynamic overbought/oversold
indicators I have ever used. As it is proprietary to him and his clients, I am
not at liberty to disclose the specific inputs. However, the idea behind
DiNapoli’s DeTrended Oscillator is simple and robust. He looks to measure
the overbought and oversold nature of any market relative to its own price
action. Both the TRI and DeTrended Oscillator are written about extensively
in my first book, One Shot – One Kill Trading.

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Sentiment Indicators
Measuring market sentiment is another indicator important to a variety of
mean-reversion strategies. Indicators like the VIX, Risk Reversals, CFTC
Commitment of Traders Reports, and Financial Conditions are some of the
sentiment gauges that can be integrated into a mean-reversion strategy. These
sentiment indicators can complement the other technical indicators, thereby
providing extra confidence in a strategy. For example, levels of extreme
negative sentiment that have proven to be turning points in the past may
mean an opportune time to buy an oversold market, while extremes on the
positive side might offer a great opportunity to get short. There are many
nuances to applying sentiment indicators and require backtesting and
contextual analysis to see if they are viable.

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Elliott Wave Count
One of the challenges with many investors is the propensity to apply
trend-following strategies when markets are choppy, and use mean-reversion
strategies when markets begin to trend. In Chapter 11 on Elliott Wave
analysis, Todd Gordon outlined how to use a wave count as one of the many
technical filters to understand the likelihood of a market to trend or mean-
revert.
Therefore, the final input I will cover in creating a strong mean-reversion
strategy is the Elliott Wave Count. Markets that are in the third wave of a
five-wave move higher are not my prime candidates to run a mean-reversion
strategy. I tend to avoid using mean-reversion strategies in markets in wave-
three patterns. As outlined in Chapter 11, markets in wave three of a five-
wave sequence are usually trending strongly and are less likely to sell down
from high extremes or rally from low extremes. However, markets that are in
the midst of corrective patterns are the ones I give a higher probability of
success as it pertains to a mean-reversion strategy.

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Execution
There are numerous aspects that go into how well one monetizes the
signal of a mean-reversion system. As compelling as a system may look
when backtested, execution in real time is the brass tacks. While I have gone
over specific inputs that form the base of a mean-reversion strategy, here are
some common elements that help determine the final level of exposure. At
this point in the book, it should surprise no one that I have a scoring system
based on the strength and weakness of each of these variables initiated
through the RPF. Here are the variables I score:

Inflection Points
Macro Narrative
Market Positioning
Calendar
Trade Structuring

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Inflection Points
Following up on the Inflection Points section from earlier, having a well-
laid-out technical grid to trade from can be a real value-add in executing a
mean-reversion strategy. The great part of being able to create solid inflection
points is that even if you guess wrong on the regime, by having solid points
to trade off of, you may be able to minimize the P&L damage. For example,
earlier in the chapter in Figure 14.2, I showed an example of where some
“off-the-shelf” mean-reversion strategies struggled in a market that was going
through a repricing. Let us look at this chart again with the perspective of
providing liquidity at key inflection points. Thanks to Joe DiNapoli’s
Fibonacci levels, Bill Glenn’s market profile work, and Todd Gordon’s
Elliott Wave analysis, I am able to create an excellent technical grid of where
markets are likely to react.
Once an inflection point grid is created, I can synchronize those points to
potential entry signals. As a result, instead of taking the signal blindly, I can
overlay this on my inflection point grid. This way, even if the regime is going
through a repricing—an environment poorly suited for mean-reversion
strategies—the strategy may nonetheless have a chance to survive. By using
these key inflection points to provide liquidity, if the position does not go in
your favor, in many cases the damage can be minimal as the market may
simply consolidate there or even put in a small bounce. Whereas, if you wait
for “confirmation” from those points, then you could be putting yourself in
position to be buying a rally that others will be selling.
Look at the euro chart below in Figure 14.9 from October 2014. The
potential entry points are Fibonacci extensions that could represent support of
the move lower. Some of my mean-reversion systems work from Fibonacci
levels. These levels are great for structuring options and defining one’s risk.
Whereas all of the mean-reversion systems shown in Figure 14.3 lost, by
providing liquidity at key levels, you can put yourself in a better position to
win.
Referencing Figure 14.9, you can see it took over four weeks for the euro
to work its way past those Fibonacci support levels while providing multiple
bounces to either delta hedge or take partial profits. Even if the trade did not
make money, having this strong technical background can dramatically alter
how a good mean-reversion strategy in a bad regime can at least tread water

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until the regime changes to be more conducive to it.

Figure 14.9

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Macro Narrative
As I showed in the two examples at the beginning of the chapter,
understanding the macro narrative of each asset class goes a long way in
assessing if there is a repricing in a market. The euro was in the midst of a
repricing against the dollar, which was not an environment conducive for
mean-reversion strategies, while the S&P 500 was mired in a nasty trading
range with no real catalyst to send it higher or lower. Understanding where
both an asset class is as well as overall risk appetite helps create a stronger
input in the regime profitability factor.

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Market Position
Market positioning and the macro narrative go hand in hand. They are
intertwined and so it only stands to reason that if you are going to put on a
counter-trend trade that understanding how this matches up with the rest of
market positioning will determine how much exposure I use. Chapter 18 will
go into greater detail in the process I use to determine this.

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Calendar
Events, both past and present, play a big factor in how much risk I allocate
to a mean-reversion strategy. If things are relatively normal on the calendar,
then looking to let the strategy run its course is desirable. However, if there
are key events that overlap with a signal, this is a factor in my decision. The
calendar is one more component that cross-pollinates with the rest of the UoR
Process in determining how to execute a trade.

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Trade Structuring
The final piece of the execution puzzle is how I take everything explained
up to this point and incorporate it into the position. As I can tell you from
experience, how I structure my position determines not only if a trade wins or
loses but to what degree the idea is monetized. In the case of a mean-
reversion strategy trade signal, there are multiple ways to accomplish this.
Consistent with any other strategy, the decision one makes on how to
structure the trade is a combination of one’s risk management
philosophy and conviction level. Here are a few examples illustrating how I
can incorporate various tactics to take on exposure.
One of the many mean-reversion strategies I have created focuses largely
on inflection points. In line with the example in Figure 14.4, if the regime
score is right, I typically have preset limit orders at these inflection points.
For example, if I have a compelling macro narrative and a solid set of
Fibonacci Resistance levels at the 122 level on USD/JPY, a price above the
USD/JPY currency that is trading at 120, then I may not only sell at the 122
level, but buy out-of-the money puts down at the 119 level. I would justify
the OTM puts if I were expecting a big reversal. This is done simply by
executing once the 122 price is hit.
Other mean-reversion systems I have, such as the one powered by the
Trend Reversal Index, wait for confirmation of a reversal from an extreme
level. Therefore, in the case of the USD/JPY, 122 may be the level I am
looking to sell; however, if I do not get a reversal signal from the TRI in that
area, then no trade is taken.
Lastly, as Neil Azous explained in Chapter 12, “Using Options to Trade
the Macro Narrative”, I love using the three-dimensionality of options to take
on a viewpoint that a market is at an extreme condition. This may mean
selling a calendar spread or vertical spread based on the dynamics of the
signal and other corroborating factors.
In the end, with nearly every trade I take, there is always a qualitative
overlay that goes into deciding how the final exposure will be comprised.
My final point on trade structuring is one that all investors, from the
beginner with just a small account to a seasoned money manager running
billions, would do well to remind themselves. As I have reiterated throughout
this book, I am an incremental trader who tries not to be “all in” or “all out”

650
of a trade, market, strategy, manager, or portfolio. Incrementalism is the key
and mean-reversion strategies are no exception to this rule. Being incremental
takes a lot of pressure off you to feel the need to be binary in all trades, and
perfect in all decisions. You would be surprised how many of those trading
large assets are in an all-or-nothing mindset toward position sizing. I am
sympathetic to this mind-set as special moments require increasing
concentration, but at the end of the day, as professional traders and
investors, we are trying to reduce noise, not empower it.

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Conclusion
Mean reversion is a vibrant part of the Protean Strategy and underscores
how with some work you can improve your chances of constructing a
portfolio that generates an excellent return per UoR. Like any strategy in the
UoR Process, there are subtleties and differences that can have a dramatic
impact on the final performance. It is important when examining what types
of mean-reversion strategies may be appropriate for you that you spend the
time either understanding your own strategies or vigilantly examining these
issues as they occur in a third-party’s strategies.
The inputs and iterations of many mean-reversion strategies can be as
complex or as simple as one deems appropriate. However, since I usually
look down before I look up, the two biggest things worth focusing on in mean
reversion are the incorporation of regime analysis and the position-sizing
philosophy. The Global Macro Edge and the contents of this chapter have
given you a great primer on understanding the pitfalls and benefits for a
mean-reversion strategy.

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CHAPTER
15

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 Finding the Follow-Up Trade
to a Catalyst Event
On a Saturday afternoon in October of 2008, I was enjoying an afternoon
lunch date with a beautiful young lady. She was fascinated with trading and
wanted to hear all I could offer up on currencies, options, and trading the
recent market volatility. However, as cool as the conversation was, showing
her my digs where the “trading magic” happened would be far more
instructive. The perks of trading in an office with a Madison Avenue
address were undeniable.
Since it was already 4 PM on a Saturday, the odds of anyone being on my
floor were slim. After arriving, my suspicions were confirmed that we had
the place to ourselves. I was doing my best to impress her without appearing
to be trying. I turned on all eight screens and showed her the software tools I
was using to attack the markets. It had quickly turned into a date between two
market nerds, and in this case the ingredients for Love Potion Number Nine
were my CQG charts.
Our penchant for market geekery would have continued, but the doorway
down the hall opened and we found that we were no longer alone. I wasn’t
sure of the extent to which using the office as a venue for romance was
frowned upon, so thinking quickly I did what seemed to be the only logical
thing: hearing footsteps, I told my companion to hide.
Sure enough, sauntering down the hall to say hello came a trader I will
call “Ryan.” We had conversed on a number of prior occasions and I had
always been impressed with his thoughts. Ryan was a brilliant, well-read, and
ambitious analyst for a European hedge fund in an adjacent room on my
floor. Given the carnage in global markets, he felt that coming into the office
at 6 PM on a Saturday evening was a good use of time to stay ahead of the
game in the fall of 2008.
On any other occasion, I would have been intensely interested in Ryan’s
thoughts on the Volkswagen/ Porsche soap opera which was unfolding in
Europe. As it was, I fidgeted nervously as he embarked on a passionate
exposition of his views on the automakers’ saga. The irony was that Ryan,
who was so perceptive about financial markets, could not tell how distracted I
was during our conversation!
Ryan has always been a piece of my network who brought a completely

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different viewpoint on how the market works. His perspective on things from
a micro level in a range of niche industries is something I have always valued
as a high-velocity macro trader.
Our conversations and debates have always left me knowing more than I
did before, even if the knowledge was acquired at the price of a few awkward
moments. Ryan’s international upbringing and top pedigree afford him
invaluable insights when it comes to looking at what trades are setting up
across the Atlantic and around the world.
It is this perspective that is a useful adjunct to capturing the global macro
edge. While the Protean Strategy is fluid, versatile, and adaptable to many
situations, having a rich network of market practitioners executing different
strategies offers valuable inputs to my decision-making process. Ryan’s
specialty is what he terms Supply Chain Trading: understanding how certain
events can create opportunities for price discovery in companies either
directly, or indirectly, related to the catalyst in question.
This bottom-up approach can yield useful insights for how to think about
markets, even for a top-down macro trader or investor. In my conversations
over the years with Ryan, I have learned the importance of avoiding a
dogmatic adherence to top-down analysis and to blend bottom-up insights
into my investment process. This flexibility is the essence of the Protean
Strategy.
The process of connecting the dots of how macro events affect specific
sectors and companies on a micro level requires foresight, discipline, and
preparation. Ryan was kind enough to open a window into his investment
universe for me through multiple interviews and years of collaboration. In
this chapter, I will endeavor to walk you through Ryan’s world so that you
can put the same processes in place for your own portfolio. In turn, this can
serve as a roadmap as you attempt to assess the impact of event
risks/catalysts on your own portfolio and holdings.

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Overview - Sector and Supply Chain Trading
Formally, supply chain trading (SCT) is an equity-based strategy that
takes positions in companies that may be impacted by a major event. Each
event brings with it unique aspects requiring a qualitative understanding of
the companies involved. These aspects make it challenging for algorithms
and the market to instantly reprice things accurately, therefore creating the
opportunities for this strategy.
In actuality, SCT can incorporate aspects of pure event-driven trading,
trend-following, mean-reversion, relative-value, and value investing. Just as
equity indices are not monolithic indicators of equity market performance
(i.e., there is an alpha component to constituent companies’ returns, as well
as a market beta), the sensitivity of individual securities to market
developments or events may depend on idiosyncratic factors unique to a
sector or corporate level. In this sense, it is vital to deploy a full analytical
toolkit rather than rely on just one or two techniques.
With many macro events, there is the “sledgehammer” or knee-jerk
reaction that immediately prices the most obvious implications into markets.
Trading this initial reaction is a part of other aspects of the Protean Strategy
but not where the value is derived from the SCT strategy.
An example of SCT can be observed in the oil patch; in early 2016, OPEC
has repeatedly refused to trim production despite obvious levels of
oversupply and collapsing prices. The first-order reaction in this case is to
sell those companies that are directly involved with exploration, extraction,
and sales of oil. What SCT does, however, is to ask what are the implications
of this decline in the price of both crude and associated companies on other
industries and sectors?
In Ryan’s case, he might look at how oil exploration was funded—via a
combination of debt issuance and bank lending. What is the maturity
schedule of this debt? Who made the loans/owns the debt? This second-order
analysis might lead him to another sector, say, banks (who make loans) or
asset managers (who own high-yield bonds). Within these sectors, there is
another order of analysis: are some regions of the world more acutely
affected than others? Clearly this is the case. He can then drill into a fourth
order of inquiry: which institutions are most heavily exposed to those firms
least likely to pay, be they North Dakota frackers or Russian equipment

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makers, and has the impact of the macro development been adequately
priced?
An important component of trading successfully is handicapping how
others will react to an event, and Supply Chain Trading is a quintessential
embodiment of this idea. In Chapter 18 on market positioning, we will
explore how this understanding of market dynamics puts traders in position to
deploy their risk units in a more efficient manner.
One of the important building blocks of a SCT trading strategy is to create
schemata for outlier events. While the actual events rarely, if ever, mirror the
exact template that you’ve planned for, having a basic playbook gives you a
good starting point to adjust to actual situations. It’s far better to be on the
front foot, executing a predetermined plan, than to scramble with the rest of
the market to react to events. This principle holds across a range of strategies,
many of which bear no resemblance to Supply Chain Trading.

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Strategy Characteristics
It is a universal principle in nature and in markets that the more
competition one faces, the more difficult it is to attain one’s goals. One aspect
of Ryan’s investment philosophy that he feels particularly strongly about is
the benefit of carving out a specific niche or segment and striving to become
the best within this narrow area of focus. While the idea of finding an
unpopulated investment universe may not be relevant to many macro traders,
the concept of identifying and focusing on one’s relative advantage or edge
applies to every successful investment strategy.
The Supply Chain Trading methodology tends to display little correlation
to broad markets, for the simple reason that it is an event- or catalyst-driven
strategy that attempts to profit from price action that has little to do with
general market trends. As such, the potential risk/reward of a position is
primarily driven by the catalyst in question rather than the overall tenor of the
market.
An important aspect of the strategy is that investment decisions are made
based on factors other than deep-dive fundamental knowledge of the
companies in question. Because Ryan and his team know that they are not the
most knowledgeable players in the stocks that they take positions in, there is
very little temptation to fall in love with a particular company or trade, and
thus there is little reticence to jettison a position from their portfolio that has
not worked or reached a profit threshold. I have found the ability to remain
dispassionate about specific trades or markets to be vital to the success of the
Protean Strategy; it is difficult to adapt, to shed one form and take on another
if you fall too hard in love with one of them.
Another key factor in the SCT methodology is the length of time that one
allows a trade work. Given that the entire basis of the strategy is that markets
are inefficient in pricing the impact of catalysts, trades do need some time to
develop. Generally speaking, the further down the chain of logic you go, the
longer it takes for markets to react. On the other hand, if a position is given
too long to work, there is a good chance that factors unrelated to the trade
may drive price action. The notion of using time as well as price to inform
risk management decisions is an important one that applies to a broad array
of strategies.
When using time stops, it is vital to have the experience to judge how

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much rope one should give a trade. A week may be far too long to give a
trade predicated on a knee-jerk market reaction, while a few hours may be too
short for a position that requires a few chains of logic to connect the dots. For
Ryan’s group, the average time stop is a couple of days. Of course, there are
times when the market only reacts after a position is exited; while this
naturally can be frustrating, the opportunity cost of trusting and sticking to an
investment process pales in comparison with the potential cost to financial
and mental capital from keeping positions indefinitely.

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Investment Process
Based on my conversations with Ryan over the years, I have gained an
appreciation for how he and his firm apply the Supply Chain Trading
methodology. It follows a fairly linear chain of steps, which we’ll examine in
greater detail below:

1. Screen for the catalyst

2. Identify the catalyst
3. Identify the read across sectors and markets
4. Selection of relevant stocks
5. Assess consensus view of stock vs. catalyst
6. Evaluate profit potential and stop loss
7. Execute
8. Monitor reception of catalyst
9. Exit via stop loss or profit taking

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1. Screen for the Catalyst
To run an SCT strategy properly, you need to be a massive information
junkie. Not only do you need a general level of knowledge about economic
linkages across geographies and sectors, but you also need to scour the world
for potential catalysts and events that might move equities. A top-notch news
and data terminal such as Bloomberg or Reuters is helpful in this regard, as it
provides reams of both general news and company-specific information.
Keeping abreast of the global financial press is de rigeur, as is reading
research from sell-side firms and research boutiques to understand the
specifics of different companies and industries. Monitoring social media such
as Twitter is also a must, as oftentimes idiosyncratic news appears there first.
All of this serves as background work for creating an investable universe
of sectors and companies, with monitoring charts mapping out a web of
suppliers, distributors, competitors, and an assessment of how each will affect
the others in the event of various catalysts hitting one of them. The charts
serve as the basis of a playbook in the event of a catalyst, and are constantly
expanding as more research is done. If this sounds time consuming, it is…
which is why Ryan’s strategy occupies such a special niche in the investment
universe. That being said, the principles involved can also be applied to top-
down macro strategies, particularly given that monitoring global news flow
and understanding global linkages and inter-relationships are an important
part of macro trading. At the end of the day, the successful application of
Supply Chain Trading is both art and science. It requires an experience of
understanding how animal spirits can potentially react to a given situation.
In the equity space, some of the catalysts that Ryan commonly screens for
include the following:

Analyst change of view

Earnings announcements
Market participant change of view
Conflicting interpretations of an event
Competitor comments
Geopolitical event or natural disaster

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2. Identify Catalyst
It is clear that not every incremental piece of news flow will affect
markets the same way. Because I have an analytical mind, as evidenced by
Chapter 5 on UoR ratios, and like to formalize inputs into my investment
process as much as possible, I like to look at potential catalysts through the
prism of what I call a “reaction ratio” to assess their significance. My
relationship with Ryan and his team was a strong catalyst for me creating the
reaction ratio. The components of the reaction ratio are as follows:

1. Relevance – Is this a subject the market cares about? Graded 1–10, with
10 being the most relevant
2. Timing – Where is this news in its life cycle? Graded 1–10, with 1
being the earliest and 10 the latest
3. Scope – How broad is the impact of a potential catalyst, in terms of the
range of markets and supply chains that are affected? Graded 1–10 with
10 being the broadest impact
The formula for the reaction ratio is simply
The higher the ratio, the more significant the catalyst. For Ryan’s equity
strategy, understanding the importance of, say, one analyst’s opinion versus
another’s is a vital component to successfully identifying catalysts. This feeds
back into the preparatory work mentioned in the previous section. While
Ryan may not use a formulaic approach like the reaction ratio, the philosophy
in terms of assessing relevance, scope, and timing is largely identical.

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3. Identify Read Across Markets and Sectors
Once a potential impact has been identified, the next step is to get a read
on how it will reverberate across various markets and sectors. It is at this step
that the monitoring charts can be consulted.
For example, in 2011 there was substantial flooding in western Thailand,
which seemed likely to close a number of manufacturing facilities there.
Although there was not necessarily a specific sector that was affected, in this
case it was important to get a read on which firms did a substantial amount of
manufacturing in the region, and had close competitors that did not.
In this case, HDD maker Western Digital had a large factory in the
flooded region while competitor Seagate Technology (symbol STX) did not.
Although it took some time for the Western media and analysts to
comprehend the severity of the flooding, once they became aware of it, the
market reaction for Seagate Technology was substantial (see Figure 15.1).

Figure 15.1 Seagate Technology

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4. Selection of Relevant Stocks
Once a catalyst has been identified and general impact established, the
next step is to sift through the universe of relevant stocks to home in on
potential trade targets. There are many ways to do this, with the easiest
probably being the SPLC function on Bloomberg (see Figure 15.2). Pulling
up a stock and then entering this command will generate a schematic of the
firms that have some sort of relationship with the company in question.
Below you can see the example of Apple, with its major suppliers shown
to the left, its customers to the right, and competitors down below. A report
that Apple is experiencing a slowdown in handset sales would have
implications for future orders from those firms on the left, suggest already
slowing sales from those on the right, and likely result in a similar outcome
being priced for those down below.

Figure 15.2 Supply Chain Analysis on Bloomberg Terminal SPLC <GO>

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5. Assess Consensus View of Stocks vs. Catalyst
When trading a catalyst-driven strategy, understanding the consensus is
absolutely critical in forming a realistic assessment of how profitable a trade
may be. Like other aspects of modern markets, it is clear that the street learns
and evolves to become more efficient at pricing new developments. It seems
that every year the market gets smarter, particularly given how technology
can now disseminate news so quickly. These days you have to be quick on
the draw to put on a trade, particularly one that is only one or two chains of
reasoning long, before the market factors it into the prices. Once again, this
reinforces the importance of proper research and preparation.
A clear example of how this has evolved was when the Fukushima
earthquake hit Japan on Friday, March 11, 2011. When Europe and the US
awoke to the news that a powerful earthquake had hit off the coast of Japan,
it first appeared that the resultant tsunami would generate some coastal
flooding and nothing more. However, by lunchtime in the US (long after
Tokyo markets had closed for the day), it became apparent that a nuclear
facility might be impacted, with potentially serious repercussions.
On that day Ryan and his team spent much of the morning brainstorming
with a whiteboard, mapping out the web of vulnerabilities from the tsunami
and a potential nuclear incident. As it started to emerge that the power plant
may be impacted, their line of thought naturally gravitated toward those
sectors that are part of the nuclear power supply chain. The market for the
company most obviously affected, TEPCO, was already closed. But any
serious nuclear incident would also have implications for other nuclear
utilities, uranium producers, or nuclear plant producers.
At this point, the stock of some uranium miners had not really moved; the
consensus had not connected the dots. There was therefore an asymmetric
opportunity to short companies like Camco and Paladin Energy, who are
prominent uranium miners. Over the weekend the severity of the tsunami’s
impact upon the Fukushima power plant became evident, and by the time
markets opened on Monday there was a gap move in the relevant companies,
such as Figure 15.3 below, for Camco. Had Ryan and his team not moved
quickly and established a position before the close of business on Friday, they
would have missed out on a substantial profit opportunity.

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Figure 15.3 Chart of Camco

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6. Evaluate Profit Potential and Stop Loss
As with any strategy, it is important to incorporate risk management early
in the trade process. In the case of SCT, it is useful to have an idea of how
big a move to expect if and as the market prices in the impact of a catalyst.
This entails sifting through a broad range of inputs, starting with a thorough
evaluation of market technicals for specific stocks, sectors, and the general
market. For example, in the autumn of 2008 a positive earnings catalyst
would still not have offered an attractive opportunity thanks to the
overwhelmingly negative tone to the broad market.
It is also useful to examine how comparable stocks have traded to similar
catalysts in earlier episodes. There’s no point hoping for a 30 percent rally on
an earnings upgrade if similar instances have only generated a 5 percent
boost in the past. As noted earlier in the chapter, it is also important at this
juncture to identify how long to give the market to pick up on a catalyst and
price it accordingly.
Identifying a reasonable price target, an acceptable risk budget, and a
realistic time frame for the trade to work then allows you to identify how best
to implement the trade. Is it a straight long or short in a single name? Can you
do a spread or pairs trade to mitigate the impact of market beta? Does it make
sense to articulate the view through options? Ultimately, this step is about
maximizing your potential return per unit-of-risk.

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7. Execution
To a large degree, execution comes down to the preference and expertise
of the trader or portfolio manager. Many equity managers, including Ryan,
prefer a mechanistic approach using TWAP (time-weighted average price) or
VWAP (volume-weighted average price) over a given window.
Macro traders in more liquid instruments may prefer to get a position on
in a one-shot trade, or benchmark themselves against a time-stamped price
and use their tactical trading acumen to improve the entry level. It all comes
down to one’s mind-set and ability, and to have a plan for getting in (and
out). What you don’t want to do, however, is leave hopeful limit orders in the
market without a backup plan, only to see potentially profitable trades start
moving without you because you were trying to save a few pennies.

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8. Monitor Reception of Catalyst
After a trade is established, it is, of course, important to monitor how the
market comes to grip with the catalyst. This is a function not only of price but
also of narrative: if no one is talking about an event after it has become public
knowledge, it’s unlikely to move the price.
Ultimately, after establishing a SCT trade you need to keep tabs on

Whether the street is talking about the event;

Why the market is reacting or not reacting;
How much price has moved in relation to the volume of narrative; and
How the narrative around the catalyst is evolving.
All of this provides real-time feedback and increases (or decreases)
confidence in how the market will trade moving forward.

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9. Exit Via Stop Loss or Profit Taking
The key to a successful trading strategy, be it Supply Chain Trading or
something completely different, is maximizing return per unit-of-risk. In step
6 above, I mentioned the importance of establishing a game plan for exiting a
position, and it is vital to adhere to that plan.
Particularly in the case of SCT, trades cannot and should not become
investments; a position is taken for very specific reasons, and if the market
demonstrates that those reasons are largely irrelevant, the entire raison d’être
for the trade becomes moot and it should be ejected from the portfolio.
It goes without saying, of course, that a successful SCT strategy represents
a series of bets that are skewed asymmetrically in the trader’s favor. It is okay
to lose on a trade as long as that loss is manageable in relation to the typical
profit setup; Ryan has noted to me that his hit ratio is actually low, but
because he takes losses quickly and painlessly, they pale in comparison to the
magnitude of his winners.
In a sense, the reason for putting a trade on can be almost irrelevant; a
trader who can manage risk well and adhere to a strict regimen will, over the
long run, generally be successful. Sometimes profits are taken too early, and
sometimes a time stop hits before the market prices the catalyst. These
episodes can be frustrating, but at the end of the day, a robust risk framework
that combines small losses with large winners should generate a superior
return per UoR.

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Further Examples
Two more short examples may further illustrate the process of Supply
Chain Trading. In the autumn of 2011, Hurricane Irene hit the Northeast
corridor of the United States amongst a great deal of clamor but relatively
little actual impact. Nevertheless, at the time Ryan and his team did a full
workup on the economic impact of such an event, placing trades such as long
homebuilders in the event of a significant hit to the regional housing stock.
Although the trades didn’t work, they now had a completely workable game-
plan in the event of a similar event occurring.
Fast-forward 12 months, and Hurricane Sandy formed in the Caribbean
before turning north and hightailing it up the East Coast of the US. As soon
as it became apparent that there was a chance of landfall in densely populated
areas, Ryan and his team were able to dust off their playbook and, because
they were well-prepared and early, place a few first- and second-order trades.
A week and a half before Sandy hit the New York area, they went short
Chubb, a premium insurer with substantial exposure to residential property in
the Northeast. Because they were well-prepared and early, they could pick
the low-hanging fruit only a link or two down the supply chain, with steadily
profitable results (see Figure 15.4).

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 Figure 15.4 Chart of Chubb
Earlier we explored the impact of the Fukushima earthquake, citing the
example of going short uranium producers on the day of the event as a
second-order trade that worked well. What about going further down the
supply chain? These are the sorts of questions that one may have asked in the
aftermath of Fukushima:

In the event of a nuclear incident, what would be the likely reaction

amongst regions most marginally attached to nuclear power?
Clearly it would harden the opposition to nuclear as an energy source.
What region(s) would likely to be impacted this way? Germany has
had a long history of protests against nuclear power, yet in 2010 derived
nearly a quarter of its energy needs from nukes.
What would be seen as an alternative to nuclear power? Insofar as
much of the German opposition to nuclear power had been
environmental in nature, alternative energy sources seemed a likely
beneficiary of any move away from nuclear.
This is the sort of reasoning that Ryan and his team sifted through over the

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weekend after Fukushima, concluding that solar energy as a sector was likely
to benefit from concerns about nuclear power. From there it was a case of
drilling down into single-security specifics, where they found SMA, a
German-listed solar energy firm that also had a large short interest. This was
an attractive additional factor: there would be pressure on shorts to cover in
the event of a rally, adding a further upside impulse.
Ryan’s team went long SMA on Monday’s open following the
earthquake; by this time the severity of the crisis affecting the Fukushima
nuclear facility was evident. They realized 5 percent in a couple of hours (see
Figure 15.5); although the stock generated further upside thereafter, they
stuck to their plan and moved onto the next trade. In this case, putting in the
research to determine a fourth-order trade generated quick profits with no
drawdowns—everyone’s favorite type of trade!

Figure 15.5 Chart of SMA

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Challenges Facing Traders/Investors in Supply Chain
Trading Strategies
For global macro traders looking to incorporate a Supply Chain Trading
framework into their existing investment process, the lack of an opportunity
set at any given time is not a particularly onerous challenge, because there are
other aspects of macro trading that they can fall back on.
For those strategies exclusively pursuing an SCT methodology, the lack of
opportunities can become problematic. While it is certainly the case that one
cannot just sit back and wait for a catalyst, proactive research and scenario
analysis form a bedrock of the strategy. By the same token, accepting
marginal trades into a portfolio may derail the long-term return profile of the
strategy.
Another risk around quiet periods is to attempt to broaden the strategy too
aggressively by expanding into many market segments at once. It should be
clear that this is a very research-intensive process, and there is capacity
constraint in terms of the volume of high-quality research that an individual
or small team can get through. Spreading oneself too thin in an attempt to
broaden the investment universe too quickly will reduce the quality of the
inputs, with a predictable impact on the output.
For equity-specific strategies such as Ryan’s, an obvious risk is that
catalysts other than that being traded upon dominate price action.
Idiosyncratically timed profit warnings, for example, can derail even the most
elegantly planned trades, all the more so if they occur outside of trading
hours, thus introducing gap risk into the portfolio.
More generally, SCT faces the same sort of headwinds that most other
investment strategies do. Occasionally, big-picture trends dominate the
signals deriving from isolated market catalysts. This was as true for anyone
trying to trade a bullish European fixed income view during the 2013 Fed
“taper tantrum” as it was for bullish equity signals in the autumn of 2008.

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Characteristics of a successful SCT strategy
Ultimately, the success of a Supply Chain Trading strategy depends on the
quality of its investment ideas and the quality of its execution and risk
management. In this, there is little to distinguish it from other discretionary
trading methodologies. The path that SCT takes to arrive there requires a
heavy investment in research and scenario analysis, as well as the mental
fortitude to adhere to a risk management framework. This is particularly
important when it comes to knowing how much rope to give a catalyst to
impact the market, which is as much art as it is science.
More specifically, a successful SCT strategy will have a research edge,
not only in its ability to build supply chains and connect the dots, but also in
its ability to synthesize the impact of catalysts upon the market due to factors
like positioning, technical, general market environment, etc. Comfort with a
broad array of derivative strategies enhances the implementation of trades by
allowing portfolio managers to maximize the expected return per unit-of-risk.
In evaluating an SCT strategy, an investment team that ticks all of the
boxes will typically generate a high Netto Number. Although the hit ratio of
their trades may not be particularly high, you should see a clear skew toward
large winners and small losers. A good investment team should be able to
define their edge, not only philosophically but also specifically in terms of
geographies, sectors, etc. Finally, because this is ultimately a fairly simple
strategy in terms of portfolio construction, a good SCT manager should be
fairly transparent, and thus able to provide high-frequency updates about
positioning and risks to investors.

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Conclusion
It may seem odd to include a chapter on a niche equity trading strategy in
a book on global macro trading. While the Supply Chain Trading
methodology is interesting in its own right, however, there are very real
applications for the top-down global macro investor. There are a number of
cases where trading top-down instruments incurs the type of single-security
or sector risk that SCT routinely deals with.
The European equity complex is a perfect example of this, where in many
cases benchmark indices comprise a much narrower range of constituents
than the S&P 500. The EURO STOXX only has 50 members, for example,
while the DAX has just 30. You might think that you are taking a view on an
entire region or country, but in fact, there is significant exposure to
idiosyncratic risks to a single company or industry.
This is particularly the case in instruments like dividend swaps, which
allow traders to make bets on the level of dividend payouts (in index points)
of and index like the EURO STOXX 50 in current and future years. On the
face of it, these are a macro investor’s dream; payouts are highly correlated to
growth and earnings, and if you get your forecast correct you are guaranteed
to get paid out at the maturity of the contract. However, because of the
narrow range of companies in the index, they can incur significant adverse
mark-to-market moves in the event of dividend cuts from large payers and/or
stress on a given sector.
Although no individual bank is among the largest dividend payers (in
terms of contribution) in the EURO STOXX 50, collectively the financial
sector represents something like 30 percent of all payouts. As such, there is a
very strong correlation in mark-to-market price action between the banking
sector and the dividend swap market. Figure 15.6 shows price action in the
December 2018 dividend swap and the SX7E banking index; note that the
lowest annual payout between 2008 and 2015 was 109.8 index points, in
2013. Observe how price action in the banks index can drive the dividend
swap below most reasonable estimates of eventual payout. To generate a
solid return per unit-of-risk in these instruments, therefore, it is imperative to
remain on top of developments in the financial sector using some of the
techniques described in this chapter.

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 Figure 13.6
More generally, however, in this chapter we have sketched out a
methodology for dealing with catalysts, both expected and idiosyncratic. It’s
clear that an average macro trader isn’t going to perform the same depth of
general research that a dedicated SCT manager will, simply because it isn’t
an efficient use of resources. However, when one has a big position and/or
there is a significant event risk on the horizon (economic data/central bank
meeting/multilateral summit), the techniques described in this chapter can
help the macro investor be proactive in determining a game plan to deal with
the situation.
If you can execute a well-conceived analytical and risk management game
plan while others are merely reacting or losing their heads, then you’re well
on your way to capturing the Global Macro Edge.

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 PHASE III

IMPLEMENTATION

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CHAPTER
16

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 Diversification Isn’t Enough –
Spotting the Paradigm Shift –
Bob Savage
With a professorial stride, Bob Savage walked to the head of the room. He
carried a dry erase marker in one hand and a single index card in the other.
After a brisk once-over of the assemblage, he looked down and read
verbatim: “In determining how long to maintain a highly accommodative
stance of monetary policy, the Committee will also consider other
information, including additional measures of labor market conditions,
indicators of inflation pressures and inflation expectations, and readings on
financial developments.”
The attendees sat silent and pondered…
“Why is this important?” Bob asked, playing maestro to the orchestra of
hedge fund managers, traders, and economists at the December 12, 2012
Track.com Idea Dinner. (My initial thought was this was more nonsense Fed
talk. I was more concerned with getting back to the West Coast in time to
avoid the New York City winter freeze.) “This is the first salvo, albeit subtle,
in the Fed shifting to a data dependency model that is not currently priced
into the market,” he continued. Now we were onto something. If Bob’s
assessment was correct, this was going to have profound implications—not
only on fixed income, but on the entire macro ecosystem. To a short-term
discretionary trader, it appeared Christmas had come a little early.
In December of 2012 and January of 2013, the Protean Strategy (see
Chapter 3 performance) made great risk-adjusted returns. A material factor
in this was being short Treasuries and benefiting from a steepening yield
curve.
One of my biggest challenges when attempting to maximize return per
unit-of-risk is to stay in sync with the changing macro drivers that influence
markets. One of the reasons risk models can underperform is an overreliance
on historical correlation and historical volatility. Diversification based on
trailing data only works when correlations remain stable. As outlined in the
performance in Chapter 3, the Protean Strategy experienced a high degree of
success incorporating anticipatory, qualitative tactics in measuring why
correlations between strategies can fluctuate. Based on these assessments, I

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am in a position to adjust my exposure accordingly.
Track.com has become an important input for the Protean Strategy for a
few reasons. The Protean approach combines a number of non-correlated,
risk-controlled strategies that may be responsibly leveraged. One of the
biggest threats to its performance occurs when these strategies become
more correlated than their history would suggest. This can lead to increased
volatility, putting greater pressure on the strategy during periods of
drawdown. Therefore, it is critical to have risk assessment be more than just
backward-looking performance metrics.
As we stated in the Introduction to this book, diversification is not
enough. True diversification is not a set-it-and-forget-it act, but an ongoing
process that evolves with the market. I found great success by blending
traditional risk measurement tools with qualitative aspects of the market. The
best risk models are the perfect combination of art and science.
This is where Track.com comes in—Bob Savage is a true market artist. He
is a thought leader who uses his website, Idea Dinners, and a lifetime of Wall
Street contacts to stay on top of macro drivers. He not only identifies the ones
that can affect market conditions, but also those that may change a number of
the historical relationships that comprise the market ecosystem. After the
fact, nearly everyone can tell you why something happened. Bob is part of a
select few who can consistently alert you to what is about to happen. He is a
repository of information, insight, and authentic perspective, shared every
morning on the pages of Track.com. Not only does Mr. Savage persuasively
articulate the drivers in the global macro space, but also he thinks like a
trader and streamlines large overarching themes into actionable investment
ideas.
Along with the daily alerts to potential macro catalysts provided by the
Track.com website, one of the most valuable aspects of my relationship with
Bob and Track.com is the ability to participate in their monthly idea dinners.
Bob choreographs this event and brings together everything necessary to let
great trading ideas flow: a talented pool of market practitioners, a
provocative host, a first-class venue, and, most importantly, ample amounts
of wine.
A driving factor in the Protean Strategy for achieving true diversification
is my relationship with Bob and Track. com. It is a relationship that helps me
stay on top of market positioning. This happens by understanding what trades
market participants are initiating, modifying, or exiting. Trade outsourcing is

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a huge part of what Track. com does. Constant exposure to an array of trade
ideas helps provide context to where a particular trading idea may be in its
lifecycle. As articulated throughout The Global Macro Edge, understanding
market positioning can have a profound impact on one’s trading P&L.
—John Netto

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Forward-Looking Risk Measurement

Bob Savage’s Overview of Track.com and Trade

Outsourcing
“Early in my career, a risk manager at Goldman Sachs mandated I have a
notebook. I had to keep a running journal of every trade idea before I would
be allowed to initiate a position. In addition, I needed to come up with five
economic fundamentals and five technical factors that supported the trade. I
needed to have an entry, exit, and a stop. And more importantly, I had to keep
this notebook more for the failures than the winners. Track.com is an
extension of that notebook.” Bob Savage, Founder and President Track.com
The aha! moment for me as a trader happened in a bar in Dallas. I had
been trading the European currencies in the early 1990s in what had been a
very dull market. The strategy from 1990 to 1992 was a quasi-fixed income
arbitrage play. The risk embedded in this strategy was the ever-present
possibility of a tail event, which would happen if the sovereigns decided to
depreciate their currency when all else failed. In spite of this risk, very few
believed it was likely and the currencies were priced to reflect this.
While sitting in a bar, my cell phone—which was the size of a shoe
(remember, this was the early ’90s)—rang with my boss on the other side of
the call. He began screaming at me about my P&L. I had shorted the Finnish
mark, and he did not understand why my P&L was up by $5 million that day.
That was a significant swing for a trader who had a VAR of $1 million—
enough to get you fired or promoted.
I had made $5 million out of the Finnish mark through a depreciation
trade rather than a fixed income arbitrage play. While I may not have
foreseen such an event when I put the trade on, I sure believed it when the
money showed. It struck me then that the world was going to change
dramatically; that a paradigm shift was about to happen; that these
depreciations could and would happen, and the markets would quickly be
forced to acknowledge it. This was my “aha” moment.
My life changed forever in a spiral of trying to figure out what was going
to be the next biggest leverageable depreciation event. Money is a
barometer for measuring the change in the market risk and reward—my

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P&L from that event woke me up to new opportunities and forced me to
evolve my process for identifying how trades would manifest themselves
in the future.
Paradigm shifts offer tremendous opportunity for price discovery. The
market is collectively trying to reprice what things should be worth. It is
hardly an exact science. Repricing can happen in an instant or over longer
periods.
Following the Finnish mark trade, currency depreciation became the
major theme driving markets for the next 18 months. The currency
cognoscenti were trying to smell out what would be the next domino.
I spend my research efforts trying to capture that moment when the phone
rings and the world that you have known is indelibly changed. Track.com
tries to capture those paradigm shifts—instances when you suddenly
realize that past analysis should be discarded and one has to rethink the
entire composition of the marketplace.

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Challenges with Static Diversification
It is key to define what diversification means to most people and how it is
used in portfolios. If you hold a diverse portfolio of trades, you may have
more opportunities to beat the market with lower risk parameters as
correlation works in your favor. Most investors think diversifying across
strategy, asset classes, and regions will suffice. However, this is only the first
step in the process, as it is insufficient to rely on static diversification rules.
As Herodotus would say—the only constant is change.
Three macroeconomic factors influence why static diversification may be
incomplete:

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Trade Relationships
Trade relationships are key, as they constitute the structural
underpinnings of cross-currency flows between countries.
Factors that drove demand for goods and services in one
decade may not continue to hold. Furthermore, the shift can
occur suddenly and dramatically. We are always changing the
patterns of global trade. Consider the rise in energy and metals
from Indonesia, following infrastructure investment and
development. Alternatively, consider Japan’s attempts to find
access to cheap natural gas, a byproduct of its desire to shut
off nuclear power plants following the 2011 Fukushima
disaster. The effect on global trade becomes enormous, and it
forces a change in the delicate balance of markets. In this case,
the yen, energy, and emerging markets experience tectonic
shifts in their traditional relationships.

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Technology
Technology can materially change past relationships
between global trading partners. The breakthrough in the US
over shale oil is a good example, as the economies of
traditional energy exporters like Russia and OPEC nations no
longer correlate to oil prices like they used to—in part because
the US is fast becoming energy independent. This makes
correlations in commodities and currencies very different than
they were just two years ago.

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Global Imbalances
Global imbalances are fluid, and the nature of macro
dependencies is ephemeral. This affects the flow of goods and
services around the world. For example, the 2008 crisis was
blamed on the US for its over-dependence on credit driving a
housing market bubble. China shared in the blame as its
intervention in the Chinese yuan to prevent depreciation left a
$3 trillion reserve fund that quickly was recycled into US
Treasuries. This kept rates abnormally low. The crisis washed
away both nations’ current account imbalances. Even in 2014,
there were others out of line with the sustainable world.
Germany and Korea, where exports dominate the economy,
had a 6+ percent current account surplus.
Macro drivers are constantly changing and very thematic. They are based
in economic theory. However, you do not need a degree in economics to use
them in your trading and risk management. What you do need is to have
some way of keeping on top of how themes shift and how macro fears
progress to a tipping point. It is these tipping points that present huge
threats to a diversified portfolio.
Track.com has a two-part goal in tracking new themes. Monitoring takes
place on a daily, weekly, and monthly basis. In this tracking process, I am not
only looking for obvious drivers that can disrupt the macro ecosystem but
less conspicuous risks as well. This is important because some of the biggest
risks to the markets are difficult to articulate or quantify. The risks that
do not fit into the traditional ideas of the moment can create asymmetrical
trades and blind spots in a portfolio.
For many years, I was the eyes and ears for big risk takers in the market. I
was only supposed to call five or six times a year when there was a game-
changing event. Today, Track.com tries to do the same thing. I go through
themes and events on a daily basis, reflect on those changes weekly, and
discuss them monthly. This is the basis for keeping traders and risk takers on
top of paradigm shifts so they can adjust their holdings to stay truly
diversified.
While it may appear to be complex, this chapter will illustrate how, with
today’s technology, nearly anyone can understand the process of building and
maintaining a truly diversified portfolio—one that combines the right blend

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of traditional portfolio tools with a rigorous qualitative approach.

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Basic Construction of a Portfolio Risk Model
A portfolio risk model is a tool used by financial professionals to analyze
the performance of portfolios and assess where risk may exist. By
familiarizing yourself with the basic construction of a portfolio risk model,
you will be able to understand where it can help you and in what areas it may
fall short. Whether you build your own or outsource, understanding the
following factors will put you in a position to gain a deeper understanding of
the process and ask the right questions.
Measuring for volatility is the primary input for a portfolio risk model.
Aside from volatility, there are three additional components, all of which
require some qualitative judgment.
The first one is measuring correlation. The second is comparing your
holdings against consensus positioning. The third and final component is
back-testing against the worst of times to understand tail risks.

1. Correlation. Global tactical asset allocation rules suggest one needs

three to four different asset classes to obtain real diversification in a
portfolio. The problem is diversification of asset classes is not enough—
it is really about correlation. How two different asset classes trade
together will shift over time. If everyone believes bonds and stocks are
negatively correlated, then over time, they will tend to become more
correlated just because of the force of positioning.
2. Positioning. There are key problems with portfolio risk models of the
present day—they underestimate the sharp shifts in correlations that
happen frequently. When everyone has the same positions across asset
classes, they can become highly correlated. This is problematic under an
extreme shock event that can lead to outsized moves in both volatility
and correlation. A portfolio truly diversified in multiple non-
correlated strategies can withstand a market of high volatility.
However, because of positioning, many portfolios can exhibit higher
volatility and higher correlation.
3. Back-Testing to Assess Tail Risks. The best approach to measuring tail
risks is not necessarily to run a Monte Carlo model but to use actual
financial history. Go back and see how your portfolio really would
perform under extreme circumstances. This will give you a profit and

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loss feel for the positioning and better highlight the risks of the portfolio.

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Finding the Blind Spots of a Portfolio
A blind spot of a portfolio is a positioning issue that would cause a
huge surge of volatility in the portfolio beyond what is modeled. These
blind spots may happen because of an outlier event, changing correlations, or
a new macro regime. How can one help prevent what appears to be a well-
diversified portfolio from enduring larger than expected drawdowns? The
solution is staying ahead of the curve. This requires both a qualitative and
quantitative approach. The Track.com stress test provides a solid quantitative
framework to begin the process.
Most risk models do a great job when market conditions are “normal.”
People measure trailing indicators quite well. Here are five things that help
comprise a Track.com stress test, which may assist you in assessing a
strategy’s potential blind spot:

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Five Key Factors in a Track.com Stress Test

1. How will it perform in a given volatility regime? Make sure the risk of
the portfolio is tested under low, normal, and high volatility situations.
2. What is the current volatility regime? How does the performance
compare to what you expected? Many times success is an accident and
the real reason for making money was that the expected volatility never
actually happened. Experienced traders will generally reduce risk, even
if it means leaving some upside potential.
3. Which macro factors can change the volatility regime or cause a strategy
performance to shift? Even if the volatility regime is unchanged, have a
list of events to watch. Not only can sharp changes cause a shift, but
they can also alter how potential future shifts will occur.
4. Are those macro factors nonlinear or linear events? Will those factors
cause a major repricing at once or will it be something that happens over
time? The biggest problem for risk managers is time. When some events
occur, it can take a month to recognize the full impact; other events
trigger an instant repricing of risk.
5. What are your assumed correlations in the positions you are holding?
Not all risk is in the asset class—some lies in the overall way each
position acts in the portfolio as a whole. For instance, consider the way
that holding a JPY long position acts against a short Nikkei stock index.
Many assume this is 85 percent correlated. However, this can shift and,
when it does, the risk has to be reduced.

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How Will It Perform in a Given Volatility Regime?
Volatility regimes are critical when assessing a portfolio’s performance.
Some models work well in low- to moderate volatility regimes. In Foreign
Exchange (FX), a low- to moderate-volatility regime is an environment
conducive for “carry” trades. In bonds, such a regime invites playing the
spread between High Yield did AAA instruments. In equities, it is suited for
investing in growth against value. Markets will shift when the story behind
the volatility shifts.
In 2013, the major shift for bonds and FX came when then-FOMC
Chairman Ben Bernanke talked about ending quantitative easing. The biggest
risks in the market were in emerging markets, which saw a considerable
unwinding of positions. The volatility regime shifted dramatically on these
comments, and planning for this is a key component in the Track.com stress
test.

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What is The Current Volatility Regime? Is the Portfolio Performing as Expected?
Along with planning how a portfolio can perform in a given volatility
regime, identifying peculiarities from the performance can be instructive. For
example, the performance of bonds in the first quarter of 2014 exhibited a
high volatility path, which was not what the market expected. Implied and
historical volatility levels alone are insufficient to capture the surprise of the
market. There was no significant shift in US bond yields in Q1 of 2014, but
there was a considerable shifting of the yield curves. Most participants
expected the yield curve to flatten and were caught off guard. The flattening
of the US yield curve led to a number of new second derivative trades. This,
in turn, led to significant stock market rotation plays, caused in part because
of the shift in the cost of money. Factoring these events into your portfolio
construction is critical.

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Which Macro Factors Can Cause the Volatility Regime to Shift?
Having a well-thought-out list of macro events that can change the market
environment is essential. For example, whereas the China PMI is something
the market may pay more attention to in the short term, it is the level of credit
availability that can materially alter the current regime.
Along with a list of macro events, having a historical perspective is a
healthy exercise in understanding what events can alter a regime. This is a
great way to gain a context for what set of economic data may influence price
action. From there you can determine the ongoing risk to each data point and
where the market has the potential to be surprised. This is what helped spawn
the creation of surprise indices.
While there are now many such surprise indices generated by banks for
economic data, the bigger impact of how a particular event or economic
release affects the market is better measured in the world of social and
public media.

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Are Those Macro Factors Nonlinear or Linear Events?
It is not only important to list what events can affect the current volatility
regime, but also to assign a degree of impact, or DOI, around them. The DOI
of a nonlinear event is quite high, as there is potential for a violent repricing
in the market, whereas the DOI of a linear event is quite low and requires a
different trading approach. Therefore, after listing what events can influence
things and assigning a DOI, I delineate them into three groups: primary,
tertiary, and lagging.

Primary – Primary factors give the biggest bang for the buck and pose
an immediate threat to a portfolio. A surprise Fed announcement, a
sudden shift in major economic data, or a geopolitical event are all
examples.
Tertiary - China announcing that Foreign Direct Investment is falling is
an important macro factor over a longer interval, but may not have an
immediate impact.
Lagging – GDP reports are lagging information. Most economists have
already put the components of GDP into their models. The way a market
reacts to lagging data is important because it reveals more about
positioning than about new information.
Below is a list of the top economic releases I pay attention to as of 2016.
This list is an example of how I keep a Top 10. In March of 2016, the below
releases would be an example of primary factors.

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TOP 10 ECONOMIC RELEASES

1. US Unemployment
2. US ISM (both service and manufacturing)
3. China PMI (both CLFP and HSBC)
4. EU PMI flash and final
5. Korea Trade (first to report)
6. Japan Tankan
7. OECD Leading Indicators
8. IMF WEO and updates
9. FOMC forecasts
10. ECB forecasts

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What Are the Assumed Correlations in the Positions You Are Holding?
As evidenced by anyone who was long AUD/JPY in 2007, it can be hard
to keep a portfolio clear of outsized drawdowns, especially if assets believed
to be non-correlated begin to trade as one. I not only run past correlations on
a portfolio to see what historical trends indicate, but also to identify the
biggest drivers behind why those markets are or are not correlated.
The periodicity is critical as well in this exercise. Not only do I want to
see how a portfolio has danced with itself, but also how it has performed over
specific time frames. Sometimes when markets are uncorrelated over a
couple of days, this is simply due to noise of the market. Other times, there
has been a macro shift in sentiment. This is where having a solid qualitative
understanding can substantially complement a quantitative approach.

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Managing Risk Qualitatively
The Track.com Stress Test provides a good quantitative framework to
identify blind spots and preserve the benefits of a truly diversified portfolio.
However, creating a diversified portfolio requires a robust qualitative process
as well. So what steps can you take to stay diversified when a paradigm shift
happens, such as the ones that occurred in the Finnish Mark or AUD/JPY
currency trades? How do you work past the limits of most risk models during
periods of high volatility? I created Track.com to provide these solutions:

1. Access a network of individuals covering a range of markets,

strategies, and mandates.
2. Filter, track, and prioritize the huge amount of news affecting your
strategy and portfolio.
3. Plan contingencies for multiple macro scenarios.

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Track.com Idea Dinners
The power of sharing information and working with a network is
emphasized throughout this book. Just as the markets have changed over the
decades, the process of how people share information about the markets has
changed as well. When I began my career on Wall Street in 1990, the
majority of information I shared was via phone with clients or through group
strategy meetings. Back then, being embedded in the finance culture brought
with it certain advantages.
Now, an investor no longer needs to be on Wall Street to have access to
this information. This has created tremendous opportunities for people to gain
market insight from a more diverse group of sources than ever before.
Investors can collaborate with a range of people to better manage the risks in
their portfolio.
At Track.com, we have always believed the market is about people and
what influences their decisions to buy and sell. A good network helps
provide a collective insight into what those factors are. This insight comes
from both virtual and face-to-face interaction. By being able to interact both
virtually and in person, you can get a deeper understanding of how a market
may respond to different stimuli and structure a portfolio more confidently.
This was the impetus behind Track.com’s monthly Idea Dinners.
The Idea Dinners are the perfect blend of trade outsourcing and forward-
looking risk. The event begins with every attendee identifying salient and
current market themes. During the second half of the event, participants share
their best trading idea and what they believe is the biggest risk to the market.
This is why it is so valuable to enhance your network. After you hear
everyone share where they see risk in the market and what their best trades
are, you may modify your own beliefs (or grow more confident in them),
cross-pollinate ideas, enrich your market schemas, and make valuable
contacts with whom you can have an ongoing dialog even after the dinner
ends.
For example, hearing an FX hedge fund manager analyze why the dollar
can rally against emerging market currencies provides you with a possible
EM piece to your network. From listening to whether he is bearish or bullish,
his trade logic, and depth of his analysis, you can add an essential piece to the
puzzle posed by global markets. Juxtapose this to a commodity trading

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advisor focusing on metals. He may have a completely different—but
nonetheless equally valid—perspective on the US dollar and how it may
influence commodities.
Track.com and its monthly Idea Dinner is a way someone can source trade
ideas and build their own network of market players from a wide-ranging
background.

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Filter, Track, and Prioritize the News Impacting Your
Strategy and Portfolio
Staying on top of all the news affecting your portfolio can be a daunting
task. With technology and the Internet, there is an abundance of information
out there to filter, track, and prioritize. Track.com helps consolidate this in a
way that allows our members to focus on the main drivers affecting their
portfolio.
Many newspapers have become useful sources through their blogs. One
example is the FT Alphaville Blog. It is a great source for strong information
and analysis about the news. However, this alone is not sufficient. One needs
an understanding of what websites specialize in and how the content they
produce should be categorized. I have five or six go-to blogs, such as The
Bespoke Analyst, Asbury Research, or Bruce Krasting and his political
economic diatribes. These websites all have the type of critical analysis that a
trader needs.
There are three aspects I use to assess every news source when filtering,
tracking, and prioritizing content:

Timeliness. Determine if the information is leading, lagging, or

concurrent with the markets.
Social impact. Even if you read about an item in the news yesterday, it
may matter even more today due to the details of exposure (for instance,
it may have landed on the front page of the WSJ) and the amount of time
it takes to digest (not all the implications of an event are immediately
apparent—some ideas take time to emerge, and even more time to
spread once they have been conceived). News has a 28-day cycle for
impact on investing.
The surprise quotient. Expectations about the news releases matter. If
you get a very weak unemployment report and everyone expected it,
then it just won’t matter.

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TOP TEN ECONOMIC BLOGS

1. FT Alphaville
2. VOXeu
3. Calculated Risk
4. Bespoke Economics
5. Gartman
6. Daily Dirtnap
7. Liberty Street - FED blog
8. The Big Picture
9. Zero Hedge
10. The Economist

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Contingency Plans
The final factor for managing risk qualitatively is creating contingency
plans for multiple macro scenarios. While it is difficult to create a
contingency plan for every scenario, the benefit of doing your work in
advance is you are much better equipped to deal with the pressure that outlier
events can exert on your portfolio. This exercise in risk assessment may also
lead to other trade ideas.
As mentioned earlier, the monthly Track.com Idea Dinners are a great
place to develop a network. Because the dinner focuses on what the biggest
risks to the markets are, as well as trade idea generation, it is also a great
venue to create contingency plans.
A few constants carry through to every Idea Dinner. The first is that I do
the hosting and pepper the attendees with questions and counterpoints. This
approach may bruise some egos, but it can also save people heartache.
The second part is that I ask for trading ideas and opinions to encompass a
three- to six-month window. For example, in the Track.com Idea Dinner for
December 2012, shorting ten-year Treasuries was one of the trade ideas to
play out over the following three to six months. This was a byproduct of the
first part of the evening, where one of the biggest risks outlined was “a
steepening yield curve and how it might impact higher beta asset classes.”
This discussion happened because of the shift in language on the FOMC
statement from a calendar-based approach to a more data-dependent one. The
dialogue about the biggest risks alerted those who were long interest-rate
sensitive assets to a possible paradigm shift in the market, a shift that could
pose outsized risks to a portfolio that was structured based on the old
paradigm.
Contingency plans and trade ideas need to be continually reevaluated. We
all know how ephemeral trading can be. Trades that begin with a three- to
six-month period can be quickly discarded when something better comes
along. The Track Idea Dinners refresh both the biggest risks and best
opportunities on a monthly basis. In the process, they also purge the themes
that may no longer be viable.
From my experience as a trader and a salesperson, there is less uniqueness
to trading ideas than people want to believe. As a market strategist, I would
love to believe I am the first person to say, “The euro has downside risks and

705
here are the reasons.” That is not a unique opinion. However, just because it
is not unique does not make it illegitimate. What you really want to know
from trade idea generation is not just how unique a view is, but also the
special sauce to make the trade a winner. Therefore, it is how we apply the
concepts of the Idea Dinners, which can then help people apply this to
their own portfolios.
Real diversification will force investors to understand the tactical
implementation of a trade idea. Sometimes the best trade idea is not the best
trade. Sometimes shorting the euro may not be the most efficient way to
make returns. Shorting the euro may not be as efficient as buying fixed
income or equities.
Everyone needs a Plan B. You either buy, sell, or hold cash. When to go
to cash is the poker game of your network. Proper investing requires
understanding the herd mentality. Therefore, having a venue that forces you
to speak on a regular basis to compare your own decision-making process
against others is important. If you go to cash and find out three other people
have gone to cash, it can serve as a viable barometer in determining whether
you should go back in. The most powerful indicator of a market shift is when
a bullish trader turns bearish on his favorite market.

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Finding the Most Liquid Opportunities
The Track Idea Dinners lead to a specific list of trades for that month.
This portfolio is watched and calculated. Amazingly, these modeled
portfolios in 2012 and 2013 have outperformed even some of the hedge funds
that have joined the dinners.
Clearly, not everyone can come to NYC, where Idea Dinners are
hosted. Therefore, a write-up of each Idea Dinner is generated and
posted on Track.com. This is measurable, trackable, and something that
makes the qualitative world of chasing alpha quantifiable. Anyone can
get access to what macro managers are saying and start to incorporate their
own forward-looking risk parameters into their trading.

Figure 16.1 Performance of Track.com Idea Dinner Portfolio

707
Conclusion
Diversification across multiple strategies, asset classes, and time
horizons is a great base to maximizing risk-adjusted returns. However,
without a robust qualitative component, a portfolio manager may be
more likely to witness outsized swings.
This chapter highlighted some of the processes I use when incorporating
modeling into a group of portfolios. They help the attendee build upon their
preexisting network, generate trade ideas, and get a sense of market
positioning. Traditional diversification is generally a great tool for
maximizing risk-adjusted return, but usually falls short on the tail-risk events
that happen. Thinking outside the model and focusing on the logic of how to
structure a trade drives another kind of risk analysis.
When do you have too much risk? With Track.com, you have
explanations, updated daily, for why risk is moving up and down so there are
not any surprises in your portfolio. When you look at your statement at the
end of every day, you should know why you made or lost money. There
should not be any shocks in your portfolio which cannot be explained without
a logical risk/reward analysis.
Here’s the last thing that really kicks in with Track and its Idea Dinners:
you are forcing another kind of diversification—that of thought. This is the
discipline of listening to many points of view and thinking through what you
really believe and why. The only way to prevent a herd mentality from
sinking your portfolio is to test it against other smart traders and analysts.
Better to know that you are a bull in a herd or a maverick bear than to be
surprised when markets react to events in ways you didn’t expect. Track.com
is one useful tool in pursuing true diversification on multiple fronts.

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CHAPTER
17

709
 Trading the Economic
Calendar: A Qualitative and
Quantitative Approach –
Jessica Hoversen
Peering through her spectacles into the cavernous room at
the Renaissance Hotel, Jessica Hoversen—slender,
unapologetically confident, and meticulously attired—stood
ready to jump-start the Saturday morning festivities. The
occasion was MF Global’s annual Introducing Broker’s
conference in Chicago—a place where the who’s who in the
futures industry would come to opine about where the market
was headed and how best to monetize that viewpoint.
As she began the presentation, Hoversen’s judicious
approach to—and passion for—the markets became quickly
evident. She seamlessly intertwined lessons learned from the
Greek classics into a deluge of graphs, Bloomberg
screenshots, and economic data supporting her case for why
Treasuries were poised to rally for not only the last two
months of 2007, but well into 2008.
The demographics of the event made her presentation even
more intriguing: Hoversen, a young lady in her mid-twenties,
was explaining esoteric fixed income dynamics to an audience
of men in their thirties, forties, and fifties. The attendees sat
captivated and made every effort to keep up with this young
market prodigy, whose deferential yet cerebral disposition left
little doubt she had already absorbed a number of the nuances
reserved for only the most blessed of trading cognoscenti.
If there was ever a moment to celebrate the fact that I don’t
drink alcohol, it was certainly now. Having used the trip to
attend the conference to meet up with my Chicago trading
family, I was only a few hours removed from a soiree that kept
me out until 4:00 AM. Being a West Coast trader and former

710
 Marine, my internal alarm woke me up like a lion in the
Savannah. With no ill effects of a night of carousing, I
watched Ms. Hoversen’s presentation with great alacrity.
Following the presentation, I adjusted quite quickly to
eschew any “hang-ups” associated with asking questions to a
woman considerably younger than I am. The opportunity to
learn from her was simply too enticing and I can only hope the
other attendees took the same tack. (Rightly or wrongly,
trading is a male-dominated field and the culture encourages
us to revere the silverback gorillas of the field. I am firmly of
the opinion that insight can come from anywhere—we just
need to know how to look for it.)
In the coming months and years, my relationship with
Hoversen would turn out to be one of the most fruitful of both
my personal and professional life. Her nightly newsletters, in
both the currency and fixed income space, began the process
of educating me on how macro drivers push the markets and
shape sentiment. Through multiple collaborations, we always
strived to bring together the process of marrying a robust
technical approach, sharp trading instincts, and key
fundamental drivers to maximize return per unit-of-risk.
As trading around before, during, and after economic
events represents a material component of my performance
attribution, this chapter will provide insight on implementing
these strategies into what you do. This chapter will emphasize
Jessica’s strong quantitative and economics background,
providing a framework for the reader to trade around key
economic numbers and macro events. Understanding how to
trade these events can oftentimes lead to opportunities of price
discovery critical in increasing the robustness of returns.
—John Netto
Woody Allen once said, “If you want to make God laugh, tell him your
plans.” Trading fundamentals and the economic calendar often feels the very
same, since the context of the macro environment can trigger a deviation
from theory, changing the impact an announcement has on asset prices. It is
truly the most important thing I have learned about economic analysis. After
eight years in the market, both as an economist and a trader, I left the street to

711
practice economics from the policy side and have found this principle still
holds.
One of the key aspects of global macro theory is aggregating, reconciling,
and analyzing economic data and its impact on a portfolio’s current exposure
in the market. As emphasized throughout The Global Macro Edge, in a
world where understanding the bigger economic picture has become
increasingly important, possessing the ability to analyze and synthesize
economic developments is vital to tilting the investment odds in your favor.
This chapter will introduce you to a few qualitative and quantitative
techniques that will provide a solid foundation for maximizing returns per
unit-of-risk.
Implementing macro strategies requires research and flexibility. Economic
fundamentals and global macro theory are widely used as a way to maximize
returns per unit-of-risk in a manner uncorrelated to traditional asset classes,
and investors continue to allocate capital toward these types of strategies.
According to Citibank Prime Finance, more than 20 percent of all hedge fund
assets under management were allocated to macro strategies in 2015.20

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Benefits of Trading Economic Fundamentals
Trading with an understanding of the macro drivers makes you a more
agile and informed investor. Event-based strategies can provide short-term
tactical opportunities to generate alpha across multiple asset classes, while a
correct evaluation of the fundamental macro regime enables you to
understand the underlying bias of the market. Finally, having the ability to
build and test investment strategies against different event and regime
environments gives you an important tool to find and capture high returns per
unit-of-risk.
The multiplier principle behind global macro trading can potentially
enhance profits as the implications of a single theme can radiate across a
number of different asset classes. For example, concerns that Chinese growth
has permanently decelerated to levels substantially below those of earlier
years may encourage you to sell commodities sensitive to world industrial
demand, such as copper and oil. This in turn has implications for both the
producers of such commodities, such as Australia and Canada, but also global
inflation rates, particularly in those regions such as the Eurozone that focus
on headline inflation. Out of a single idea, therefore, you might arrive at a
portfolio with multiple positions, such as:
1) Short copper and oil, since decreased Chinese growth will
lead decreased Chinese demand (and the knock-on effects will lead
to decreased demand from nations dependent on China).
2) Short Australian and Canadian dollars, as these are
“commodity currencies” that tend to appreciate when prices and
demand surges for the commodities these countries export, and
depreciate when prices collapse. The Australian dollar may be
especially hard hit, as Australia enjoys a particularly close trade
relationship with China.
3) Long high-quality Eurozone government debt, as
declining commodity prices should have a deflationary effect,
which in turn boosts the prices of debt (it lowers the yields).
Of course, such a portfolio is highly correlated to a single idea, reducing
diversification and incurring risks if the theme temporarily falls out of favor.
However, there are ways to get around this. Tactical event-driven trading
may enable you to capture return streams that are not dependent on a single

713
macro theme, and conducting correlation and strategy analysis can help you
mitigate the reliance upon getting a single big idea right. As noted throughout
The Global Macro Edge, it just takes careful prep work to ensure you’re not
putting all your eggs in the same basket (while still making sure you’ve
picked some pretty good baskets for them!).

714
Challenges of Trading Economic Fundamentals
Inevitably, there will be times when capital markets trade without a clear
relationship to the underlying fundamentals. This can be a function of
speculative positioning, hidden capital flows driven by non-fundamental
factors, or just plain groupthink driven by irrational fear or exuberance. John
Maynard Keynes’ famous maxim that “the market can stay irrational longer
than you can stay solvent” remains as true today as it was in the 1930s, and a
refusal to adapt and respect market conditions can be a fatal mistake.
For example, during the European sovereign debt crisis that started in
2009 and reached a crescendo during 2010–2012, shorting the euro was a
popular and seemingly obvious trade. However, thanks to a number of
factors, including easy US monetary policy and the repatriation of assets
from European banks, EUR/USD failed to deliver and sustain the expected
downward move, instead generating several painful squeezes from 2009 to
2014 (see Figure 17.1). Getting and staying short during these squeezes
proved extremely costly for many investors, both financially and mentally.
When an obvious trade continually works against you, it is always useful to
step back, reconsider your assumptions, and reassess the regime in which you
find yourself.

715
 Figure 17.1
Time frame can also be a key challenge when looking to structure a macro
portfolio. It makes little sense to put on a position expressing a six-month
view if you are unable to weather even short-term drawdowns. Even if you
have the emotional and mental discipline to invest thematically, tactical
trading around events can present short-term opportunities to create alpha.
Unfortunately, this has been complicated in the years leading up to
publication by high-frequency computer algorithms that react more quickly
than any human could. From 2008 to 2015, computerized trading has become
consistently more prevalent in the event trading space. The markets have
historically rewarded three skills: speed, intelligence, and timing. While it
may not be within everyone’s means to invest in speed (true high-frequency
systems can cost millions of dollars to set up and maintain), many of us can
still benefit from better timing and more intelligent processes—algorithmic
systems do not yet have an edge over human intuition in those domains.
Ultimately, however, even the most-well prepared investor can still be
surprised by unscheduled events (“headline bombs” like natural disasters,
geopolitical developments, corporate announcements, liquidity squeezes,

716
etc.). While such outcomes can, of course, also provide opportunity,
experience suggests that the market’s first reaction is generally to liquidate
positions, incurring at least temporary drawdowns for most fundamentally
driven macro investors.

717
Qualitative Context – Getting Started in Macro
Analysis
Your first port of call in performing macro analysis is to understand the
current environment and context. In other words, you must understand where
we are and how we got here before you can make an accurate assessment of
where we are going. A lower-than-expected inflation print may generate very
different market outcomes depending on whether the current inflation rate is
5 percent, 2 percent, or 0 percent. Moreover, the immediate signal from a
“headline” number can be misleading if—after closer analysis—the details of
a report suggest that underlying developments are moving in a contrary
direction.
It is crucial to understand the reality of the data. Though markets and
your P&L can only move north or south, the factors driving this movement
are substantially more three-dimensional and dynamic.
Fortunately, there is a wealth of data and information available to the
modern macro investor. Professional services such as the Bloomberg terminal
or the Thomson Reuters Eikon platform provide not only detailed economic
calendars, but also a repository of economic data available to view on-screen
or by download. Even without those services, however, one can still follow
the ebb and flow of fundamentals quite closely. A simple Google search
enables you to find detailed world economic calendars that are updated in real
time, and there is a wealth of free data available on various government-
sponsored websites. (More on this below.)
Here is the process that I use to follow the fundamentals, get a sense of the
economic and market context, and to develop a macro view:
1. Get an idea of what the calendar looks like for the next two
weeks: The first step in trading the calendar is knowing what is on it. On
Saturday or Sunday before the trading week starts, call up the international
calendar (for example, ECO <Go> on Bloomberg) and start scrolling
through the events. Many calendars enable you to customize the countries
displayed: a useful starting point is the G7 countries plus China. Most
events occur around the same time each month (PMIs, non-farm payrolls,
and inflation data to name a few) but things do change and you don’t want
to be ambushed by a surprise release.
Along with economic releases, you can see the schedule for key central

718
bank speeches, which can often produce market-moving headlines. As I
mention later, the focus of the market can shift, and if the market is focused
on a particular theme or event, data points that are typically market moving
may not hold the same potency. For example, PMI releases are usually quite
significant, but if a central bank has indicated that it is primarily concerned
with the trend in inflation data, the market reaction to an out-of-consensus
PMI may be more muted than normal.
Be thorough in your calendar search. You may miss important events with
a simple cursory look. Be sure to look beyond just the data releases as
events, speeches, or even bond auctions can be just as impactful,
depending on the context. It is important to remember that as the economic
cycle evolves, certain releases are more significant at some times than others.
However, there are some that can almost always be counted upon to provoke
a market reaction. Appendix I has a sample of a daily calendar for further
references and times. Below is a list of ten data releases to keep on your
trading radar:

a. U.S. Nonfarm Payrolls: Monthly

b. US ISM Purchasing Manager Index (both Manufacturing and Non-
Manufacturing): monthly
c. Markit European Purchasing Manager Indices: monthly
d. Central Bank Meetings: Among the most important are the U.S.
Federal Open Market Committee, European Central Bank, Bank of
England, and Bank of Japan
e. Bank of England Inflation Report: Quarterly
f. Japanese Quarterly Tankan Survey: Quarterly
g. Chinese Economic Data: Retail Sales, Trade Balance, Industrial
Production, CPI—all are released monthly in close proximity
h. Chinese PMI (both HSBC and CLFP): Monthly
i. CPI inflation data in the US, Eurozone, UK, Japan, and Canada:
Monthly
j. GDP reports: Quarterly. There are usually several iterations of
economic growth reports, with revisions coming as fresh underlying
data is reported. The initial release is usually the most impactful.
2. Look at a trend of the data: Any good macro trader can tell you
what the “market” expects. While this is usually anchored by the panel of

719
economists surveyed to generate a consensus forecast, oftentimes there is a
“whisper” number that is priced into markets, which can occasionally
deviate from the published consensus. When the data is released, it is
important to go beyond simply the previous value—get a three- or six-
month average and pull up a graph plotting the data for the last few months.
For example, to pull up a chart of an economic release through the
Bloomberg terminal:

a. Type WECO <GO>

b. Click on the country whose calendar you would like to use.
c. Click on the economic release you would like to view.
d. Type GPO <GO> to view a graph. You can adjust both the duration of
the graph as well as moving averages of the release.
e. Type HP <GO> to get a list of historical prices.
f. Type ECOS <GO> to get economists’ forecasts along with other
statistical metric on the forecasts.
Type WECO

Figure 17.2 Click on Eurozone Aggregate

720
Figure 17.3 Click on Number 27. “Retail Sales MoM”

Figure 17.4 Chart of Retail Sales

721
 Figure 17.5 Type HP <GO> to View Historical Prices

Figure 17.6 Type ECOS <GO> to See Economists Survey

722
 Because economists often react to shifts in economic conditions in their
forecasts, rather than predict them, the surprise in a series of economic data
releases relative to expectations often comes in related bursts. For example,
when an economy begins to accelerate, there will usually be a series of better-
than expected data releases before economists begin to shift their forecast
profiles upward. Economic data surprise indices, such as those published by
Citigroup, provide an easy shorthand way of gauging the trend of the data
relative to expectations.
3. Understand that market focus shifts. As noted previously, while
there are certain events (US non-farm payrolls or a Fed meeting, for
example) that are almost always market-moving, there are also other cases
where the object of market focus can ebb and flow with the overall market
regime and circumstances. For example, during the height of the European
sovereign crisis, bond auctions in key peripheral countries were noteworthy
and market-moving events. A couple of years later, however, investors’
focus was much more clearly attuned to inflation data as a driver of ECB
policy, and bond auctions held relatively little interest for anyone but
government bond specialists. A peripheral data release is also more likely to
move quiet markets (when traders are looking for some piece of
information to latch onto) but be relatively ignored when markets are
deluged (and fatigued) by other releases.
4. Follow corporate releases: In some cases, corporate announcements
can provide an excellent bottom-up view of the global economy, especially
those firms that tap into cyclically sensitive industries such as shipping,
mining, consumer electronics, etc. I have found that these releases can
act as leading indicators. Hints of big-picture trends, such as shifts in
inflation and consumer spending, are often visible in corporate
observations before they become evident in the data. By the same token,
announcements from key banking institutions provide insight on the state of
financial markets, particularly during and in the aftermath of crises. Many
of the transcripts and past conference calls are available via professional
data platforms or through corporate investor relations departments.
5. Understand seasonality: While most data releases are seasonally
adjusted to remove cyclical effects (such as a spike in US hiring in
November and December, when many stores take on extra help for the
Christmas season), such techniques are not perfect and can be impacted by
things such as structural shifts, abnormal weather, etc. Moreover, there are

723
certain situations where idiosyncratic factors make adjustment very
difficult, such as the variable timing of Chinese New Year or the decennial
boost to US payrolls resulting from census hiring. What is important to
realize, however, is that financial markets are not seasonally adjusted, and
that there are occasionally predictable seasonal flows that can enable you to
generate alpha if you identify them early enough. For instance, the
infamous “January Effect,” which is associated with a pop in equity prices
in January of most years. The SEAG function on Bloomberg is useful in
assessing seasonality.
6. Understand sentiment: Even the newest of traders are quick to
realize that the market does not always do what it should based solely upon
economic fundamentals. While incoming information adds to the sum of
our knowledge about economic circumstances, market reaction can
sometimes appear perverse based upon a cursory reading of the data. As is
the case in many facets of life, understanding expectations is the key to
success. News is always relative and it is sentiment that often acts as a
catalyst for counterintuitive price action. A loss of 100,000 jobs in the
monthly payroll report may sound distressing; however, if previous months
had lost 300,000, then this new figure would represent an improvement in
the trend. Here are a few tools I use to help me gauge sentiment and
expectations:

a. Volatility: Indicators such as the level of implied volatility or option

skew provide insight on perceived risk. The VIX is a popular measure of
equity volatility based on implied volatility in S&P 500 options, and
extremely low or high readings can indicate complacency or panic,
respectively. Put/call ratios on equity indices can also indicate sentiment
extremes, while FX risk reversal pricing can be used as a leading
indicator of currency trends. As discussed throughout this book, these
signals are only part of a very large toolkit—I am most confident about
what they are telling me when they are corroborated by other indicators.
b. Positioning: The CFTC’s weekly Commitment of Traders report is a
popular and easy-to-access way of following speculative and
commercial positioning across a range of futures markets. Although the
universe of markets is not exhaustive (over-the-counter products and
non-US futures are not included), the report still provides a useful gauge
of sentiment, as we’ll discuss in more detail later in this chapter.

724
c. Surprise: Identifying the surprise of a release (i.e., the difference
between the market forecast and the actual result) that will trigger a
market move is as much of an art as a science. Looking at the
distribution of forecasts, keeping an ear to the ground for the market’s
“whisper number,” conducting event studies, and cultivating an intuitive
“feel” for what the number should be can all serve as effective
approaches.

725
Data Management and Quantitative Analysis
Quantitative analysis can take on many forms, from simple correlation
analysis to the complex computer algorithms used by the high-frequency
trading community. While The Global Macro Edge aims to be as complete
as possible, it would be a multi-volume tome if I were to attempt an
exhaustive study of analytical techniques. Still, an overview of quantitative
analytical techniques will go a long way toward providing readers with the
tools to maximize returns per unit-of-risk.

726
i. Finding Data
Data is, of course, the ground from which quantitative analysis springs—
both the foundation that observations are based on and the clay from which
insights are molded. It is the raw material from which trade ideas and
investment conclusions are born. Fortunately, there is now a wealth of
fundamental and market data available to all manner of investors. For the
former, Bloomberg and Thomson Reuters both have exhaustive data libraries
that can, with a few clicks of the mouse, provide time series as diverse as
Norwegian house prices to Chinese electricity usage. While each of these
platforms uses their own set of (occasionally arcane) codes, the search
interface for each is pretty intuitive and easy to use.
Detailed study of the economic calendar can also introduce you to data
sets and inspire new areas of research. Any time you find yourself looking at
a data release and trying to put it into historical context, it is a good idea to
download a time series of the data and save it in a spreadsheet. Not only does
this allow you to study the data in any way you see fit, but soon you’ll have
an impressive library of economic data that you can call upon whenever you
like, even if you’re offline.
For those investors without access to the data libraries of Bloomberg or
Thomson Reuters, there are still a number of options to source high-quality
fundamental data. The St. Louis Fed’s FRED website
(https://research.stlouisfed.org/fred2/) has a large, diverse, and up-to-date
collection of US economic and financial data, as well key data sets from
other countries. Generally, the national statistics agencies of most countries
offer data for download on their websites. In many cases, there will even be
an English-language version of the website to help you navigate; failing that,
Google Translate can usually help you find the data sets that you are after.
Finally, the IMF, World Bank, and BIS websites also offer a wealth of
economic and financial data freely available for download. These websites
and others are available as part of Appendix II.

727
ii. The Philosophy of Data Analysis
When analyzing economic and market data, the scientific approach fits
hand in hand with the Protean Strategy, which calls for traders to go with the
flow, adjusting to new information as it presents itself. While it is helpful to
have a prior idea or hypothesis of what the data might tell you, you should
allow the data to flow to the conclusions (and not the other way around), even
if the results can occasionally be counterintuitive. While there is nothing
wrong with attacking a problem from a few different angles, you also want to
avoid grocery shopping for results—situations where you perform ten
different studies until you find the conclusion that you wanted in the first
place. In other words, traders should avoid the dreaded “confirmation” bias,
which occurs when you actively seek out information that agrees with what
you already believe, or interpret data to support the conclusions made in
advance.
As a note: if you find results that imply an extraordinarily strong
relationship between variables or an exceptional level of profitability for a
trading strategy, it’s always best to double-check your methodology and
results. If something seems too good to be true, it usually is.

728
iii. Aggregating and Standardizing the Data
While there are many programs available for data analysis, including
advanced statistical packages, we’ll assume for our purposes that you’re
using Excel, which is quick, efficient, and widely available. If downloading
open source data, you will usually get a CSV file that can be converted into
an Excel document.
To download Bloomberg data in Excel:

1. Click on the Bloomberg tab in Excel.

2. Click the Import Data icon.
3. You can search for static data and data sets using the Market,
Reference, Analytical, Data Sets option; for time series data, using the
Historical End of Day option; and intraday data using the Historical
Intraday option (bars or ticks).
4. The wizard will guide you through entering your securities one by one
or uploading from the spreadsheet, selecting the datatypes you want,
defining the time period, frequency, currency, etc.21 If you already have
an Excel spreadsheet with Bloomberg data, you can change the data by
typing in the ticker of the information you want to view in the cell where
the current ticker exists. The below example shows you how to
download weekly closes of the S&P for five years as well as five years
of historical price data for nonfarm payrolls.
Standardizing the data is one of the most important parts of the process.
Release frequency, holidays, currency denomination, inflation adjustments,
and units often vary from data set to data set. Comparing variables measured
on different scales reduces the accuracy of the study; we need to apply the
principle of comparing apples with apples. For example, understand that
correlating a trending series (such as the S&P 500) with a mean-reverting one
(such as the ISM PMI survey, revolves around a “neutral” score of 50) may
show a relationship in the short run, but that it is unlikely to hold over a
longer time series. To determine the strength of the relationship over longer
periods, it is imperative to convert the S&P 500 data to a mean-reverting
series (such as looking at percentage changes over a given period.)
There are a number of issues to consider when downloading and analyzing
data. Among the most important are the following:

729
a. Temporal consistency. Different markets have different holiday
calendars, which can lead to inconsistent data sets if comparing, say,
S&P 500 futures with Euro Stoxx 50 futures. A simple workaround is to
include “non-trading weekdays” in your sample so that data sets include
the same number of days. At the same time, if comparing long-term
relationships between economic data or policy regimes and financial
market pricing, you need to convert one data set to the frequency of the
other (e.g., daily to monthly). It’s usually easiest to compare monthly
market pricing with monthly data releases over longer time periods (a
decade or more).
b. Avoid forward-looking data. One of the easiest traps to fall into when
comparing economic and market data, at least when trying to determine
how the market will react to a release, is to assume that the market
“knew” the economic figure before it was released. For example, US
trade data is usually released about six weeks after the end of the month;
that is, figures for December are released in mid-February. If you
assume that the market knew the data for the entire month of February,
say, by correlating the trade figures to the monthly change in USD/JPY
by using end-of-month FX rates, you will get misleading results.
However, it is important to keep in mind how this data is used—if you
are merely trying to determine economic correlation, then, to continue
the example, it is fair to compare USD/JPY moves in a month to the
underlying trade flows even if the exact data was unknown at the time.
However, if you are trying to determine market reaction, it is not. It pays
to think critically about how each data release works, and how you want
to use it.
c. Do not compare apples with oranges. This covers a myriad of issues,
including the trending versus mean-reverting issue mentioned earlier. It
sounds obvious to ensure that you generally want to compare real (i.e.,
inflation-adjusted) figures with other real figures, and nominal data with
nominal, but it is an easy mistake to make. Over short periods, the
apples-to-apples issue is less relevant, but over longer periods where you
are trying to capture a “signal” as opposed to noise, it becomes
extremely important.
d. Correlation does not imply causation. Correlation analysis is a
fundamental technique of global macro research that seeks to establish
causal relationships between two variables. In many cases, the

730
 relationships that one can identify are sound, particularly if there is a
prior reason to expect such a relationship. However, just because an
overlay or a correlation study suggests a relationship does not mean that
there is one. Correlations that may have existed by coincidence in the
past may not necessarily hold in the future (or a shift in conditions or
regime may cause correlations to change). Furthermore, it cannot be
established whether one factor has caused another (that is to say, it has
directly or indirectly led to it happening), whether both factors have
been firmly influenced by another external factor that caused both shifts,
or whether something else entirely has occurred. It is important to
consider correlations in greater context, with reference to other data, and
also to apply a degree of common sense in thinking about them.
e. Normalizing can help compare assets of different volatilities. When
comparing assets with markedly different volatility profiles (such as
Brent crude oil and EUR/NOK), an easy way of rendering the two as an
apples-to-apples comparison is to normalize them by expressing price
changes in standard deviations rather percentages. One of the issues in
doing so is choosing the look-back window for calculating the standard
deviation; one year is usually a good window that is often used by bank
and fund VaR models.

731
iv. Studies
As noted earlier, quantitative methods can add context to your macro
analysis and help you to identify potential trading strategies. There are a
number of sources of possible inspiration for analytical studies. While you
may find yourself asking interesting questions during your own macro
research, oftentimes you will also be inspired by reading other research or
papers published by academics and central banks.
Below we identify several types of analytical study and provide brief
examples of the process and outcome.
1. Economic Studies. One of the basic types of study used in global
macro analysis is to use one or more sets of economic variables to predict
other economic outcomes. This type of analysis works because a) some
variables tend to lead others, such as oil price and inflation, and b) some data
points are released more frequently than others, but correlate very highly to
them.
For example, the Institute for Supply Management (ISM) in the United
States publishes monthly purchasing managers’ indices (PMIs) for both
manufacturing and non-manufacturing industries. These surveys cover a wide
swath of economic behavior, from orders and deliveries to hiring intentions
to prices paid. If we download time series of the ISM reports and weight
them according to their respective importance to the US economy (roughly
15 percent manufacturing, 85 percent non-manufacturing), we find that the
result correlates very highly to trends in US GDP growth (see Figure 17.7).
Because ISM PMIs are reported monthly and GDP only quarterly, tracking
the composite ISM reading gives us a real-time estimate of trends in GDP
growth…before the official figures are released.

732
 Figure 17.7 Graphing Correlation Between Composite ISM and US GDP
Growth
2. Event Studies. Event studies seek to answer the question: how has
the market previously traded around a particular event? The purpose of
these studies is ultimately to determine whether markets respond
consistently and predictably to new information. For readers with a
Bloomberg terminal, performing quick-and-dirty analysis of this nature has
never been easier, thanks to the ECMI (Economic Market Impact) function
(see Figure 17.8). You can query a data point and type in ECMI; the
terminal will display the last year’s releases, the surprise relative to the
consensus expectation (expressed in standard deviations), and the
performance of an asset of your choice over a user-defined window of time.
Figure 17.8 shows the performance of AUD/USD in the 30 minutes
following the release of Australian employment figures. In this case, you
can see that there is usually a solid relationship between the strength of the
numbers and the subsequent price action in the AUD.

733
 Figure 17.8 ECMI <GO> on Bloomberg Terminal
If you want to dive deeper, however, you’ll generally want to do the work
yourself. An example is the performance of the S&P 500 on FOMC
announcement days. In 2012, the New York Fed published an interesting
piece of research suggesting that since 1994, US equities have performed
extraordinarily well over the 24 hours preceding a monetary policy
announcement. (http://libertystreeteconomics.newyorkfed.org/2012/07/the-
puzzling-pre-fomc-announcement-drift.html#.Vp_irFneLuB) However, the
study does not distinguish between easing, tightening, or on-hold decisions.
A natural question that one might ask is whether the outcome of the decision
impacts the pre-announcement drift, or whether unscheduled announcements
differ from scheduled ones. The way to find out is to go back and check! It is
a relatively simple matter of downloading closing SPX price data, and one
can find historical meeting dates on the Fed website. The results of the study
are set out in Figure 17.9 below, where “T” represents the day of a Fed
announcement:

734
 Figure 17.9
As you can see, while equities perform best around easing
announcements, the phenomenon holds when policy is unchanged or
tightened as well. In fact, more than half of the total price appreciation of US
equities between 1994–2015 occurred on the day before and day of Fed
announcements!
It is also generally useful to look at the distribution of returns to see if
outliers are skewing the results. Looking at the bell curve of data points
from highest percentage change to lowest percentage change will identify
the outliers. Once you have identified the statistical outperformers (high
positive or negative returns), research the potential triggers for that move. For
example, was the market disappointed with the announcement? This is often
a cause of a counterintuitive move. When preparing to trade the economic
calendar, examine your event study and see if the current trading
environment is consistent with historical instances of anomalous movements
in asset classes. Understanding such moves will help you prepare for trading
surprises.
Finally, one issue to consider is that, in some cases, smaller time windows
are preferable when conducting event studies. There are times when market
focus or sensitivity to certain pieces of economic data changes, and a longer
time window may capture periods when the sensitivity is greater or smaller

735
than it is at the time of the study. One technique is to look at the correlation
of the event with market reaction over multiple time frames; if the more
recent time frame has a higher correlation, then you can be reasonably
confident that it is an economically sensitive release and you can use a
shorter window for your analysis.
3. Correlation Studies. Global macro investors often use one or more
economic or market variables to predict the performance of another asset
price. For example, interest rate differentials are often used to predict
movement in exchange rates. Generally speaking, these types of studies
look to a) establish a relationship between two variables by measuring the
statistical correlation, say, in an Excel spreadsheet or on the Bloomberg
terminal, b) run a regression to develop a formula that uses input asset
prices to predict the level or change in another asset price, or c) overlay one
variable with another, and look for divergences that might predict future
market action.
A simple example is the relationship between Japan’s trade balance and
USD/JPY. Economic theory suggests that a higher trade balance should mean
a stronger yen, and a lower trade balance a weaker yen. For many years, this
was the case; in fact, trends in the trade balance tended to lead trends in the
exchange rate by roughly a year, making it an excellent forecasting tool for
USD/JPY (see Figure 17.10).

736
 Figure 17.10
It can be perilous to rely too heavily upon correlations, however. At times,
things other than the modelled variables will exert an influence upon the
output asset price. It is generally the case that in times of stress,
correlations break down. In order to stay adaptive (and successfully
recognize a regime shift), the Protean trader must monitor them and
consider why a breakdown is occurring. Revisiting our USD/JPY example,
the financial crisis of 2008 led to a structural break in the relationship
between trade and the yen (see Figure 17.11), as extreme risk aversion
generated strong demand for the Japanese currency as a safe haven, even as
the trade surplus collapsed.

737
 Figure 17.11
In sum, correlation analysis can be very useful in explaining or forecasting
economic variables or market price action. However, it is important to
remember the limitations of the technique and to use common sense when
applying it, particularly in times of stress.
4. Strategy Studies. Testing the historical performance of an investment
strategy is a bread-and-butter component of macro investing. Although
most commonly associated with quantitative strategies such as trend-
following CTAs, it is also an integral part of a discretionary investment
process to ask how a given trade or strategy has worked over time.
An interesting example during the post-crisis period is an investment that
matches longs in S&P E-mini futures with ownership of long-dated
Eurodollar futures. Dubbed “Spoos and Blues” by David Zervos at Jefferies,
the theory behind the strategy is that both assets benefit from generous
financial conditions but are negatively correlated on a high-frequency basis,
thus generating a superior risk-adjusted return.
To test this hypothesis, we first need to set the parameters of our study. In
making these decisions, we must consider many of the same factors that a
trader or portfolio manager would consider in actual execution. Among the

738
issues we need to consider are the following:

How do we weight the portfolio? Do we size the portfolio equally in

nominal terms or in volatility weighting? Generally speaking, for a
portfolio of diverse assets like this you would want to create an equal
volatility weighting (more volatile assets receive a heavier weight, less
volatile assets a lighter one, so that volatility times weight is equal for
each asset). For bond spreads, you’d want to match duration. For swap
or short end spreads, match the DV01 (dollar change in P/L for a 1 basis
point move), etc. For spreads across economic zones, don’t forget to
account for the different currency denominations!
What securities are we buying (or selling)? What is the cost of
carrying/rolling them? For the purposes of this study we assume that
the portfolio is long the front E-mini S&P futures and the 14th
Eurodollar contract, also known as the “Spoos and Blues” strategy.
However, given that both of these roll quarterly, we also need to
download data for the second E-mini and 15th Eurodollar contract so
that we can account for the cost/benefit of rolling the contracts close to
expiry. (Expiry conventions are available on exchange websites.) You
must also consider carry for other assets like FX, bonds, swaps, and
equity dividends.
Do not forget to account for transaction costs. For a low-turnover
transaction strategy like “Spoos and Blues” it is not so important, but for
higher turnover strategies it is vital to be conservative in your
transaction cost assumptions. Probably the most common mistake
that traders make when modelling strategies is to understate the
cost of trading, which leads to inflated assumptions of profitability.
For the purposes of this study, we assume that the strategy goes long 1000
E-minis and 3600 of the 14th Eurodollar contract, which reflects an equal
volatility weighting for the several years prior to this study (see Figure
17.12). We roll the futures three days before contract expiry. As you can see,
from 2009 to 2015, the strategy generated excellent returns. Had one
performed this analysis in, say, 2012, it would have encouraged the investor
to generate excellent returns over the next several years.

739
 Figure 17.12
However, what if we look at the strategy’s returns over longer periods of
time, when central bank policy or liquidity conditions were not so favorable
(see Figure 17.13)? We find that, while the strategy has made money overall,
there can be lengthy periods of underperformance and that our original
sample period looks anomalous. This highlights the utility of our next section
on regime studies.

740
 Figure 17.13
5. Regime studies: As discussed in Phase I of this book, not every
investment climate produces identical returns across asset markets. Periods
of high inflation and central bank tightening are usually bad for government
bonds, for example, while falling inflation and policy easing are bullish. It
can be useful to ascertain how assets have performed during various
regimes in the past to distill insights into how they may act in the future.
A recent example is the five years following the financial crisis, a period
in which there were a number of different policies deployed by the Federal
Reserve. After years of asset purchases, forward guidance, maturity
extensions, and occasionally doing nothing, the FOMC announced in
December of 2013 that it would begin to wind down its third and final
quantitative easing program, which duly ended in October 2014.
Suppose one wanted to have an informed idea of how asset markets would
trade thereafter, in the absence of Fed participation in the market. One way
would be to perform a study which analyzed the performance of different
assets across various Fed policy settings over the previous five years. If a

741
sensible pattern of behavior emerged, it would likely provide clues to future
market performance.
The results of just such a study are set out in Figure 17.14 below,
conducted as of the end of October 2014. The results set out the annualized
asset return (or yield change) and volatility across four policy regimes, in
order of most to least dovish: full-blown QE, tapered QE asset purchases,
Operation Twist (i.e., a maturity extension), and no active policy program.
These four states cover the entire period between March 2009 (when the Fed
announced its first Treasury-buying program) and October 2014 (when it
finished its last one).

Figure 17.14
The ideal result from a study such as this would be a consistent pattern of
behavior that accords with a prior understanding of economic fundamentals.
In this case, we see that the performance of the S&P 500 deteriorated steadily

742
as the degree of policy accommodation lessened. This would suggest that
equities might struggle following the end of the QE program. Similarly, oil
fared very well under full-blown QE, but generally struggled as the degree of
accommodation lessened; although the relationship was not as strong as that
of the S&P 500, it may have warned of a bear market in oil once the Fed
reverted to doing nothing.
Occasionally, the performance of an asset may be consistent but
counterintuitive. In this case, we observe that when the Fed engaged in full-
blown asset purchases, bond yields tended to rise, but that any other policy
setting led to progressively lower yields. This is the opposite of what one
might expect given the literal market flows generated by the Fed. However,
when one also takes risk aversion, volatility, and economic uncertainty into
account, a safe-haven flow into government bonds in the absence of Fed
support for markets makes a bit more sense.
In this study, the dollar tended to do relatively better with less
accommodative conditions except during the period when the Fed did
nothing, when it fared very poorly. This is an example of the type of
counterintuitive outlier described in the event study section. In this case, the
USD weakened in 2011 as European banks repatriated assets and the US
government credit rating was downgraded by S&P. This is a case where it is
a judgment call whether you wish to look through the counterintuitive outlier
or not.
Finally, the results of the gold study were a bit all over the place. A
counterintuitive sell-off during QE and rally when the Fed did nothing, with
low-quality signals in between. That the apparently best signal (the rally as
the Fed did nothing) came over the smallest sample size is also a cause for
suspicion. This is an example of a study with inconclusive results that you
would not want to employ as an input to your investment decisions.
6. Positioning Studies. Positioning is something of a Holy Grail for
many investors. Knowing exactly how a market is positioned would enable
you to anticipate many trend accelerations and reversals, as well as the
reaction to specific macroeconomic events. Positioning is so important that
Chapter 18 is wholly dedicated to it. While it is very difficult to know
market positioning in aggregate, there are a few useful tools that provide a
snapshot of certain traders’ investment profiles, most notably the CFTC
Commitment of Traders Report (CoT).
The CoT report is a staple of many fund managers’ Friday routine and

743
something highlighted—among other places—by Jason Roney in Chapter 4,
and in the following chapter by John Netto, as a key to understanding market
positioning. The data reports the breakdown of futures positioning and open
interest as of Tuesday of the reporting week. Looking at a spread of non-
commercial shorts and non-commercial longs will give you an idea of where
speculative investors (i.e., hedge fund, locals, etc.) are allocating capital.
The chart below illustrates this concept as it plots EUR/USD versus the
net non-commercial EUR futures position, the spread between non-
commercial longs and shorts. As noted earlier in the chapter, investors
repeatedly attempted to short the euro during the European sovereign crisis,
only to see it rally and confound their expectations. An example of how
monitoring position data could have warned you of this in 2012 is shown in
the black box of Figure 17.15; observe that the market was very short euros
and had begun to cover before the exchange rate bottomed.

Figure 17.15
On the other side, by the summer of 2014, Europe was in the grips of a
deflation scare requiring more aggressive ECB easing, but the market was
broadly neutral EUR/USD. However, it became clear that selling pressure

744
was starting to emerge (black arrow); a couple of months later, the exchange
rate duly followed.
You should be aware of the limitations of the data. Not every market
participant trades futures, and in some cases (such as bonds), positions may
be part of a cross market spread that entails relatively little directional risk.
Still, applied judiciously, positioning studies can provide you with an early
warning of an impending trend…or a reversal.

745
Conclusion
Understanding and trading market fundamentals is a crucial part of trading
global macro. Knowing how markets are likely to react before an economic
event or trend emerges is an invaluable weapon in a global macro investor’s
arsenal. In this chapter, we have tried to show you how to become immersed
in the data and have given you an introduction to the types of quantitative and
data analysis that can help you generate maximize return per unit-of-risk.
20 See
https://www.citibank.com/mss/products/investor_svcs/prime_finance/business_advisory/docs/hf_mont
21 Cornell University Library Guide: http://guides.library.cornell.edu/content.

746
CHAPTER
18

747
How to Quantify and Visualize
Market Positioning

748
Introduction
Staying ahead of the crowd on Wall Street requires a lot of homework. In
the long run, only the most passionate, talented, and disciplined traders rise to
the top and maintain that level of consistency. In my effort to grow as a
market practitioner, I am constantly looking for those who have a burning
desire to find that unique angle, who cultivate an authentic perspective, and
who are willing to challenge conventional wisdom when piecing together the
“next trade.”
Ted Mermel, a sell-side FX and EM salesperson for Societe Generale,
impressed me from the moment we first crossed paths in 2008. After
meeting, he began sending me his daily currency newsletters. The process of
reading through his thoughts was a real education, as well as a bit humbling.
There were ideas, jargon, and economic issues I simply was not familiar with.
My technical analysis and trading instincts had kept me safe; now learning to
trade the economic drivers at the heart of that price action would make me
wealthy.
I am a big believer that currency trading is synonymous with global macro
trading given the importance of fiscal, monetary, and political policy to trade
flows, relative inflation, interest rates, and economic growth. These factors
are drivers of global macro markets in general (not to mention the entire
global risk complex) and currency markets in particular. As we have seen
play out in the markets repeatedly since the 1970s, those in touch with macro
drivers of the currency markets have been well positioned to profit across all
risk assets.
Mermel’s daily letters were my gateway drug to two vital aspects of the
Protean Strategy and UoR Process. The first involves incorporating the
macro narrative to give context on price action. The second, and equally
critical, entails understanding the influence of market positioning.
Having cut my teeth playing No Limit Texas Hold’em cash games for
many years in Las Vegas, the idea of playing the player and not the cards is
very intuitive to me. Reading other players in poker is a combination of art
and science. Things like body language, tone of voice, playing style, and
game theory can go a long way toward building a pile of chips on the green
felt.
Mermel’s daily FX pieces were constantly referencing positions and

749
providing color on order flow from the day’s price action. I began to extend
my poker skills for reading other players to starting to read the market. I
discovered that while the event itself is important, it really is about how
people are positioned for the event that has a profound impact on the
subsequent price action. In the years that followed, I became obsessed with
developing a way to incorporate this into my trading. Despite the
comprehensive methods outlined in this chapter and the many years of
incorporating this into the UoR Process, I consider my ability to assess
market positioning a fluid endeavor—one always seeking to improve itself,
ever adjusting to changing circumstances, and requiring refinement in
perpetuity.
The macro narrative and market positioning can be very abstract concepts
to many people. This chapter will show readers not only how I quantify and
visualize these abstractions, but how I am able to incorporate them into my
UoR Process. This chapter was written as a foundation for Chapters 19 and
20, Emotions Are Our Greatest Ally and The MPACT! of Automation.
These chapters will build on what is explained here.
As you read this chapter, please keep in the back of your mind that—at its
very heart—the ability to think about and incorporate the macro narrative and
market positioning in your process is predicated upon being able to
empathize with the feelings, thoughts, and potential actions of other market
participants. These issues will be extensively explored in the forthcoming
pages.
Denise Shull spends a good portion of her book, Market Mind Games,
highlighting the research illustrating that traders who perform well are
usually factoring in what other market players are thinking. When I
understand the macro narrative and combine that with a process that attempts
to empathize with others, then the art and science of deconstructing market
positioning becomes more tenable.
By understanding how I aggregate, organize, and assimilate
information on market players, you will have a better handle on
quantifying and visualizing the scenarios priced into the market. This
puts you in a great position when opportunities arise around key market
events.
In this chapter, I am going to cover the following things:

The Importance of Market Positioning

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Pricing in the Market Position Premium (MPP)
Using the Macro Narrative and Your Network to Quantify MPP
Factors to Create an MPACT!™ Ratio
Creating a Cognitive Empathy Grid (CEG)

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Market Positioning
Understanding market positioning and sentiment is a critical aspect in
maximizing return per unit-of-risk. As many of us already know, trades do
not happen in a vacuum. The market is an amalgam of our collective
thoughts, feelings, and expectations about the future. By understanding which
way the market is positioned, and what is already being factored into the
current price action, one can significantly improve their ability to expose
themselves to positions with a higher expected Netto Number.
When I analyze a risk-to-reward scenario, understanding what I can
potentially make comprises a huge factor of this analysis. One of the
problems of being in a market that has already priced in a good outcome is
that, even if that outcome occurs, you may not be rewarded commensurately
with the risk you are taking. Therefore, before I take on any position, I
always incorporate into my pricing model the negative or positive
market position premium.

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Market Position Premium (MPP)
Below I am going to outline my process for accounting for market
position premium (MPP). My MPP pricing model assigns a numerical value
to account for how much a bullish or bearish event is already priced into a
particular market. The process for pricing in this premium is extensive.
Below is a basic example to give you an estimate of how influential this
premium can be and why it would behoove investors to account for this
factor.
Let us go back to an example used in Chapter 8. On April 3, 2015, the
market was expecting the monthly US nonfarm payrolls number to be strong.
The average forecast for the report was 245,000 jobs added and the standard
deviation of forecasts was 22,000. While I generally price out a lot more than
five scenarios, the simplified example below will give a basic idea of how
this can play out. This example is only factoring in perceptions over the jobs
data itself and no other market dynamics.22
Scenario Amount Probability
1. Big Beat (of 267,000 or more (+1.0 standard deviation or 12 percent
the #) more)
2. Modest Beat 256,001 to 266,999 (just above +0.5 to just 24 percent
under +1.0 standard deviations)
3. In Line with 234,000 to 256,000 (±0.5 standard 28 percent
Expectations deviations)
4. Modest Miss 223,001 to 233,999 (just above -1.0 to just 24 percent
below -0.5 standard deviations)
5. Big Miss 223,000 or less (-1.0 standard deviations or 12 percent
less)
By running a basic probability model, we can price out what the expected
value of each scenario is 15 minutes after an event. However, simply pricing
out the average end result is an incomplete approach. If we price out the
average expected maximum adverse excursion (MAE) and maximum
favorable excursion (MFE), then we can really see some profound feedback.
The importance of the MAE and MFE was outlined in Chapter 5 with the
agony/ecstasy ratio. As explained above, this is something I do in front of
every event.

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 Given the nonfarm payrolls scenarios above, what is the price of the
euro/US dollar currency cross 15 minutes after the announcement for each
scenario?

By calculating the expected value (add the products of expected payoff

multiplied by the respective probability for each scenario) and you can see
that by understanding market positioning you can either enhance a current
viewpoint or avoid putting yourself in spots of horrible asymmetries.
Expected Value =
(ProbabilityScenario1 * ExpectedEURMoveScenario1) +
(ProbabilityScenario2 * ExpectedEURMoveScenario2) +
(ProbabilityScenario3 * ExpectedEURMoveScenario3) +
(ProbabilityScenario4 * ExpectedEURMoveScenario4) +
(ProbabilityScenario5 * ExpectedEURMoveScenario5)
= (0.12 * -80) + (0.24 * -10) + (0.28 * 35) + (0.24 * 60) + (0.12 *
145)
= -9.6 + -2.4 + 9.8 + 14.4 + 17.4
= 29.6 ticks of positive premium (or positive “market position
premium” if you are long the euro going into the jobs report).
This is a very basic way my model prices MPP. I have established much
greater levels of complexity of scenario analysis in some of my models,
and I do this for each asset class and strategy. For instance, some of my
models attempt to decompose market moves by dividing them into different
scenario buckets (this is essentially the above calculation in reverse, but it
takes a much greater deal of work). Still, the end game is about boiling things
down to an informative number, which in turn gives us a good idea about
market positioning.
This helps explain why some people on Wall Street make a good living
as contrarian investors. They are earning the “positive” carry from the
market position premium that can play out over time. However, this
“positive” carry may come with some increased volatility.

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 Some may wonder if one should ever take on positions with a negative
MPP. I routinely take on negative MPP trades as the other factors that go into
my UoR Process suggest that, regardless of the negative carry from MPP, it is
still worth having the exposure. If I have a viewpoint that is already largely
reflected in the underlying price action, but still want some exposure, then I
take on a greater tactical nature in my position management and understand
that some negative asymmetries exist.
Over the years, there are many examples of trades that matched up with
the larger overarching macro theme that nonetheless did not yield a profit.
Many of these trades were “crowded,” or the MPP had gotten too rich,
thereby creating a dynamic of supply and demand inhibiting the trade from
playing out. The bottom line is every investment or trade should be analyzed
by thinking about how the market is positioned for both a specific event and
for more general moves.

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The MPP and MPACT!™ Ratio
The market position premium works hand-in-hand with the Market Price
ACTion Ratio (the “MPACT!™ Ratio”). This a ratio I created to measure
where certain asset classes may trade based on the outcome of approximately
30 economic releases, central bank policy statements, and other one-off
macroeconomic events. The MPACT!™ Ratio, outlined in Chapter 5, does
this by calculating how many “risk multiples” (as defined by a Roney Ratio)
a market may move as the result of the macroeconomic event.
Market positioning is the second largest input in the MPACT! Ratio,
with the biggest input naturally being the result of the event itself.
Therefore, by walking you through the inputs of how I create the MPACT!
Ratio, I am also teaching you how I assess market positioning.
A hypothetical example of the MPACT! Ratio would work as follows:
The Federal Reserve comes out with a policy decision that is more dovish
than what markets have anticipated in their positioning.

The US dollar is likely to weaken because of loose monetary policy. As

such, the EUR/USD currency may get an MPACT! Ratio of +2,
meaning the EUR/USD could move two risk multiples over a specified
period of time.
Five-year Treasuries, which may benefit from the Fed dovishness, may
get an MPACT! Ratio of +2.4.
Two-year Treasuries, which are also likely to benefit but are more
sensitive to Federal Policy than five-years, may get an MPACT! Ratio
of +3.
The S&P 500 may get an MPACT! Ratio of +1.5. The S&P could get a
lower positive score than the Treasuries and EURUSD to reflect a
nuance in the Fed statement that the Fed were concerned with US
growth and hitting their inflation mandate (both of which would drag on
US corporate earnings, somewhat counterbalancing the effect of dovish
policy). Had the Fed mentioned they were positive on US growth but
kept their same level of dovishness, then the S&P 500 could potentially
have an MPACT! Ratio of +3 as well.
All of these events are bespoke situations that require constant refinement.
This is why the MPACT! Ratio has as many qualitative inputs as quantitative

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ones. It should be noted that MPACT! Ratios are custom to each asset class
and require a lot of ongoing work, preparation, and maintenance. The ratios
are updated before the week starts, with final adjustments happening before
the event itself. In the case of a non-scheduled event, I have found that I can
still gather value and compare it with something that I did schedule, as
market positioning will help determine where markets may reprice.
While this may take a lot of work, there are many benefits to maintaining
updated MPACT! Ratios. In the heat of the battle (when the market is going
through its period of price discovery), having a reference sheet of MPACT!
Ratios ready after an event can help take advantage of opportunities,
especially if there is a surprise. It takes a lot of legwork out of thinking
through an event, and positions a market practitioner to act quickly and
confidently.
The idea of measuring how an event affects a market is nothing unique.
However, where I think the MPACT! ratio provides a lot of value is in
crystalizing a process to assess both scheduled and non-scheduled event risk.
Much of the success in this game is about being ready when opportunity
calls, and the MPACT! Ratio has helped me in this process, thereby
generating the returns discussed in Chapter 3.
Both the MPP and the MPACT! Ratio were drivers behind automating my
position and risk management process (discussed further in Chapter 20, The
MPACT! of Automation). While the MPP tells me how much premium is
in the market at any given moment, the MPACT! Ratio outlines where
the market will likely trade over a specific period. For example, in the
euro example above, there were roughly 30 ticks of positive MPP in the euro
and a bearish jobs report would generate an MPACT! Ratio of two, meaning
an up move of two risk multiples. The result of combining both in an
automated system is a proprietary heat map identifying which asset classes to
focus on based on the projections made by the MPACT! Ratio and MPP
indications of market positioning.

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Challenges in Quantifying MPP
The challenges in trying to quantify something that to some can be very
obscure and abstract, while to others can be described as tenuously palpable,
is a very fine line. I spend a great deal of time and effort trying to
contextualize market price action before an event and to think about what the
drivers of that price action may be. One of the biggest challenges I—and
many others—have experienced in assessing MPP is ascertaining whether the
market is moving over concerns of the event or based on a stronger macro
trend. This is an important nuance in determining MPP and creating an
MPACT! Ratio.
If price in US bonds are headed higher (yields lower) because of larger
macro concerns, such as the Greek election, and this is substantively spilling
over into all risk markets, it may be very hard for the result of retail sales in
the US to meaningfully alter that trend higher in bonds. However, if a sharp
rally in bond prices was due to concerns over the retail sales number itself
being weak and an emerging narrative of consumer spending dropping off,
then this can lead to a much higher MPACT! Ratio being assigned to the US
retail sales number. The latter situation carries with it the potential to send
bond prices sharply lower if the retail sales number is stronger than
consensus, because the bond market was overreacting to the perceived
weakness of consumer demand and will quickly need to correct itself.
It is in situations like the former that contrarian investors have the
potential to experience outsized losses. Mean-reversion traders believe they
are taking on trades with a positive MPP, justifying a long position in a
falling market. However, the MPP may actually be negative and widening
as we may be in the midst of a market reprice based on a much larger
narrative. Some good examples are the Japanese yen, starting in November
of 2012, and crude oil in 2014 and 2015. This is why a big move does not
necessarily equate to a large premium or discount of MPP in a particular
market.
One bellwether for me to overcome this challenge is how the range of
people in my network are exposed to a large market move. If they are
exposed, then this suggests that a round of profit taking may provide a relief
bounce. However, if they did not monetize the move to the extent their bias
would suggest, then the move probably has more legs. Again, where

758
contrarian investors or mean-reversion strategies can get into trouble is taking
on negative MPP trades they believe offer positive premium. There is nothing
wrong with getting into a position based on one’s process, but staying with
the trade when the theme is no longer present is what presents the potential
for an outsized loss. Boom goes the dynamic and—if your eyes are not on the
ball—your P&L could follow. As Chapter 3 outlined, my October 2015
performance is a prime example of me being caught in a reprice when I
was focused on the wrong theme at the wrong time with too large a
position.
The second largest challenge to quantifying MPP is breaking news of an
unscheduled event, or what we traders affectionately call “a headline bomb.”
Breaking news is the single biggest disruptor of a current fundamental and
technical regime. I have seen great fundamental models come under
tremendous stress when faced with an outlier news event, as well as great
technical trading systems that struggle when the price action reflects this new
price action regime.
The good news is this also presents tremendous opportunity for those who
keep track of all of the factors we have outlined in this book—opportunities
that can lead to tremendous positive asymmetries and great returns per UoR. I
have prepared for this by creating a desktop that utilizes TradeTheNews
Audio Squawk, Bloomberg Professional Terminal, as well as an array of
instant messaging services to chat rooms and colleagues.
In order to develop a robust quantitative model that consistently priced in
the right MPP (paradoxically a model built largely on qualitative inputs), a
repeatable process needed to be put in place. Trying to record things like
feelings, psychological states, impulses, and instincts may seem daunting to
most. It should, though because it is. There was, and continues to be, an
immense amount of trial and error in applying my MPP model to the UoR
Process. It was quite humbling how wrong I have been at times and what
mistakes I have made while developing this. That said, the performance from
July 2013, the single largest up month covered in the performance of Chapter
3, was a direct result of the successful application of one of my earlier MPP
pricing models to the US Treasury market (see the specific trade example in
the following chapter).
The exercise of thinking about other market participants has been a
demonstrable net benefit. This exercise of quantifying MPP repeatedly takes
me out of the self-absorbed state most of us can find ourselves in when trying

759
to maximize return per unit-of-risk.
What was surprising about this is that something as visceral as the
market’s psyche can be much more quantitative than I originally thought.
These challenges are what excite me because the less quantifiable something
is, the more lucrative the alpha source. If it is easy to model mathematically,
there are likely computers programmed to exploit or arbitrage it. It can be
very hard to backtest something like a “person’s raw feelings” or “what my
intuition was telling me at the time” but this is precisely where the
opportunities lie. If you can qualitatively state a strategic argument for a
policy shift, intuit the vague or mixed sentiments of market participants, or
even just get a gut feeling (good or bad) about a development and then mine
that feeling for further insights, then you can develop an edge that the pure
quants don’t have. However, pure qualitative insight can also be hard to pin
down. The map of the territory is often the size of the territory. The marriage
between the qualitative and quantitative forces is a tricky balance, but it helps
to rarefy and reduce that additional intuitive edge into something much more
manageable.

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Factors in Developing MPP and MPACT!™ Ratios
Now that we have discussed from a basic mathematical perspective why it
is so important to have a strong understanding of how a market may be
positioned, I will explain the basket of inputs I use in determining MPP and
creating a Market Price ACTion (“MPACT!”) Ratio of an event in the
market. The following inputs can carry over nicely to options pricing
models as well. The MPACT! Ratio is a part of how I determine fair value
across the Options Greeks and how much optionality exists in a trade. When
the MPACT! Ratio is combined with the opportunity ratio, also discussed in
Chapter 5, I use the two to try and find a mispriced option string.
What follows are the groups of quantitative and qualitative inputs that I
use. I will touch briefly on each one.

a. Macro Narrative (What I read. Who I talk to.)

b. Significance of Event
c. Whisper Numbers
d. Relative Value Trades / Relative Strength of Asset Classes
e. Sentiment Indexes, Surveys, and Spreads
f. Key Technical Levels / Price Action
g. Risk Reversals
h. CFTC Commitment of Traders Reports
i. Options Open Interest
j. Social Media
k. Calendar Events
l. Earnings
m. Government / Political Actors / Central Banks
n. Idiosyncratic Market Variables

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a. The Macro Narrative
The first input in quantifying MPP and creating an MPACT! Ratio is
defining the macro narrative. This is the ultimate combination of art and
science and critical in the success of the Protean Strategy. The narrative is not
limited to one item or a single time frame, and, like nearly every other aspect
of the market, it ebbs and flows around different ideas, sentiment, and time
tables. I come to the narrative by combining a solid swath of great literary
resources with a great network. If you do not understand the macro narrative,
then understanding market positioning and, by extension, creating an
MPACT! Ratio is not feasible.
Staying in sync with the heartbeat of the markets is a rigorously
qualitative endeavor, as the nuances can be very fluid and cyclical. Later in
this chapter, as well as in Chapter 19, I will explain how I connect all of these
dots of not only what the narrative is but how it may be causing the entire
ecosystem to feel at any given moment. The macro narrative is key to
understanding this palpable dynamic.
My process for staying on top of the macro narrative is broken into
two components:

i. What I read
ii. Whom I talk to

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i. What I read
With most good narratives, it is about finding the right storytellers. I
divide my storytellers into three areas:

News Aggregation/Summarization
Background, Context, and Unique Perspective
Trade Ideas
In Chapter 8, I outlined my core go-to content people who encapsulate a
range of perspectives and specialties. Below is a more expansive list that I
read at least once a week and have learned a tremendous amount from:

Econ Alpha FT Alphaville

Sight Beyond Sight Newsletter by Neil Atlanta Fed Macroblog
Azous
Wall Street Journal (Real-Time Economics Financial Times
Blog)
Fixed Income Notes with Kevin McNeil The Economist
and John Briggs RBS
Track.com Mish’s Global Economic Trend
Analysis
Ted Mermel Sell Side FX Notes - Societe Bloomberg Daily FFM’s
Generale
Hedgeye (Daily Newsletter, Real-Time Allendale Commodity Reports
Trade Alerts, Macro Show, Daily Levels)
Macro Man RealVision
Calculated Risk Daily Speculations
Bloomberg Briefs (Economic, European Any article on Ted Mermel’s
Economic, Hedge Funds) Sunday Morning Macro Recap
While it is important to tell you what I read, sharing with you how I read
is something that may help crystalize my process. I am always looking to
grow and believe I can learn something from everyone. Therefore, with each
piece that I read, I am always looking to improve my overall systems,
strategies, and knowledge of the markets. I am continually asking myself the
following questions:

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 How is this making me feel?
Do others feel this way when they come across this information?
Is this information unique? Does it corroborate or contradict current
market sentiment about the narrative?
Where in the lifecycle is this information? Is it avant-garde, early stages,
currently taking effect in the price action, or already discounted in the
price?
Is this information straightforward or did the biggest value add come
from connecting the dots to other blogs I am reading?
Is there a bias in the writing style? Does this bias contribute to an
information skew?
Is this a one-off piece or a message that is fairly consistent?
Below is a specific example of some unique questions I ask myself when I
read one of my favorite blogs, Macro Man (http://macro-man.blogspot.com/).
Asking these types of questions has helped me learn a lot from Macro Man.
On December 8, 2015, with crude oil falling to multi-year lows and
putting pressure on the high yield market, Macro Man shared some great
primary research in his blog. He focused his piece that day on the iBoxx
credit indices because they offer an easy way to track the total return of
investment grade and high yield. To Macro Man’s dismay, the iBoxx credit
indices only go back to 1999. Being the adaptive individual that he is, Macro
Man created a synthetic index from Moody’s BAA index that goes back to
the 1980s. As I read this, I asked myself these specific questions and share
the answers below. This will help you understand how I read these articles
and process this information:

Is what Macro Man sharing a part of my process? Answer – Creating

synthetic indexes is part of my process but I had never thought of
constructing a credit index in this way to gain a longer-term context on
this issue of equity versus credit performance.
Can I incorporate this analysis into my process? Answer – Yes. This is
something worth building and something Bloomberg Support can guide
me to construct.
What other things is he referencing in either charts or analysis? Answer
– The relative performance of equity versus credit. His chart is
potentially suggesting equities are priced rich in light of the
environment.

764
 Is the chart he is using here important? Answer – It may not be
important to the mainstream financial media, but more and more
portfolio managers may start to factor this in if volatility continues.
What can I learn about from this article and potentially what other
questions can I ask in the same way? Answer – What synthetic indexes
can be created for other countries in the same way? Do the results from
this appear to be predictive? What are the exogenous factors like
monetary policy, fiscal policy, and market volatility that may influence
the historical returns of the asset classes in the synthetic index? Et
cetera, et cetera.
If you have some professional self-development time, read the last 50
Macro Man blogs and ask these questions of every piece. You will probably
see 50 different charts, perspectives, etc. and have some great content to
enhance your process.
I use my Bloomberg Terminal exhaustively in piecing together the macro
narrative. There are various news aggregation tools and the ability to filter for
specific topics. The terminal has a number of features that will also let you
track which stories have seen increased action. Alerts can be programmed to
automatically email you when certain criteria have been met. As of April
2016, my most used commands for finding news on the terminal are:

1. N – Create a customized news page (it is a great aggregator)

2. TREN – Study what is trending in news sentiment
3. TOP – Top stories
4. MMN – Market-moving news
5. NH BSV – Monitor social velocity alerts triggered by sudden increases
in social media activity
6. TWTR – Allows you to build your own Twitter functionality
The bottom line is technology has made it possible for a small team of
individuals to aggregate news information with a specificity that was not
possible even a decade ago. This outlines what literary pieces are important
in building the macro narrative.

765
ii. Who I talk to
Whereas the first part of defining the macro narrative for me is to conduct
my own research via literary resources, the second part involves a human
element. This human element happens by sharing ideas within a network.
Being able to develop a good network is directly proportional to the value I
can provide to the network. For me, the single biggest value proposition I
offer to my network is the transparency over how I am positioned in the
market.
Here are five factors that I strive for to make a great network:

1. Consistency of communication/Willingness to share quality info.

Participants must be ready and willing to share information. They could
have the greatest market insights in the world, but if they are not willing
to share, there is no value to me. Furthermore, they must be willing to
share consistently. It takes a lot of energy to do one’s part in a network,
and it’s not generally worth it to do it in exchange for pearls of wisdom
that emerge and an unpredictable schedule every few months (it’s not
even clear I will be paying attention to the source if it is not consistently
producing communication).
2. Diversity of opinions. It is important to establish a healthy diversity in
order to cross-pollinate ideas, and to get some externality (if everyone in
a network is thinking the same way, many opportunities and threats are
never detected). This includes diversity in the strategies and biases out
there. I love talking to a mean-reversion trader who is bearish the SPX
on a shorter time horizon as well as a trend follower who is neutral fixed
income on a longer-term time horizon. This diversity really helps me
empathize with what various market players are doing and thinking.
Ideally, a network should be generating new ideas from all sides, and
then providing feedback from many different angles. This enables
participants to be part of a much richer discourse, and gives them the
easier task of picking the most credible insights and contributing smaller
parts to them (rather than generating all research and opinions from
scratch).
3. People who have skin in the game. Not all of participants need to have
money in the market, but they need to have skin in the game for me to
see them as credible. This skin can be a newsletter, their reputation in

766
 the media, or some type of political motivation. Without skin, there is
not much keeping them diligent and committed to the conversation.
4. Varying time horizons. Focus on different time horizons (from days
long, months and even years long) can yield different kind of insights.
You see very different things in a market when you focus on next week
as opposed to next year, but the interplay between these perspectives in
a network can yield some fantastic insights.
5. Diversified areas of specialization. If the participants in a network
have developed areas of specialization, they can use their specialized
experience to spot issues and draw parallels that would otherwise have
gone unnoticed, and then bring it to the attention of others in the
network. By diversifying specializations, it allows for more cross-
pollination.
The robustness of a network can contribute to a virtuous circle. The more
my network expands with diversified, specialized individuals who have skin
in the game, the more I can share back with them
As Jason Roney mentioned in Chapter 4, I also have a three-tier approach
in my network. The first tier consists of three to five core people I talk to
every day throughout the day. The second tier I correspond with at least once
every few weeks or depending upon market circumstances. The last tier
consists of people I touch base with around once a quarter. Approximately 75
percent of my communication is over Instant Messenger or email, 15 percent
over the phone, and less than 5 percent in person.
Here is a sample conversation I had with Jason Roney on a
morning over Instant Messenger:
Netto: Overnight sentiment is heavy on Treasuries led by
weakness in Bund/Bobl/Schatz. Given that European Fixed
has been the tail wagging the dog in global bond prices for last
six weeks and a CPI release coming up in 30 minutes, could
be special. If CPI comes in hot on Core and OER maintains its
stickiness, think real potential for the curve to steepen further
given overhang from European Fixed Income. I am short 5’s,
10’s, Euro, and Gold. Carrying them ’til European Equity
close.
Roney: Thx. Your EUR trade is well intended but CHF
and JPY are structurally better shorts given composition of
European equity strength and price action in peripheral debt

767
 markets. I like your short 5’s and 10’s but gold not the place to
get greatest return per UoR given other choices out there. I’m
short CHF, Long MXN, and long some FTSE. Carpe Diem
Netto: Carpe Diem
From this exchange, we quickly conveyed key points by being transparent
in positions, strategy, and thoughts. I led the IM with how I was positioned. It
does not get any more transparent than that. I gave him an opinion and, right
or wrong, he gave me some great feedback.
We both only want one thing and that is to maximize return per UoR.
Neither one of us cares about our ego. Therefore, by sharing specifics, he can
decide if he wants to act or maybe he was positioned the same way. This
gave him more confidence in his position or he thought about another way of
structuring a similar viewpoint. The other possibility is he points out
something to me that completely contradicts my positions. This may lead to
me not being blindsided, thereby helping me conserve my risk units. Money
saved is money earned.
Therefore, by staying well-read and sharing with others in my network my
positioning, the conclusions of my research, and personal reactions to
breaking news events, I maintain a compelling value proposition to keep
those in my network proactively sharing their insights with me.
Being that I share positions, others in my network open up to me in the
same way. Deriving this is an art form.
As outlined in Chapter 16 (on Track.com), evolving my network through
functions like Idea Dinners is an essential part of my business. As great as it
is to be at a loud, raucous bar where you have to scream to be heard, sitting
down for three hours is more conducive to sizing up how a person can fit into
your network. This is where having a cognitive empathy grid (CEG) of your
network helps synthesize the information better. A current CEG can also
address weak points as to what segments of the market you may need to
improve your information flow.
Therefore, the questions I typically ask others in my network or try to
understand are the following:

What markets or themes are people involved in and what vehicles are
they using and how?
What is their psyche?
How are they feeling?

768
 Are they nervous about an event, a position?
Is anyone I wouldn’t expect to be involved in something getting
involved in that thing or asking about it?
Are the non-speculative hedging types moving into a market?
Are the longer-term players positioning a market?
Is it just short-term types?
How much or how little exposure do they have to a given trade or
theme?
Do they not have as much as they would like or maybe they have too
much exposure?
Is it a new position?
Is it an unwind?
Is it a hedge?
Are they concerned?
Are they speculating?
Is this consistent with their style?
Have they been in flow with the market?
How do they do in certain regimes?
Along with aggregating on my own and connecting the dots, I like to go to
other “aggregators” as well. A great part of my network to get answers on
these questions is to hit up my sell-side contacts. As noted earlier, Ted
Mermel from Societe Generale and Bob Savage from Track.com have been
great resources in this regard.
Whether I’m coalescing this information so I can factor an MPP score, or
just looking for context on order flow, Ted shares with his clients both
proximity and granularity of the transactions taking place on the FX desk.
This sentiment and positioning information helps people form views and are
important items that the sell-side can share with clients.
Ted has helped me connect the dots and ascertain if the positioning or
sentiment is leaning too heavily in a given direction. This can help grade
out a larger positive MPP. More often than not, markets will need to get
some of those cleaned up before they can move on to trading on the news
and fundamentals.
Figure 18.1 is a modified, somewhat pared-down cognitive empathy grid
(CEG) outlining how I visualize my network and the different aspects of
importance. The modified CEG rendering shown later in this chapter will go

769
over a more expansive look of how I visualize the entire market ecosystem.
The CEG outlines the different participants, strategies, biases, time horizons,
and asset classes I like to have in my network. A description of the entire
CEG system can be found at the end of this chapter.
There is a global macro ecosystem. One can see from the modified CEG
below just how comprehensive a network can be. If you are really doing
global macro correctly, you are probably following 30 to 50 markets at once.
When I say markets, I mean economies, commodities, bond markets, equity
markets—you have all those things in your head and sometimes they rotate in
and out. Sometimes they play off each other. One must keep doing a lot of
research both individually and from your network. The modified CEG helps
keep me focused and provides a great roadmap. You may not be involved in
these markets now, but things can change and things that were, for example,
deep in the 40s (on the order of priority) can suddenly make it to the top ten
list.

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Figure 18.1 – Modified Cognitive Empathy Grid

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b. Significance of Event
After taking you through what I read and whom I talk to in order to
calculate MPP and create an MPACT! Ratio, the remaining inputs are more
quantitative in nature. The “Significance of Event” input is largely
quantitative, (recall now the previous chapter in this book, by Jessica
Hoversen, showed us how to measure the historical impact of an event and
theme on an asset class). This serves as a good base for understanding how a
future event may play out. Therefore, one of the inputs in the MPACT! Ratio
is naturally the significance of the event. This is fluid and gets graded on a
relative scale. Intuitively, this input is higher if the market is really focused
on it; other times it is lower if the market’s focus is on other drivers.

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c. Whisper Numbers
A whisper number is the unofficial forecasted number for a
macroeconomic event. Every economic event has a formal expectation,
usually generated by a number of paid economists who submit their forecasts
to places like Bloomberg or Thomson Reuters. These aggregated forecasts
become the “consensus” estimate for an event. However, due to a variety of
factors, at times the perceived outcome of the market will differ from this
consensus estimate. This perceived outcome is referred to as the “whisper
number.”
For example, crude oil inventory may have a formal survey expectation of
four million barrels. However, despite this forecast, many traders may
actually be expecting the number to be closer to two million barrels.
Therefore, the whisper number is for less of a build. As a result, if the
number comes in at three million barrels, crude oil may sell off initially
(rather than rally, for coming in below official expectations) because many
traders were assessing the event against the whisper number.

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d. Relative Value Trades / Relative Strength of Asset
Classes
The performance of asset classes on a relative basis can tell a great deal
about how a market may react and is positioned before a certain event.
Different asset classes react differently to events. This is why I not only look
at how an individual market has reacted in the past but how spreads have
acted as well. The UoR Dashboards created by Thom Hartle help
tremendously with this by ranking these relative-value trades based on a
number of factors.
Here are some of the spreads I look at when building an MPACT! Ratio
and quantifying MPP:

High Beta/Dividend Paying Stocks

US Big Caps / European Big Caps
US Big Caps / US Small Caps
SPY/EEM
Commodity Spreads in Energy Markets
Gold/Copper
Yield Curve Trades
AAA European Govt / European Peripheral Debt

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e. Sentiment Indexes, Surveys, and Spreads
Traders have been using various indicators of market sentiment for many
years (technical measures that they must calculate from market movements,
custom indicators based on their own research, or prepackaged quantitative
indicators released by other entities) in order to inform their trading. There
are a number of prepackaged quantitative indicators out there that indicate
market sentiment: Citi Surprise Indexes, Jake Bernstein’s Daily Sentiment
Index, and the Bloomberg Economic Surprise Index (command: ECSU) are
great examples. Credit Default Swaps (CDS—essentially tradeable insurance
policies on various market instruments) can be a very rich source of data on
market risk sentiment. Similarly, volatility indices (like the VIX or
VSTOXX), which calculate market volatility from the implied volatility in a
basket of relevant options, can also be extremely informative. Furthermore,
various market surveys—like the Stone & McCarthy Portfolio Managers’
Survey and the JP Morgan survey—can further fill in the gaps on market
sentiment. Finally, the spreads between various instruments traded on the
market can be extremely informative. Elsewhere, we have discussed how the
steepening or flattening of the yield curve (essentially a spread between the
long and short end) can indicate market sentiment—other spreads include the
TED spread (the spread between T-bills and Eurodollar futures), the
Muni/10Y spread (between municipal bonds and ten-year Treasuries), and
the Crack spread (between the price of crude oil and refined petroleum
products).
Having a firm handle on sentiment can inform and enrich every aspect of
trading. It is intuitive that knowing sentiment can help with trend-based and
consensus-based trading, but it can also tell contrarians what to trade against.
The theory of contrary opinion asserts that if a majority of traders agrees on
the direction of a market move, then the odds are significant that prices will,
in fact, move in the opposite direction. If the markets have not had their
feathers jostled in a while, and expectations have grown too complacent, it
might be time to start thinking about contrarian surprises.

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f. Key Technical Levels / Price Action
Price is king—it is generally the most immediate and readily available
data point in markets, and it influences how we perceive everything on the
market. When a market has just broken out to a new high or tumbled to a new
low, this can have a profound impact on sentiment and market positioning.
Conversely, markets that have been range-bound for some time can lead to a
greater complacency among participants. I incorporate a lot of the technical
tools shared earlier in this book regarding Fibonacci levels, market profile,
Elliott Wave, and key technical inflection points as another input in the
MPACT! Ratio.

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g. Risk Reversals
The risk reversal is a measure of the skew in the demand for out-of-the-
money options. It is defined as the implied volatility for call options minus
the implied volatility for put options with the same delta (commonly 0.25)
and expiration date. A positive risk reversal indicates the market expectation
that the underlying will see fewer, but larger up-moves relative to down-
moves; a negative risk reversal indicates the market expectation that the
underlying will see fewer, but larger down-moves relative to up-moves.
Risk reversals have a much bigger following in the Forex space, where the
options markets are more developed. As a result, there are some idiosyncratic
aspects when it comes to applying risk reversal analysis to other asset classes,
such as equities, given the preponderance of index hedging via puts. Like
many things in this book, context is key. WCRS <GO> on the Bloomberg
Terminal is a good portal for Forex risk reversals.

Figure 18.2 – Bloomberg Risk Reversal Screen

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h. CFTC Commitment of Traders Reports
The Weekly Commitment of Traders (“COT”) Report from the CFTC is
one of the quantitative variables that I match up with the macro narrative to
help ascertain how the market may be positioned. In terms of the Forex
market, it only represents a fraction of the daily volume but it can nonetheless
give a decent perspective of how the market was positioned. The report is
released on Friday afternoon and represents the change of positions for the
week ending the previous Tuesday (three days prior to release). The report
gives—among other things—the net long positions, the net short positions,
and the open interest for futures contracts traded on the CME. Type in COT
on the Bloomberg Terminal to get the information or { XLTP XCOT <GO> }
and open up a very intuitive and easy-to-use spreadsheet that feeds the data
from the Bloomberg Terminal into Excel.
Figures 18.3 and 18.4 show how the data looks imported in Excel, and I
can quickly assess both visually and numerically the trends in place. I can
toggle and select from all the different asset classes covered in the COT
Report

Figure 18.3 – Consolidated Commitment of Traders Euro Contract Data in

Tabular Format

778
 Figure 18.4 – Consolidated Commitment of Traders Euro Contract Data in
Chart Format
If I want to take the data from the figure above, I can load it into a custom
graph in Bloomberg. Below is a custom chart I learned how to create reading
an FFM in Bloomberg from June 2012 titled, “Calculating the Probability of
the Euro Setting a New Low.” The custom chart allows me to combine the
EUR/USD spot price, risk reversals, and net speculative shorts in the COT. I
like to play with these charts and get a visual perspective of the COT data and
what macro narrative might have been in play and how this matched up with
other technical factors.

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Figure 18.5 – Customized Bloomberg Screen Showing Euro Spot, Risk
Reversal, and COT Positions

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i. Options Open Interest
Options activity can be very instructive about how prices and markets may
react to both scheduled and unscheduled events. Similar to the philosophy
behind risk reversals, I grade out how much gamma is in the market at certain
points as it can create asymmetrical situations given the time of expiry,
impact of an event, or shift in sentiment.

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j. Social Media
I use Twitter, social velocity alerts, and some proprietary web content
aggregation tools to measure general market sentiment around specific
events. A lot of this is just detective work and has the element of randomness
to it. If I see a tweet from someone, I will reach out to them and get their
thoughts. Twittersphere can be a place of raw impulse and I have been
surprised by how awesomely authentic some responses can be when a
commenter is in the moment.

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k. Calendar Events
The makeup of the calendar is another factor I use when creating
MPACT! Ratios over multiple time frames. For example, the S&P 500 may
only have so much upside potential before a big event and people begin to
square positions. Weeks of economic data with high “significance scores”
may cause a lower MPACT! Ratio on a per-event basis due to market fatigue,
whereas a week where there is only one highly significant event then the
MPACT! Ratio may be higher. Either way, understanding how the calendar is
configured for economic, central bank, and policy speeches can help to avoid
overestimating or underestimating the effects of given events.

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l. Earnings
As risk markets are discounting mechanisms for future earnings, the
relative success or failure of earnings season can influence market sentiment.
Whether it involves a bellwether tech giant like Apple or the trends of the
earnings season in general, understanding the extent earnings drivers are
pushing the market can have a material impact on one’s MPP and MPACT!
Ratio. Market practitioners should be aware of whether poor earnings are
already discounted into the price of the market, as this could lead to upside
surprises. On the other hand, downside surprises can occur when the market
is taking a rearview mirror approach or discounting a particular sector like
energy in 2015, but acutely sensitive to financials. Understanding all of these
factors for what earnings announcements matter comes from an ongoing
commitment of staying apprised and informed.
A quick snapshot I use to see the trend in both sectors and the broad
market is the EA <GO> command on Bloomberg. My style is less bottom-up
equity analyst and more top-down macro trader, so this function on
Bloomberg sets me up nicely.

Figure 18.6 – Bloomberg Earnings Analysis Screen

784
m. Government / Political Actors / Central Banks
Understanding where we are in terms of an election cycle, what legislation
may be forthcoming, and whether a central bank is perceived to be shifting
policy can stall or exacerbate a move in the markets. If an event normally
would generate an MPACT! Ratio of one for the euro, but a key European
election is coming before the weekend, I may have to adjust downward as the
market holds its breath, or make further adjustments based on the sentiment
over how the election results will be.

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n. Idiosyncratic Market Variables
Let us not forget the market is a place of many actors and idiosyncratic
events. Understanding things like fund performance, a liquidation event
taking place, a large position unwind, a blow-up, an act of war or terrorist
attack, a force majeure event (an act of God, such as an extreme weather
event), or other special events can cause deviations in how things trade.
These are also factored into the MPACT! Ratio and MPP.

786
The Cognitive Empathy Grid (CEG)
The cognitive empathy grid (CEG) is how I figuratively “connect the
dots” (and quite literally “connect the shapes”) by combining the macro
narrative and positioning in determining how a particular market may trade. I
do this by placing eight separate categories and attaching a unique
geometrical shape to each one. These shapes represent different parts of the
market ecosystem and allow me to crystalize my thoughts by making the
exercise as visual as possible. From there, I can assign a probability of how
each of these factors will influence the market accordingly. Once I have
completed this process, I can program the respective scenarios into MPACT!
™
Phases I and II of The Global Macro Edge were about illustrating the
tools to define the regime and understanding the various strategies one could
use in those regimes. With Phase III focusing on how to implement the two
of those, many of the inputs about to be outlined have already been covered.
Below is one of my many renderings of a CEG. I learned the term “cognitive
empathy” from Denise Shull’s book, Market Mind Games, and have
assimilated it into my UoR Process.
A CEG can be very complex or very simple. One can literally create
hundreds of subcomponents to these factors if one desires. Generally, I
believe the exercise of thinking about how others are thinking and feeling is
more important than trying to make this excessively elaborate. As you will
notice from these categories, there can be overlap as an entity can fall into
both the long/short equity subcomponent as well as the mean-reversion
subcomponent. Therefore, for me it is about a balance.

787
788
 Figure 18.7 – Cognitive Empathy Grid
The macro version of my cognitive empathy grid, or CEG, is broken into
eight factors:

a. Participants
b. Strategies
c. Bias
d. Asset Class
e. Time Horizon
f. Emphasis
g. Technical Regime
h. Fundamental Regime

789
a. Participants
The participants’ component of my CEG can be as narrow or as expansive
as I feel the situation calls for. The eight types of participants I track are: Real
Money, Active Discretionary, Retail, Algorithms, Media, Sell Side, Third-
Party Analysts, and Government/Political.
However, keep in mind that this list is just a working sample—users can
customize participants in a CEG to their particular needs. These components
can be further subdivided, as Real Money can include pension funds,
endowments, and family offices while the Media may include traditional
television, online blogs, Twittersphere, etc. As you can imagine, the
subcomponents of any one of those could spawn numerous choices.

790
b. Strategies
I include the strategies section to remind myself of all the different
investment philosophies at play in the market. This section of the CEG feeds
in nicely with my Regime Profitability Factor and UoR Strategy Grid shared
in Chapters 5 and 8. The eight types of strategies I track are: Long/Short
Equity, Trend Following, Mean Reversion, Volatility, Pairs Trading /
Relative Value, Pattern Recognition, Value Investing, and Event-Driven
strategies.
In the UoR Strategy Grid, I assign a score based on how effective a
strategy will be in a certain environment. The CEG helps me determine that
variable and how I should adjust the Strategy Grid based on the outcome of
events.

791
c. Bias
Bias is a huge factor in running through the CEG, as a sharp reaction to an
event is only as powerful as the sentiment of the market going into that event.
Therefore, if a planned or unplanned event produces a reaction contrary to the
underlying bias, this is a key part of the exercise. I list five biases: Bearish,
Modestly Bearish, Neutral, Modestly Bullish, and Bullish—but you can be
more detailed if you like. Again, for me it is not about being overly
concerned with pinning down the exact sentiment as it is getting the sense of
where the general market bias is.

792
d. Asset Class
The asset class is the next factor in the CEG because different asset
classes have different idiosyncratic aspects. For this CEG rendering, I track
four asset classes: Equities, Fixed Income, Currencies, and Commodities.
Still, one could break these down into much greater detail. Extrapolated out,
if you were to create a CEG for an earnings announcement for AAPL, you
could make a category with AAPL stock, suppliers, technology stocks, etc.

793
e. Time Horizon
Time horizon is the next input I use when determining how a market may
react to an event. Clearly participants like a Real Money Fund aren’t trading
on a one-minute chart. However, having different levels of time granularity
can help predict the subsequent price action and construct tactics appropriate
to the event. I recognize six time horizons in my CEG (but—as with all other
subcomponents—this can be altered to a user’s preference): Short Term (1
minute to three hours), Short/Medium Term (three hours to three days),
Medium Term (four days to two weeks), Medium/Long Term (two weeks to
three months), and Long Term (three months to three years).

794
f. Emphasis
The emphasis component helps me analyze how important an event is
relative to the respective parties from the previous five categories. If an event
has the potential to change the narrative to a broad group of participants, then
that gets graded differently than an event that may only matter to a select few.
I recognize five levels of emphasis in my CEG: Low, Low/Medium,
Medium, Medium/High, and High.

795
g. Technical Regime
Chapter 4 by Jason Roney outlines these variables and they speak for
themselves. The price action taking place will have a lot to do with what sort
of market reaction we may get from any planned or unplanned event. The
five technical regimes in my CEG are: Volatility, Correlation, Volume,
Momentum, and Sentiment.

796
h. Fundamental Regime
The last component in the CEG is the fundamental regime. If this event
has the potential to alter the perception about any of these fundamental inputs
to a broad array of participants, then it can receive a higher score. The eight
fundamental regimes in my CEG are: Growth, Inflation, Monetary Policy,
Earnings, Fiscal Policy, and Geopolitical Risk.

797
Applying The Cognitive Empathy Grid
We have spent this chapter outlining how, using qualitative and
quantitative factors, I price in MPP, construct an MPACT! Ratio, and
determine how a market may react to an event. I also incorporate the CEG in
my day-to-day trading—in fact, it intertwines with the UoR Strategy Grid.
Therefore, I wanted to walk you through the conceptual process I use this to
deconstruct how the market will collectively react.
It is worth repeating there are numerous iterations of CEGs that I have
constructed to account for multiple situations in the market. Per the UoR
Process, CEGs can take on a very bespoke nature or be very general. These
CEGs can be applied to how a single stock may react to earnings versus the
potential price action on a holiday shortened Friday. The big takeaway is that
you are going through an exercise that takes you out of your own shoes and
puts you in the perspective of other participants. This is the essence of
cognitive empathy (or theory of mind—the ability to understand and analyze
the different beliefs of others), and is accomplished by both visualization and
quantification.
In using the CEG, I start at the top and go down the line while connecting
the shapes from each category. I look at the market and attempt to link
together the various factors that comprise the market ecosystem. If you have
a CPI number coming out and you want to assess where the market may
move for the next 24 hours, you may connect the shapes in the following
way:
Participants: Active discretionary
Strategies: Long/short equity
Bias: Bullish
Asset Class: Equities
Time Horizon: Medium term
Emphasis on Event: Medium
Technical Regime: High volatility, low correlation,
modest volume, strong momentum, and bad sentiment [note
this uses all these sub-components, and further categorizes
them]
Fundamental Regime: Modest growth, modest inflation,
weak earnings, modest fiscal policy, accommodative monetary

798
 policy, and high geopolitical risk [note this also uses all these
sub-components, and further categorizes them]
Thinking about all the elements the CEG grid has helped identify, I can
summarize a result or set of results based on different contingencies. For
instance, let us visit a specific result based on the CPI and PCE Deflator
inflation numbers.
Result if inflation is hot: Potential to change market participant bias in
an economy with modest growth and rising inflation. Market participants may
lower their outlook if we have threat of Fed moving in to control inflation.
This applies to a set of participants that have been long equities and, given
this fundamental and technical regime, are not doing well. If inflation comes
in strong, individuals such as this one may have to get more defensive if
inflation starts to become an issue. They may need to go to more cash as
rising rates in a low-growth environment present all sorts of problems for
already bad sentiment.
MPACT! Ratio of SPX on hot number for next 24 hours is -1.5 risk
multiples, or 30 points.
What I’m trying to do is profile someone from the CEG and how I piece
together how they may react, or empathize with their situation. By doing this
for a cross section of individuals, it only strengthens the process of building a
better MPACT! Ratio. The process and inputs are much more expansive than
this, but I wanted to at least provide a working example as a result of this
visualization exercise and then show how it feeds into MPP and MPACT!
Ratio.

799
Conclusion
Quantifying and visualizing market positioning is like a language that,
over time, many can learn. Understanding how other traders and investors
will perceive information begins with understanding the underlying drivers
yourself. As a foreign language enthusiast, I have many times gone through
the process of tackling a new vocabulary, a new syntax, a new set of norms,
and a new way of listening and speaking. However, I have found certain
advantages in it. Some thoughts, some sentiments, are simply more easily
expressed in other languages. As market practitioners, we must be fluent in
both qualitative and quantitative languages, and our trading—at its very best
—should be the poetry that stems from this combination. When a visual
component, such as the cognitive empathy grid, is added, it is yet another
language to enrich the whole experience, another modality of thinking to
grant additional insight. The vast totality of market sentiment and market
positioning is an extremely broad subject, with a lot to think about, so it helps
to take it on from as many angles as possible.
22 Note that these scenarios differ from the distributions that would be projected by
only paying attention to the standard distribution (which, for instance, would project
that roughly 15.9% of observations would be one standard deviation or more above the
mean, and 15.9% of observations would be one standard deviation or more below the
mean). There is some level of art involved in putting together these numbers. While the
normal distribution may be used as a baseline, market practitioners should use
everything they know about the markets in fine-tuning their estimates and establishing
probabilities.

800
CHAPTER
19

801
 Emotions Are Our Greatest
Ally, Not Our Biggest Enemy
“When I start to get too comfortable in a position, it makes me nervous.”—John
Netto
When we were conceptualizing this book, my coauthors and I wanted to
reframe the narrative on many stubborn misconceptions, bad habits, and
lasting prejudices in the financial world. Emotion—the topic of this chapter
—sits near the top of the list of prejudices. There has long been a negative
stigma associated with making emotionally informed investment decisions.
Market participants of all pedigrees have dedicated time, money, and energy
to purging all emotion from their investment process. Countless pages have
been written over the years on the benefits of dispassionate, emotionally
detached investing, and we thought it was time to print a few in opposition of
the idea.
History is filled with examples of people looking at what was perceived to
be a huge challenge and turning it into a bastion of opportunity. Increasingly,
more neuroscience research is suggesting such an opportunity exists when it
comes to understanding the role emotions play in our investment decisions.
This chapter will lay out why our own emotions can serve as a repository
of information about the animal spirits of the market. Many market
participants believe that using their emotions in the decision-making process
may undermine their success. This negative perception exists because of the
personal experiences many of us have had of succumbing to an impulsive
decision, only to see negative results follow. The decision outside of our
process may have led to us putting on excessive risk, breaking our rules, or
suffering an outsized loss.
As a natural defense to preventing these experiences from happening
again, many of us hypercorrect—we overgeneralize the rule that any
application of emotions to trading is bad, without seeking to analyze what
was detrimental about a specific situation. In short, we look past a source of
tremendous opportunity to tap into trades with incredible positive
asymmetries. We can only tap into this unconventional source of alpha if we
are willing to identify, compartmentalize, and integrate emotions into the
trading process. I will show you how I have done this in my own trading.
It is my assertion that the next paradigm shift in investing will not come

802
from building faster connections to exchanges, more robust economic
forecasting models, nor adaptive artificial intelligence. The next wave of
alpha will be generated by tapping directly into the “emotionality” or
animal spirits of the markets, harnessing our own intuitions as signal
sources. Investors who understand their own emotionality, as well as the
collective emotions of the market, possess a valuable tool—albeit one still in
its nascent stages—for generating alpha.
Emotionality is an “X Factor” for gauging markets that are not easily
measured by VaR, Sharpe, AUM, or a “minimum of a five-year track
record.” Measuring it is not presently taught in any major MBA
program, and it will probably take decades to adopt formally. My process
for measuring my own emotions has been touched on in Chapter 8, where I
outlined my qualitative self-assessment embedded in my trading plan, and in
the last chapter on quantifying and visualizing market positioning.
If I am being intellectually honest with myself, then I must admit there are
two huge factors at the root of my outsized performance as a professional
trader. The first is that I incorporate the macro narrative into nearly every
trade I make. The second is the development of my intuition over many
years. I believe both of these factors are equally responsible for my ability to
make a living as a professional trader. In this chapter, I will share with you—
in the most transparent and descriptive manner I can provide— how I have
learned to quantify and harness my own emotions, feelings, and intuition to
help maximize return per UoR. It is my aspiration that readers who assimilate
my process, in part or in whole, will experience similar benefits.

803
The Choice
We will begin this literary journey positing one question. If you were
given only one strategy with a limited budget, what would you do to derive
the most consistent profits?

1. Would you replicate the trades of the three most successful traders you
knew?
2. Would you do the opposite of the three worst traders you knew?
The answer for me is obvious:

804
DO THE OPPOSITE OF THE WORST TRADERS!
Often, the most successful trades are unique to a time and place. The best
traders have opened themselves up to the opportunities for such trades, and
they pounce on them when they present themselves (as when Soros “broke”
the Bank of England in 1992). This may not be replicable even a day later, so
recreating the trades of the most successful traders may not be a successful or
even appropriate strategy. The best traders stay versatile (just as the Protean
Strategy advocates adaptability), so it is generally not possible to imitate or
predict them.
The worst traders, on the other hand, tend to engage in a system of
behaviors that make it much harder for them to succeed in the long run.
These behaviors are significantly more predictable, more observable, and
readily avoidable. It is very easy for the majority of traders to succumb to
emotional impulse in terms of what they do and do not execute. The worst
traders are not the masters of their emotions, and they give in to destructive
impulses on a regular basis. Speaking from experience, my results when
succumbing to an emotional impulse have produced the most spectacular
losses of my career. Losses so incredible and so consistent that they
compelled me to study how I could incorporate these signals as a “contra-
signal.” As much respect as I have for the best traders I’ve worked with, I
know there is nothing more powerful than fading an emotional trader “on
tilt.” (Here I am borrowing a phrase from my years as a professional cash-
game poker player in Las Vegas. In poker, being “on tilt” refers to pursuing a
suboptimal strategy after becoming mentally or emotionally flustered. It is
quite literally the opposite of maintaining an even keel.)
Even great traders have to continually work at not succumbing to the
impulse of taking profits too quickly, managing leverage, or having the
discipline to follow their plan. The bottom line is that it is much easier for
a bad trader to behave badly than for a great trader to stay great. I want
consistency in my system. Anything that can consistently produce explosive
results, for the positive or the negative, needs to be studied exhaustively to
see what we can learn.
I have broken this chapter into two sections, reflecting my two-stage
process for incorporating my emotions. The first section is the process I use
to understand my own emotional state, what my natural instincts are, and the

805
tools I have used to develop my market intuition. The second section will
outline how I take this information and apply it to my Unit-of-Risk Process.
In these explanations, I will put forth ideas of how one may incorporate
aspects of what I do into their own practices.

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How My Past Influenced My Present
My route to becoming a professional trader took a less traditional journey,
a journey I want to share with you because, as I will expound on further in
this chapter, our journeys have a profound impact on our trading disposition.
Experiences we have as children or in our adolescence can unconsciously
influence how we manage a trade on a five-minute chart decades later.
To this day, I have never worked for a Wall Street firm. Due to my pursuit
of other entrepreneurial endeavors during my adolescence, being a perennial
academic underachiever in high school, and a desire to be part of something
bigger than myself, the US Marine Corps was the path that made the most
sense for me when leaving home at 18.
The final four years of my Marine Corps career were spent as an enlisted
Marine in the NROTC program at the University of Washington from 1998–
2002. After morning drill, I would come in and day trade in the wardroom on
the huge VGA monitors. Being that nothing ever goes unnoticed by the cadre
of Navy midshipmen and Marine officer candidates, I would often be asked
where I learned to trade. I responded honestly that I picked it up by reading
books like Trading with DiNapoli Levels, searching stuff online, and by just
“doing it.”
Authentically answering people’s questions to the best of my ability
became a real passion. This passion led me to become the business editor at
The Daily, the student newspaper at the UW in 2000 and 2001. The
interesting part was that I was not a business major. While I loved my major
in Japanese, Chinese, and Asian Studies, I was really pushing myself outside
my comfort zone to share opinions on the market with the UW student body.
Without formal training, I was petrified before each article would go out. In
my mind, I always had doubts whether I really had anything of value to offer.
This doubt stemmed from more than just not having a Wall Street
background. There were a few things at play that, unbeknownst to me, were a
big part of the trading early in my career. The first is that my grades in high
school had been a huge disappointment to my father. My dad was a man who
passionately loved my brother and me. He made tremendous sacrifices to do
what he thought was best to see us succeed. He always emphasized how
important grades were and pointed out to me how a number of my older
cousins and younger brother excelled academically. As a result, even though

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he did not purposely try to make me feel this way, it became ingrained in my
mind that because I was not able to excel academically, I must not have been
that intelligent.
Nine months into my Marine Corps career, and only weeks before being
sent to my first duty station in Japan, my father passed away at the age of 54.
Along with the devastation of losing a parent, I felt tremendous regret at not
living up to his expectations and doubted what I was even capable of doing.
Once this sentiment was established, it was not easy to alter. Even after
spending four years in Japan and teaching myself to speak, read, and write
Japanese at a very high level, a part of me had significant doubts about what I
could achieve. Upon being accepted to the University of Washington in 1998,
I was filled with mixed emotions. Given my tenuous academic past, and
doubts about my capabilities, I was not even sure whether or not I would be
able to graduate.
I bring all of this to the forefront because these factors played a huge role
in my trading career. I asked myself questions like:

Do I really have an edge in this trade?

Am I intelligent enough to make money trading?
Since I thought of this strategy or idea, will it really work out? Wouldn’t
someone else have thought of this earlier?
How could I possibly find an edge given all the other smart people with
huge resources at their disposal trying to do the same thing?
This second-guessing led to some less-than-ideal trading behavior. I
would cut winners short for fear that I did not have an edge and would give
back all my profits if I held on. I thought that, if I was in a winning trade, it
was only because of luck. In short, I developed anxiety from not believing in
myself and my ability to keep trading successfully.23
I knew from the research that I had done, winning trades that I had made,
and my spot-on market calls that I was playing a beatable game. Too many
times, however, when the adrenaline took over, my emotional impulses
became the driving factor of my decisions. I would abandon my entire
process and succumb to these strong animalistic forces. I needed to take
action to correct this.

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Developing an “Intuition” Infrastructure
In order to correct the challenges outlined above, I sought outside help. It
was incumbent upon me to put in place a system and structure that would
allow me to harness my emotional energy and intuition, rather than allow it to
be the cause of my downfall. My journey to fully assimilating my intuition
into my trading process came from three key events:

Working with a performance coach;

Reading Denise Shull’s book, Market Mind Games;
Collaborating with Denise Shull and her company, The ReThink Group.
I will lay out how each of these factors was vital in creating the intuition
infrastructure essential in my trading success. I will also describe what key
aspects I took from each of these three and set up a template for you to
consider for your own investment process.

809
Performance Coaching
I began using a performance coach in 2002 and have continued to do so
ever since. Despite my initially incredulous view about how powerful
intuition is, as well as my continually questioning the methods she used, she
convinced me the long journey of assimilating my feelings, emotions, and
intuition would reap tremendous dividends. It was a Mr. Miyagi and Karate
Kid type of relationship tailor-made for CNBC.
My coach was not a cushy life coach preaching some obscure doctrine.
She had been hardened from working on Wall Street for many years at some
of the most reputable firms. Her responsibilities required a rigorous
quantitative approach as both a computer programmer and risk manager of
major traders.
My coach significantly recalibrated how I approached many things in and
out of the markets. She put me through a spiritual boot camp that brought to
the fore the previously described issues with my father and many other buried
things that influenced my perspective. It was an approach Denise Shull also
subsequently outlined in Market Mind Games and it was a cleansing that was
as methodical as it was deep.
She also strongly ingrained in me the importance of being gentle on
myself. When I started my sessions with her, I was my own toughest critic.
This behavior created unrealistic expectations for myself and my trading that
hindered my P&L. Learning to be gentle, as if I was speaking to a child,
really helped me. Having spent over eight years in the Marines, and growing
up in a competitive culture, my stance was to always expect more of myself;
my credo was that any problem may be solved with time and perseverance.
Maybe the most luminous change my coach was responsible for was
shifting my perspective on situations to one of abundance. I was always a
natural risk taker but never understood how an emotional state of scarcity—
believing that assets are hard to come by, and thus should be hoarded,
overvalued, and protected—could really hinder my P&L. We worked on
drills so that when I had to exit a losing trade, it was done from a perspective
of abundance. People with a scarcity mentality tend to hold onto losers
longer, while an abundance mentality understands there are better
opportunities around the corner.
The final key piece of having an abundance mentality is celebrating.

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Again, this is where my Marine Corps background and upbringing told me
that if you did something outstanding, it was not given a second thought—
excellence was the standard and celebrating successes felt weird. I came to
learn that celebrating success (in essence, rewarding it immediately by
allowing myself to feel happiness—even joy—at a job well done) is an
essential component to receiving more of it through the conscious and
unconscious power of positive reinforcement.
To give an example: I had a rough trading day where my execution was
flawless and yet I nonetheless lost money. Because I executed the process
perfectly, I stopped my portfolio from losing substantially more. When my
coach heard how well I executed, she was really excited over my “loss.” She
insisted I go out and splurge on a huge dinner at the Bellagio in Las Vegas. I
was not really feeling it because I lost on the day, but I respected where she
was going by emphasizing the “process vs. result.” For more than a decade
these and many other things were the driving factors for shaping my mind-set
and disposition.
It is imperative to keep in mind that we ultimately do not have control
over the markets—we can do everything perfectly from our end and still have
a negative result (though certainly not as negative as it would be if we’d
bungled the situation). If we bang our heads against the wall (“positive
punishment” in psychological terms) or deprive ourselves of joy or rewards
(“negative punishment”—the deprivation of a pleasurable stimulus), we
encourage ourselves to act differently the next time, to avoid the behaviors
that led to that less-than-ideal result. When we’ve performed perfectly on our
end, this is a problem—there’s no way to go but down, and any change in our
behavior will take us further from ideal execution.
What my coach has taught me is that we can’t let circumstances beyond
our control change our behavior for the worse. We can’t convince ourselves
that something totally out of our hands is our fault, and then totally destroy
our successful trading habits by way of apology. We must recognize when
we are exercising the right habits—the habits that will make us money in
the long run (though that doesn’t mean 100 percent of all days will be
profitable)—and we must reward them and stick with them. The Protean
Strategy advocates versatility and malleability, but the best traders are
intelligent about making changes—they do not tell themselves that every
bump in the road warrants a shift in behavior, and they do not punish
themselves for doing the right thing even when it does not work out.

811
 Many times a month my coach and I talked about the trades I put on, what
events were going on in my life, and took a pulse of my energy. My coach
did not focus our conversations around trades based on the technical factors,
such as if we were at key technical support or the influence of the latest
economic news. Her questions were about my energy and the energy of the
markets. She would ask me questions like:

How did I feel before getting into this trade?

Did that affect the sizing?
What were my range of feelings while managing the position?
Was I confident or afraid?
What was the energy of the market? Not defined by a technical indicator
per se but did it feel tired, excited, indifferent, etc.?
How did I feel after the trade?
What was determining my emotional state? The result of the trade or the
process of managing the trade?
Am I seeing any degree of consistency between my range of feelings
and outcome of the trades (i.e., when I’m trading mad, calm, or tired,
does that have an impact, etc.)?
The more detail I could provide her the better our sessions went.
Unbeknownst to me at the time, she was engraining a more formal process of
both acknowledging the market energy and incorporating my intuition into
my trades.
In focusing on my feelings, my coach also helped me separate my ego
from my trading, and to accept that it is okay to be wrong at times. There are
traders out there who would rather be right than rich. They feel that if the
original plan or thesis they presented isn’t correct, then somehow this is an
affront to them. At this point, being “right” becomes more important than
maximizing return per UoR. This mentality can fly in the face of sound risk
management practices and fostering an ethos of adaptability. If you ask
yourself the same sort of questions my coach asked me, stay introspective,
and allow yourself to be wrong when necessary, you can avoid this trap.
Maybe the most important skill set I have developed from working with
my coach is the ability to know myself. This is a tremendous benefit from a
risk management standpoint. In Denise Shull’s research, this is called the
thinking style of “differentiating risks” and is the foundation of the thinking
styles of intuiting markets using feelings and emotions. Having the ability to

812
understand where we are in the emotional spectrum requires tremendous self-
awareness and introspection. Over the years, these skills have allowed me to
prevent outsized losses one would typically find with the performance profile
of the Protean Strategy. This ability to dampen downside volatility while still
allowing the upside potential to exist is a byproduct of this “emotional
alpha.”
Keeping a journal certainly helps in the introspection process. The use of
my trading journal became critical in my sessions with my coach and
ultimately morphed into the system that you saw outlined in Chapter 8.
Creating the journal took more than a decade, and history suggests it has
many more iterations to go through. My coach helped me in many ways on a
personal and professional level. As I became older and wiser, I saw how such
personal and professional issues are interrelated and can influence each other.

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Market Mind Games
Market Mind Games, written by neuroeconomist Denise Shull24 and
published in 2012, is an amazing, paradigm-changing literary work on how a
trader’s mind works in the markets. It had a profound influence on me in my
journey of developing my intuition. Why do I feel this way?
With books that change how we approach our craft, there are usually
immediate benefits for the reader and longer-term themes at play. When
spanning 50 years of alternative investment history, one clearly sees how
dominating regimes like that of AW Jones (the revered patriarch of the hedge
fund industry) revolutionized the game in the ’60s with a basic long/short
portfolio. The ’70s brought the incipient use of computers, trend-following,
and mutual funds for the masses. The ’80s and ’90s elevated global-macro
managers to rock star status. The dawn of the 21st century commoditized
traditional liquidity, providing trading action deep into the decimals on
electronic venues.
So how will history judge the pioneers of investment innovation for the
2010s and 2020s? After reading Market Mind Games, harnessing one’s inner
alpha is the next logical step in this chronology of cutting-edge approaches.
While many would argue that markets have become more dehumanized,
Shull justifiably posits that an untapped reservoir of alpha sits at most
traders’ disposal who are willing learn to think in terms of intuiting markets
and differentiating risks on a feeling level.
The book has a number of compelling facets to it. Along with
deconstructing the neuroscience involved in a trader’s brain, Shull weaves in
real-world anecdotes to help illustrate the lessons that readers should carry
and implement immediately into their investment process. She spends an
extensive amount of time highlighting the research that illustrates that traders
who do well are always factoring in what other market players are thinking.
Even more importantly, the book is replete with assertions that bust a number
of long-held beliefs about how traders should manage risk, quantify
emotions, and approach the market. I have many highlighted sections in my
Kindle edition of Market Mind Games that I am constantly referencing.
As a person who is always looking for an edge that plays upon widespread
misconceptions, the information resonated with me in a profound way. It
corroborated and enhanced how I review and contextualize my market

814
analysis and execution. Shull’s writing style, choice of content, and
instructional method strikes the right balance of stimulating those passionate
about the market, while not talking down to the reader. It is a hard balance to
strike, and she does it nicely.
I am confident that, in the coming years, we will hear about more billion-
dollar funds retaining the services of individuals like Shull to get as much out
of their traders’ and portfolio managers’ P&L as possible. Oftentimes, the
most obvious solution to a problem rests right in front of us…

815
Denise Shull and the ReThink Group
While I had known Denise before the 2012 publication of Market Mind
Games (and was always impressed with her disposition, intellect, and
irreverence for conventional thinking), it was listening to a CQG webinar she
gave in 2012 that catalyzed me to take the relationship to the next level.
While my coach took a bespoke approach to developing my personal skills
intuition, Denise put forth a complementary (but much more generally
applicable) literary work incorporating the latest neuroscience research that
corroborated all the things my coach taught me. This combination of a
holistic approach from my performance coach and empirical science
from Denise was a compelling, vigorous, and robust one-two punch in
raising my ability to maximize return per UoR.
My collaboration with Denise and her company, the ReThink Group, has
been quite prolific. Denise and I have hosted two webinars for CQG where I
was trading the markets live in front of hundreds of people. The first was in
October of 2013 and the second in November of 2014. These were incredible
exercises that allowed me to grow from having Denise give feedback on the
introspective process I use when trading. She asked me live questions about
my feelings and intuition as I was trading. She gave great color to the
audience and it served as a fantastic reference point for me as well. I
managed positions, placed orders, and explained my rationale while she
provided analysis of my feelings, intuitions, and thought process. I encourage
everyone to use the link in the below footnote, go back, and watch them
thoroughly.25 I believe Denise does an extremely good job at highlighting and
explaining concepts from her book.
The collaboration goes well beyond webinars. Denise and I also worked
extensively on quantifying the fear-of-missing-out (FOMO) feelings I
experience before, during, and after a trade. This collaboration with Denise
was the catalyst to make the FOMO Spectrum, which will be explained later
in this chapter. Notably, much of the content, structure, and spirit in this
chapter was a result of Ms. Shull’s gracious contributions and extensive
feedback.
Further collaboration spawned the creation of the cognitive empathy grid.
One of the things Denise focuses on in Market Mind Games and espouses in
her private coaching sessions with clients is being able to imagine the

816
thoughts of other market participants. Groundbreaking research from Cal-
Tech has shown that this thinking style is what is happening in the brains of
people who are good at predicting price. Denise writes about this extensively
and calls it “Theory of Mind” while it is also known as cognitive empathy or
mentalizing. The cognitive empathy grid illustrated in the last chapter was
another aspect of my trading that came as a result of working with the
ReThink Group.
While there are many other things I worked on with the ReThink Group,
the last point I will cover is the importance of the group’s Talent Assessment
Protocol exam (TAPx). The TAPx provides a unique measure of the “X
Factor” potential for traders and asset managers to produce superior long-run
performance. The assessment reveals the degree to which an individual
possesses two thinking styles—differentiating risks and intuiting markets—
that research has shown to be related to the abilities to read markets and
manage risk. TAPx offers a state-of-the-art assessment tool for predicting the
potential long-term results that are likely to be delivered by asset managers or
traders. One way it does this is by revealing the degree to which a set of
cognitive skills associated with emotional sophistication are present within
the individual market professional. Particularly germane to market talent,
TAPx scores indicate a greater potential ability to untangle mood from
judgment. Higher scores are associated with a potentially higher degree of
raw talent and expected performance in both market strategy and risk
management decisions.
I myself took the TAPx test in March of 2015, and want to go over the test
in general and some of my results. Used with permission from The ReThink
Group Inc.
Measuring for the X Factor - Excerpts from John Netto Score Report on
the ReThink Group’s Talent Assessment Protocol.
The TAPx can be used like I did, as a self-assessment tool, to see where
my potential emotional strengths and weakness may exist. It may also be
used when considering what manager to select as a complement to their Netto
Number and strategy.
The results are comprised of two parts and analyses:

Intuiting Markets Score

Risk Differentiation Score
The Market Intuition score relates more to seeing opportunity,

817
while the Risk Differentiation score relates more to managing risk.
Seeing opportunity is intuitively the more important factor in trader
intuition. Without it, risk management may allow a trader to be good but
rarely great. It also speaks to what kind of trades a trader may be good
at—momentum and market extremes versus highly calculated risks such
as option overlays.
Intuiting Markets Score
Research suggests that the brain does not primarily tap into
quantitative ability when predicting the path of future prices. Rather,
the most talented market predictors are consciously or unconsciously
using their ability to predict the reactions of other people. The Market
Intution score therefore assesses the ability to think about the market in
terms of who is on the other side of a trade or investment and who will
be on the other side of the eventual exit. This score reflects an
individual’s potential to predict other market participants’ emotions and
behavior—i.e., a mental facility also known as cognitive empathy or
mentalizing. This thinking style has been shown in neuroeconomic
research to be the elusive factor in “trader intuition.”
In other words, the Market Intuition score measures the ability to
recognize the human patterns in price action. This thinking style can be
conscious or unconscious and therefore TAP’s first score is particularly
informative. Think of it metaphorically as the ability to “smell” fear and
greed.
Below is the result from the “Market Intuition” score from my test
and the bespoke analysis that came with it.

“John Netto’s ‘JN’ market intuition score of 100 is the highest score
ever recorded versus other traders and the highest score ever recorded
versus a general population being tested for the underlying thinking
style since its inception 30 years ago. This indicates that he is
exceptional at seeing opportunity and recognizing how price movements
are developing. JN’s risk differentiation score is also quite high.”
Differentiating Risks Score
The Differentiating Risks score quantifies a candidate’s potential to

818
 understand and differentiate between the meanings in their multiple
personal reactions to market action. Accurate risk perception emerges
not only from quantitative analysis but also from an appreciation of the
power of one’s cognitive and emotional biases—for example, feelings
associated with a past trade.

Think of the Differentiating Risks score as the potential ability to

avoid impulsive or ill-advised action by using self-awareness.
Two different studies, covering almost 200 portfolio managers and
traders, found that the skill of differentiating detail and nuance in one’s
own feelings is central to those who are most successful. Therefore, the
Differentiating Risks score indicates the likelihood that a market
professional will, over time, adhere to their risk management
parameters
This goes back to the coaching I have done for over a decade and the
ability to assess my own feelings and emotions and assimilate that self-
awareness into my trading. Using the FOMO Spectrum combined with a
strong sense of self-awareness is a great exercise to develop this ability.
The implications for an investor looking for managers who can
adhere to a predefined risk budget are profound.
As TAPx measures two thinking styles that each have different meanings
regarding how a trader or manager will interact with the markets and make
trading or investing decisions, an individual can score differently on each
one, and different scores have different implications for trading and investing
performance.

819
Key Research
Up to this point in the chapter, I have made a holistic and qualitative case
for building an infrastructure that can help harness traders’ emotions and
intuition. Along with this, there is more research substantiating my assertion
about the role intuition and emotions play in our success. I want to use this
section to provide a synopsis of three of the numerous research pieces out in
the market:

The Emotional Oracle Effect

Jennifer Lerner’s Risk Decision Matrix
ReThink Group White Paper
I encourage you to follow up and read these reports in their entirety after
reading my summaries.

820
Feeling the Future: The Emotional Oracle Effect
This is a piece that has been referenced in many different circles of
academia, as the effects have profound implications on everything from
trading the markets to consumer spending habits. The synopsis at the
beginning of the paper is as follows:
“Eight studies reveal an intriguing phenomenon: individuals who have
higher trust in their feelings can predict the outcomes of future events
better than individuals with lower trust in their feelings. This emotional
oracle effect was found across a variety of prediction domains, including
(a) the 2008 US Democratic presidential nomination, (b) movie box-office
success, (c) the winner of American Idol, (d) the stock market, (e) college
football, and even (f) the weather. It is mostly high trust in feelings that
improves prediction accuracy rather than low trust in feelings that impairs
it. However, the effect occurs only among individuals who possess
sufficient background knowledge about the prediction domain, and it
dissipates when the prediction criterion becomes inherently unpredictable.
The authors hypothesize that the effect arises because trusting one’s
feelings encourages access to a “privileged window” into the vast amount
of predictive information that people learn, often unconsciously, about
their environments.”
The key takeaway from a trading perspective is the emphasis on
individuals possessing trust in their feelings (traders must be in touch with—
and open to—their own intuition to use it effectively), sufficient background
knowledge about the prediction domain (traders must know their field before
intuition kicks in), and the dissipation of the effect in inherently
unpredictable domains (traders should try to predict knowable outcomes, not
essentially random or arbitrary ones). This was a great paper and essential
reading.

821
The Risk Decision Matrix – Jennifer Lerner
Research on emotion and decision making is converging on the idea that
conscious and unconscious emotions function as a standard in the brain.
When we are contemplating meaning or action, we are testing against how
this interpretation or behavior will make us feel. This is the conclusion Lerner
et al. (2015) gave in the Annual Review of Psychology, based on a meta-
analysis of studies on emotion and decision making. This relationship is
depicted in the graph below by the reciprocal arrows between Trading
Emotions and Imagined Results. The chart is adapted from Jennifer Lerner’s
emotion-imbued choice model.
To give a specific example, say I am contemplating taking my profits in a
trade. Consciously and unconsciously I am asking myself how that decision
will make me feel and the answer is essentially determining the choice. If we
have sorted out all of our emotions, our intuitive ones will help us make what
turns out to be an optimal choice. If we haven’t sorted out our feelings, the
incidental emotions—including ones from our past experience—will have
undue influence on our current emotions, which will in turn color our choice.

822
Figure 19.1 – Adapted Risk Decision Matrix

823
ReThink Group White Paper and Talent Assessment
Protocol
Denise Shull and Bill Long of the ReThink Group published a white paper
on the opportunity to measure a money manager or trader’s ability to intuit
other market participants through the dimension of emotional predictions
described above. The white paper referenced an array of research and
outlined the process of how ReThink’s Talent Assessment Protocol exam
(TAPx) provides a score for an individual’s current state of conscious
recognition of their emotional standards.
For example, the below is taken directly from their work:
In another behavioral study, 100 bank traders spoke about
how they do their jobs. Researchers found a distinct difference
between how the most successful (as measured by
compensation) handle their intuitive and reactionary feelings
versus how the less successful and less experienced described
their feelings and emotional experiences in the market. The
most successful integrate the informational component of
emotions with their other objective sources of information.
According to the authors:
Emotion cues generated by reactions to information
relevant to current trading under time constraints play an
important role in guiding attention and rapidly choosing
appropriate actions.
Likewise, a second study of 52 managers with at least ten
years of experience and an average of $10B under
management, noted the “…critical role of emotion in all
thinking and experience and thus takes in account how
emotions drive investment decisions and financial activity.”
The paper is available through their website (therethinkgroup.net) and I
encourage all readers to check it out.

824
My Personal Tools
I have shared with you my journey of working through a
counterproductive belief set that resonated from my childhood, how many
years of coaching sharpened my intuition, the importance of the scholarship
of Denise Shull in enhancing the UoR Process, as well as key research on the
subject. All of these things are great for a coffee shop discussion after a tough
trading day, but how do these factors:

help someone develop his or her own market intuition?

identify qualities in successful money managers who have this ability?
contribute to a process to tap into emotional alpha?
What is market intuition? Denise will tell you, “A pattern recognition
intelligence focused on people or social intelligence.” As noted above, it’s
referred to as cognitive empathy, mentalizing, or “Theory of Mind” (ToM),
the latter of which is the academic term for the ability to predict the feelings
and behavior of another person. My definition is “that indescribable gut
feeling letting you know something is about to happen in the markets.”
In more innovative work from the ReThink Group, Bloomberg Tradebook
released in 2016 a trader brain warm-up exercise built by Denise Shull and
Bill Long26 based on the research in Theory of Mind and trading. It helps to
hone your recognition of the feelings you are getting from observing the
speed and rhythm of price movement. Despite the derivative between actually
seeing a person (like in the trading pits) and only seeing the reflection of their
behavior, the human ability for Theory of Mind/cognitive empathy still
works.
Because this market intuition comes from within, developing it is
completely dependent on recognizing your state and then understanding the
factors contributing to it. Once you understand your emotional state, you
can more accurately quantify where you are in it. It has taken many years
to tailor my trading journal to account for these various factors. My journal,
as outlined in Chapter 8, goes to exhaustive lengths to record and quantify
my emotional state through my various FOMO scores and qualitative self-
assessment. Understanding your own emotions (and what they compel you to
do) is essential in attempting to attach a scale to yourself. Once you
understand how your own emotions compel you to act, you can then begin

825
the process of putting context around them and figuring out how others may
behave as well. You can separate the feelings of market intuition from the
feelings that tell you to manage risk—risks being added by your own state of
mind in particular.
My emotions are a powerful contextual tool that—when overlaid on top of
a strong understanding of the macro narrative, cognitive empathy grid, and
robustness of the Protean Strategy—provide an edge that is outlined in the
performance in Chapter 3.
A key tool I use to quantify my emotions and intuition is my FOMO
worksheet. The following section outlines how I use this.

826
Fear of Missing Out (FOMO)
I took away many things from Market Mind Games, but nothing has been
more important to my daily process than assimilating the concept of “the fear
of missing out,” or FOMO, into my daily routine. More neuroscience
evidence is proving that emotion “determines how we perceive our world,
organize our memory, and make important decisions” (Brosch et al, 2013).
Therefore, while conventional wisdom suggests we should not allow our
emotions to be involved in our trading decisions, it seems inappropriate
for me not to have my emotions as my wingman.
Fear is the strongest emotion in the markets. This is not just limited to the
fear that is commonly associated with markets crashing and people selling,
but it extends to the fear that can compel people to enter positions initially—
the Fear of Missing Out.
I needed to come up with a way to record such feelings inside of me and
then ultimately compare these emotions with that of the market and
underlying macro narrative in order to see the greater picture. The solution
to this was the FOMO Worksheet and FOMO Spectrum.

827
FOMO Worksheet
FOMO is something I have started to quantify and record as an active part
of my trade journal. At first, it may sound challenging to have the granularity
to give a degree of a feeling but it’s something that, after years of coaching
with my coach and collaborating with Denise Shull, I’ve improved at
significantly.
This is an active part of my trade journal recorded as three types of
FOMO scores. The first is my Pre-Trade FOMO, the second is my In-Trade
FOMO, and the third is the market’s FOMO.
In order to be as granular as possible, I created the “FOMO Spectrum” to
help describe my emotional state about a trade I was looking to put on, trades
I am currently managing, or how the market is feeling.
On a scale of 0 to 100, I have found that my sweet spot for getting into
trades with a high Netto Number is a Pre-Trade FOMO between 35 and 65.
[This is a little broader than the “sweet spot” of 41-59 listed below, but
individual ranges and tolerances (and FOMO score reporting itself) may vary
from person to person. It is important to record and assess your own FOMO
scores to determine your own personal sweet spot range.] Like many things
in nature, being balanced is the key. You do not want to be consumed with
fear, but you want to have some compulsion to act, as risk taking is a natural
part of growing capital and generating returns.

828
FOMO Spectrum
Score of 0-15- Overcome with panic and fearful of taking on a position,
no way to make money is seen. The perspective is that, despite analysis or
systems calling for it, the trade is completely on the wrong side of the market
and the trader has no confidence at all that the trade will be successful. There
is tremendous emotional attachment to how the loss will feel. Fear takes
away all flexibility in how to manage the position. The trader is acutely aware
and focused on everything that can go wrong. A huge alpha generation
challenge exists. It is impossible to take on the sort of risk one needs to be
successful if this is one’s state of mind.
Comments: In this state, profits will be grabbed immediately and losses
will be cut very fast as well. It is almost impossible to let any profits work to
their “predefined” targets. Losses are cut quick because traders are afraid of
losing big in a hurry. A manager in this state will perform poorly relative to
the Return Per UoR Potential of the strategy. The Netto Number from the few
trades that will be put on in this part of the FOMO Spectrum will likely be
negative.
Score of 16-28 – Very cognizant about how much one can lose, skeptical
of trade having success, very uncomfortable. Some inclination toward
potential benefit and modest inclination toward risk-taking behavior. Some
emotional attachment to how it will feel to lose.
Comments: In this FOMO range, there is a little more flexibility. Still,
profits will be taken fairly quickly because of the level of anxiety. However,
holding on for a sustained move is still challenging unless it is a quick move
in one’s favor. (When I’m in this part of the FOMO Spectrum, I usually look
for any logical reason to get out and be flat, regardless of the message of the
market or rules of the strategy). The return per UoR of this strategy will
suffer as a result of my skew toward the downside caused by my emotional
state. The Netto Number could be anywhere from one-third to one-half the
potential if one was executing the strategy in the sweet spot of the FOMO
Spectrum. So instead of performance generating a Netto Number of 3, the
Netto Number may only be 1 if one is in this part of the FOMO Spectrum.
Score of 29-40 – Deference for risk and palpable “edge” about potential
loss has me a little anxious but not necessarily fearful. One has an awareness
of mild emotional attachment to the result but it is well within control, with

829
an appreciation of what upside may entail.
Comments: In this FOMO range, things start to get interesting. In my
experience, I start to let the plan develop more, and the “edge” I am feeling
represents potential energy the market can run with. I will likely take profits
ahead of profit targets and cut losses before predefined exit points. However,
if I get a quick move in my favor I will look to manage the position
conservatively by immediately taking some profits and trailing stops to
ensure I don’t lose, regardless if that’s part of the plan. A trader in this range
is not objectively incorporating all new information, but is experiencing
significantly greater upside than the first two grids. The Netto Number in this
range could be 50-75 percent of that of the same strategy in the sweet spot of
the FOMO Spectrum.
Score of 41-59 – The sweet spot, ranging from a fairly even sense of what
risks entail to what rewards entail. There is an “edge” about the trade that is
respected and embraced as a healthy and natural part of the process. Traders
in this range believe they have an advantage and appropriate risk-taking
action must be taken; they are in a balanced state about the expectations of
outcomes with no emotional attachment; and they remain flexible and
objective on their position based on incoming market information.
Comments: In this FOMO range, traders are in the most desirable
position to maximize return per UoR with a strategy that has an edge. The
ability to be emotionally balanced and respectful of both upside potential and
downside risks is the most ideal risk management situation. The Netto
Number is highest for traders in this FOMO range, as they tend to maximize
their profits (they recognize optimal areas to exit and feel comfortable doing
so) while minimizing drawdown (they feel comfortable cutting their losses).
Score of 60-71 – The focus is skewed toward potential rewards rather
than downside risks. Traders in this range are inclined to think about how
much they are going to make rather than what they can lose. There is a
recognition of potential loss, but expectation is still for profit, generating mild
emotional attachment to a positive outcome.
Comments: There is a marginally higher risk-of-ruin potential at this
level due to the mild emotional attachment. That said, there is also potential
to see marginally higher upside profits as a result of the inclination to size
slightly too large relative to the edge one has. Volatility should be modestly
higher and Netto Number modestly lower than if operating in the sweet spot
of the FOMO spectrum, as traders may wait just a little too long to exit or

830
stomach larger drawdowns
Score of 72-85 – In this range, there is a tremendous compulsion to act
with high confidence in trading as the comfort level is very high about a
positive outcome. One has developed a significant emotional attachment to
this trade (specifically to the potential profits that are anticipated). I’m
attached to how good I will feel, and how it will feel to manage winning
positions of the trade. The negative emotions should this trade lose are not
generally contemplated, as any loss is seen as distant and highly unlikely.
Vigilance begins to be forsaken for instant gratification.
Comments: Despite having a system with a positive expected return,
when a trader spends time in this part of the FOMO spectrum, that strategy
should underperform on a return per UoR basis. The systems will likely earn
half the Netto Number compared to using the same system in the FOMO
Spectrum sweet spot. One will be risking too much relative to the actual edge
of the strategy, thereby subjecting the portfolio to a greater chance of risk of
ruin.
Score of 86-100 – This is not a good place to be. Traders in this range are
consumed with out-of-body, primal greed and lust that creates a sense to act
immediately with reckless abandon, foregoing well-established pre-trade
protocols. These traders feel it is incomprehensible this trade can lose, much
less ever go against them. The impulsive feelings create a bona fide
emotional attachment to making instant, enormous profits. Traders often have
a huge desire to use significant leverage, as losses are not contemplated and
they see no need to concern themselves with the risk side.
When I have found myself in this range (though I try to avoid it at all
costs by recognizing it and adjusting for it), I am focused solely on getting in
as fast as possible with as much size as possible. I have a tremendous
emotional attachment to the outcome and a total inability to be flexible to
other outcomes despite what my statistics suggest. I have no fear of loss
whatsoever. Paradoxically, I have a huge sense of scarcity as this opportunity
is viewed as so unique it will not come around again, so I must act
immediately.
Comments: A FOMO score in these levels represents huge risk
management issues. Having no regard for risk means huge leverage applied
at spots that potentially offer very negatively skewed asymmetries. Due to
excessive volatility caused by sizing too large, even if one’s system has
substantial edge, the penchant to size too large can bring blow-up potential to

831
even the most polished trading system. Return per UoR should suffer as a
result, with a greater chance of risk-of-ruin. Despite the edge of the system, it
can still see a negative Netto Number.
With all of the above states, having those emotions is not a bad thing. In
fact, they represent the totally natural ebb and flow of things. I have learned
the hard way over the years that trying to deny these feelings can only cause
more problems in the future. I created this grid from my own experiences
over the many years I have been trading to take account of where I am in the
FOMO Spectrum. This is a huge part of my trading journal and came about
from extensive coaching and collaboration with my coach and Denise.
By at least having a range, each one of us can establish this for ourselves.
It may also serve as a useful gauge when looking to assess the investment
potential of someone else. I personally would never invest in a portfolio
manager that was not open to performing this sort of recurring self-
evaluation.
The next generation of investors will want to know what the
corresponding Netto Number is for a manager when their FOMO is in certain
ranges. Using the three-dimensionality of the Netto Number combined with
the introspection of the FOMO Spectrum creates a powerful combination of
risk management and performance assessment. If a manager struggles to
maximize return per UoR in certain FOMO ranges, then instituting FOMO
Spectrum analysis may turn out to be a very lucrative method of dampening
downside volatility. The idea of assigning an “emotional efficacy score” to
a trader may not be far away, especially if it is determined to be
predictive for outsized moves to the downside.

Figure 19.2 – FOMO Table

Fear of Missing Out – (FOMO) – Pre-Trade, In-Trade, and Market
Taking the above scoring system, I apply it to the following three types of
FOMO situations:

1. Pre-Trade FOMO

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 2. In-Trade FOMO
3. Market FOMO
These all serve three distinct measures for not only understanding our own
emotions and feelings, but effectively incorporating those into my position
management and cognitive empathy grid, CEG. All three of these types of
FOMO have a score from 0 to 100 and embrace the descriptions used above.
While I am always attempting to assess the various levels of FOMO, I try to
carve out three to four times a day to record them for future reference and
analysis.

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All Times Eastern
8 PM (The Night Before) – This is an important time for me to assess my
FOMO score for the potential of the next day’s trades. The big issue with
FOMO is when it is at one extreme or another, there is incredible emotional
attachment to the outcome. Therefore, if I’m tilting toward one extreme or the
other, I want to identify that early on. The point isn’t to try and deny how I’m
feeling but just to be aware of it. This goes a long way in maintaining my
Protean stance.
8 AM – This is a critical time as I get ready to trade before the US
markets open and overnight developments may have shifted my perception
about the trade opportunities for the day. This is another key time in my
trading journal because a material portion of the trading I do comes over the
next three to four hours and assessing my FOMO level is critical.
As outlined in the FOMO Spectrum, it is desirable to be between the 40
and 60 level. I’m very balanced at this level and stay aware of the energy it is
creating in me. Oftentimes, my FOMO is something that is feeding off the
energy of the market themselves. What some people may perceive to be fear
in themselves before a trade to me is the natural energy of the market letting
you know how willing she is to accommodate your trade. This is a message I
try to listen to very closely and is a huge factor in my Market FOMO Score.
Noon – This is potentially one of two postmortem times for me as most of
my trading is usually wrapped up for the day. However, if I am still in
positions, this serves as a very useful point to record my emotions. This is
also an effective time to assess Market FOMO by reviewing my CEG and
Market FOMO scores to see if there are any opportunities potentially setting
up in the afternoon or days to follow.
4 PM – This is the second postmortem time of the day. Now that I have
gotten some distance from my trading, I will use it to see where my FOMO is
and how much my P&L is influencing it. I have demonstrated through my
record keeping that when I’m up on the day, I have a higher FOMO of future
trades and when I’m down I have a lower FOMO. Just being aware of this
dynamic really helps me address that and go through a protocol to assess it.
This is also a great time to assess Market FOMO.
I have outlined some of the emotions and feelings a FOMO score
encapsulates, attached a color spectrum to help visualize it, and shared the
four times of day I try to record the FOMO. Now I want to dive into each of

834
the three levels of FOMO I record and, specifically, what may stand out in
them.
Pre-Trade FOMO – Score of 0 to 100
As outlined in the FOMO Spectrum above, my “Pre-Trade FOMO” score
refers to the level of emotional impulse I am feeling toward putting on a
trade. The FOMO score is a representation of how I am feeling
emotionally, not about the logic behind going long or short per se. If I
find myself at the higher extreme, it means my emotional need to enter a
trade may lead me to overstate the benefits and/or overlook the risks; if I find
myself at the lower extreme, the opposite phenomenon may occur. I regard
my personal pre-trade sweet spot as between the high thirties to the low
sixties.
On September 29, 2015 the S&P 500 appeared to be heading back to test
its lows from a serious August sell-off. The market felt weak, panic was
starting to come into the market and, in an impulsive decision as the markets
started to crescendo, I felt this complete sense of invincibility about shorting
SPX contracts in size. Over the course of a few minutes I started piling on
contracts. However, in honoring my process (which, among other things, was
put into place to prevent rash decisions), I stopped myself and went through
my FOMO grid. I exhibited all of the traits of being in the red spectrum of the
FOMO regime grid with a score of 95.

835
 Figure 19.3 – S&P 500 Daily Chart, September – October 2015
My self-regulating FOMO grid allowed me to quickly come to the
conclusion that I had no trepidation this position could lose. I was
emotionally attached to the money I could make quickly and easily. Lastly, I
was not concerned about a stop as my sole focus was just making money
from a market that was obviously vulnerable.
Going through this process immediately told me to get the heck out of the
position and start scaling back because I was in that high-risk zone I don’t
find myself in often. A zone that can see market moves just crush me because

836
I have lost my deference for the risk in the trade. The S&P went on to bottom
out in the next 15 minutes and rip for the following three weeks from 1860 to
above 2000.
In-Trade FOMO – Score of 0 to 100
One of my biggest breakthroughs when incorporating FOMO scores has
been taking my emotional pulse while managing positions. My energy
stemming from a trade before I am in it is often different than the energy I
have once I put it on. This is especially true if it is a bigger position with a
higher conviction rate.
One of the most remarkable things to observe as a person aware of my
FOMO is the negative correlation between a position moving in my favor and
a decreasing FOMO score, or vice versa. This ebb and flow of the position’s
P&L impacts how I feel. I am similar to a lot of people in that my energy can
shift once I’ve entered a position, since the market serves as this reinforcing
mechanism constantly telling you how smart or stupid you are.
For example, if I am long SPX futures and up money in the trade, as I start
to see a noticeable appreciation in my FOMO from 55 to 70, the ES market
will immediately pull back. The same applies to losing trades as well. I have
many examples of being in trades that have gone against me and I can feel
my FOMO go from 55 to 35. I may find myself becoming more aware of the
potential for loss and how the emotional aspect of that loss will feel. As this
happens, the market will reverse and rally. This happens all the time—one
need only to examine one’s own feelings while trading or investing to
recognize it.
In-Trade FOMO helps me quantify and distill my feelings and thoughts
while in a trade. By taking stock of them, I can then ascertain if they may
lead me to take an impulsive action that is not part of my process.
Qualitatively and quantitatively, the most explosive trades in my history
have occurred when I had the right amount of deference that the market could
take away the profits but I nonetheless remained in a calm and collected state
about how to manage the position. In my personal trading, I’ve had an In-
Trade FOMO score between 25-50 for some of my biggest trading days.
These lower scores seem to generate much better follow-through in a much
quicker fashion than when my In-Trade FOMO is near 65 to 75. I know that
this range tends to be lower than the general sweet spot at 41-59 (or my pre-
trade sweet spot at 35-65) but, as counterintuitive as this may sound, I love to
have some butterflies while in the trade. I want to feel a little uneasy about

837
holding on to it because it means the trade probably hasn’t run to its full
potential yet. I embrace this uneasiness, or “edge,” the same way any
performer feeds off their nerves right before going on stage.
In my discussions, I have found a lot of traders have a similar stance—
they always want to feel a little nervous about a trade, keeping cautiously
alert for any sudden changes in circumstances. This is why many traders
won’t congratulate other traders on winning trades. There is a “FOMO
reversal” after doing so—it opens the window for an emotional shift that
allows the trade to reverse. Similarly, traders are reluctant to make conclusive
remarks about the state of the market. I have many observations from Instant
Messages or the Twittersphere. Once I am comfortable enough to say, “This
market looks really strong,” then I’m increasingly aware for the market to
relax that trend. These are all qualitative factors I pay attention to in the In-
Trade FOMO score.
Market FOMO – Score of 0 to 100
The last FOMO score I record is that of the market. This is the cognitive
empathy aspect that scores how panicky or greedy the market is about a
certain position. For example, when looking at the S&P 500, I will ask the
general question about how the market feels about going higher. For
example, with a score of 60, the market feels good but is aware of the risks;
with a score of 35, the market is more aware of the downside and skewed
more toward the risks than the rewards.
I am always asking myself, “If this event happens, what will the FOMO of
the market be?” If, for example, there is a huge technical breakout, then I ask
myself how it will influence trading from a FOMO perspective. This has been
helpful in spotting extremes and plays nicely off the cognitive empathy grid.
If the score is moderate, then it may require me to stay tactical with profits. If
the event can shift the Market FOMO from one part of the spectrum to
another, then we may be part of a larger inflection point and repricing.
However, if it is high—indicating that market participants are in a state of
desperation at one extreme or another—then we may be looking for a
massive reversal.

838
Harnessing Emotional Energy to Maximize Return Per
UoR
There are two aspects that understanding emotional energy can contribute
to maximizing return per UoR. The first benefit comes from identifying spots
where you may be entering the market at a compromising spot, using too
much size, or maintaining an unbalanced position. Avoiding these situations
can go a long way to potentially dampening downside volatility and
controlling tail risk in your trading system.
The second aspect takes on a more predictive quality in that I use my
FOMO scores to guide how I enter, size, and manage positions. This is
illustrated in the example below.

839
Signal Source on Predictive Aspects of FOMO
It is one of my goals following the publication of The Global Macro Edge
to commission a broader study on the predictive power of FOMO at various
stages in the trade process. While I have made it a robust part of my
qualitative risk management process, seeing more empirical evidence
measured out-of-sample amongst a wider array of candidates is necessary. It
is my strong belief these studies will reveal very interesting aspects about the
predictability of market price and what, if any, signal source exists
within us all.
From a practical standpoint, for those looking to understand market
reactions around FOMO scores, a way to manage the risk if you are entering
a position and your FOMO is high is by buying out-of-the money calls or
puts in the opposite direction of the trade you are putting on. In all of my
time journaling strong FOMO scores, the instances of the market remaining
flat when I was trying to get aggressively short or long with a FOMO at 90
are minimal. What has happened nearly every time is the market will not only
go against me, but scream against me hard.
Example:
Dampen Downside Volatility / Control Tail Risk – With high
FOMO, purchase OTM delta hedges at 3X the exposure. If shorting SPX
contracts at 2050 with target to 2000, and FOMO of 90, purchase 2100
SPX calls for three times position size. If you are wrong on the short
position, the trade has the potential to fail spectacularly because of the
high FOMO of 90. Therefore, while you may lose on the SPX short,
there is a potential to pick up a ton of gamma on the reversal by being
long the 2100 calls. I can count on one hand how time times a trade with
a FOMO of 90 was in my favor an hour after I was in it, much less a day
later, so the protection is just about always worth it.
In my experience, extreme FOMO scores in one direction or another are
very gamma-rich environments. For example, on the SPX trade I highlighted
in Figure 19.3, had I bought 20-delta out-of-the money calls “OTM Calls” at
three times my position size with a two-week expiration, things could have
become very interesting very quickly. In this example, my own high FOMO
about being short the SPX would compel me—based on my own trade
protocol—to set up that hedge, which may develop into a real screamer in the

840
other direction. If the short SPX trade did move in my direction to the
downside, then I have my risk defined by only losing the premium of the
OTM calls.
My experience is these extreme FOMO readings are analogous to a
blowoff wave 5 top or bottom discussed in Chapter 11 by Todd Gordon.

841
FOMO in the UoR Process
Now that I have explained both my real-world discoveries as well as
growing scientific evidence, how can we incorporate this into our investing
process? There are two pursuits I have when incorporating my instincts,
emotions, and feelings. The first one is to prevent blowups, or dampening
downside volatility (i.e., understanding what impulses I have acted on that
took me outside my process and caused duress to my equity curve as a
result). The second is to understand the message my spiritual energy is telling
me, or create a signal source. The former is powerful in and of itself, as being
able to identify behavior or warnings signs that may help mitigate is an
incredibly useful tool. However, being the fan of offensive football that I am,
it is my desire to incorporate my spiritual energy into a signal source—one
that tells me when to take on new positions, rather than just hedge the ones I
have—that I want to take a deep dive into.
Whether the goal is to prevent extreme downside swings in your equity, or
more actively incorporate your emotions into your investment strategy, you
are probably going to have to push yourself significantly outside your
comfort zone. It will take incredible patience and foresight to understand that
when you are looking to develop a signal source from yourself, then you
really have to know yourself at a deep level. Not only does this take
discipline—especially if you want to keep knowing yourself—but it requires
putting in place systems (like the cognitive empathy grid) to help standardize
observations and maintain a consistent signal.

842
Incorporating the FOMO Score with the Cognitive
Empathy Grid
Incorporating the cognitive empathy grid (CEG) and the three types of
FOMO scores is an exercise I am constantly utilizing and refining. Below is
an example of how I actively used my In-Trade FOMO to help manage a
short position I had on the Treasury market in 2013, which contributed a
significant part of the best month I had from 2010 to 2015.
As outlined in Figure 19.4 illustrating the performance of 2013 from a
nominal amount of one million dollars and a risk budget of $250,000, July
was a critical month for me. I made $247,306 and generated a Netto Number
of over 8.0 in 2013. Figure 19.5 shows my broker statements from July 5,
2013, highlighting the fills and final P&L of $77,265, or more than 25
percent of July’s gains. These gains came from a short ten-year note position
I had on the first week of that July.

Figure 19.4 – 2013 Protean Strategy P&L

843
 Figure 19.5 – Protean Strategy Brokerage Statement, July 5, 2013
I will walk you through how I used the CEG, FOMO Spectrum, and UoR
Process to spot this short trade and the three FOMO scores I used to help
enter and manage it.
As outlined from the previous chapter, there are eight different sections of
the CEG: Participants, Strategies, Bias, Asset Class, Time Horizon,
Emphasis, Technical Regime, and Fundamental Regime. Figure 19.6 is a
modified CEG. I will lay out these parts of how I used the CEG and my
FOMO score on the July 2013 Treasury trade.
A fair question when looking at how I apply my market intuition and CEG
is to compare it to someone who applies game theory to understanding

844
market positioning. It is my belief game theory and cognitive empathy are
complementary. Both emphasize analyzing the reaction function of others.
Game theory has built something of a science upon applying economic
optimization and strategic analysis to situations where decision makers act
based on how they think others will act (but keeping in mind that those others
will, in turn, act based on how they think the decision makers will act—this
can go on back and forth to infinity). Cognitive empathy puts a greater
emphasis into understanding the biases and emotions of others (particularly
large groups of other actors who would be somewhat less interested in
tailoring their responses to a set of outlying individuals trying to “game”
what they are doing).
There are a few other differences worth noting. Game theory is a primarily
mathematical endeavor. It makes simplifying assumptions in order to model
behavior. For instance, most game theoretic models (and all traditional
models) assume an unrealistic “rational economic man” (sometimes jokingly
called “homo economicus”), who makes hyper-rational, super-smart
decisions to maximize his own utility. This is a mathematical necessity—
certain axioms of consistent behavior must be laid out before game theory
can model reaction functions. However, homo economicus does not resemble
any market participant I’ve ever met—he does not fall prey to biases like the
FOMO; he is able to think things through perfectly and doesn’t seem to have
any idiosyncrasies. While game theoretic approaches have been able to
provide a theoretical lens to explain isolated aspects of market functioning
(the “information cascade” is an especially compelling concept, worthy of
Googling by interested readers), it has traditionally struggled when trying to
predict the whole of markets at any given moment. Furthermore, markets are
ever-adaptive—if there was ever an easy-to-model system for making money,
markets would very quickly adjust in an effort to exploit it, altering their
behavior and rendering the model useless. I believe the harder something is to
model, the longer it will be effective in maximizing return per UoR.
On the other hand, cognitive empathy is geared toward recognizing how
people actually react, and it takes a lot more psychology into account. It stays
pragmatic and flexible, as its goal is to develop a broad-based theory of mind
of others. How I use the CEG, calculate market position premium (MPP), and
create MPACT! Ratios is ultimately a subjective process made up largely of
qualitative inputs. It is my opinion that this combination of the CEG,
MPP, and the MPACT! Ratio based on qualitative factors that are easy

845
to understand but hard to model (the art of intuitive analysis comes into
play when interpreting it all) supersedes the precision of game theory
models divorced from market reality. My personal experiences trading
would suggest this as well.

Figure 19.6 – Modified Cognitive Empathy Grid

Let’s get back to July of 2013. Heading into the week of July 1 to July 5

846
of that year, the market was more than a month deep into the infamous
“Taper Tantrum” that started in May of 2013. This was the beginning of a
shift in how risk was perceived in different asset classes based on how the
Fed would remove their bond purchases following a Ben Bernanke speech.
Economic data that had meant very little up to this point was suddenly
reshaping the volatility curves across a number of asset classes, as markets
developed a new understanding of the Federal Reserve’s reaction function.
This was a seminal change in how nearly every market participant in the
CEG would have to act to endure. Irrespective of strategy, bias, asset class, or
time horizon, the market was now going through a recalibration and regime
change.
Friday, July 5 was a unique day because I deduced—based on my CEG,
MPP, and Market FOMO score— that the taper tantrum selldown had a few
more legs. I had been working a short position most of the week in
Treasuries, gold, and the yen. Beginning Thursday, July 4, after a nice
fireworks show in NYC, it was time to start getting aggressively more short
those markets.
The ten-year Treasury, in particular, had a lot of appeal. I saw a shift in
the market FOMO from moving from the 80 zone (meaning longs in the
Treasury market were really complacent about the downside) through the 50
zone and felt very confident it could head down to the 25-30 zone given we
were on a holiday and it was a huge non-farm payroll trading day. I thought
this shift would be reflected in the price action, and my personal In-Trade
FOMO was sitting at about 40 (meaning I wanted to get short, had a healthy
appreciation that I could lose, but still wanted to take on the risk with no
emotional attachment to winning).

847
 Figure 19.7 – is minute Chart of Treasuries, July 5, 2013
I was very deferential to this trade and had a nice level of butterflies about
adding more short Treasury positions. When I get the macro narrative
matching up with my CEG, Market FOMO Spectrum, and my Pre-Trade
FOMO giving me serious butterflies, it is time to stack the trade. This is a
sign the market has a ton of energy and wants to move. It is also a
qualitative observation that my robust systems are generating trade
signals that are uncomfortable to execute. When one of my systems starts
generating signals that I feel totally comfortable taking, I become more aware
we may be entering into a regime that is becoming less profitable. Call me
neurotic, but I go out of my way to understand what my own internal
signals are telling me and how that matches up with the market.
As the account statements show, I started pressing the short ten-year
position on the way down. Instead of doing what was comfortable and
covering, I got really aggressive after the payroll number came in super hot. I
was short 50 ten-year contracts going into the jobs report. The jobs report
came in hot and the ten-year flushed lower. This was the final catalyst to
compel me to risk all of the profits by adding another 100 short contracts
after the release. Adding in double the size to an already winning position
presents many risks. The trade could snap back against me hard and wipe out
all of my profits. My In-Trade FOMO was my guide and compelled me to do
more than just hold on to my current position, but go from 50 shorts to 150
short contracts.

848
 My In-Trade FOMO was not rising, as I was seeing the P&L grow larger
from my other shorts of gold and yen. This was a great sign when I decided
to press more. All of these ancillary factors were matching up, and my gut
was filled with this palpable nervous energy. Energy that was making it hard
to hold on.
However, as counterintuitive as it may sound, the nervous energy that was
making it hard to hold on, energy that compels us to cover for no other reason
than that it feels good to take profits, is probably the strongest sign we can
get from ourselves that the short trade has more distance to go to the
downside.
On the other hand, if I was feeling really easy and comfortable and my In-
Trade FOMO was at 80, then adding to the shorts would be ill-advised and
even letting them run further could be problematic as they would likely snap
back against me.
Instead, this was a market that was vulnerable to a selldown and I was just
as uneasy about holding these shorts as I was when I first started getting in.
Therefore, I had to rise above the moment and understand that what was
happening was natural and embrace the message my butterflies were
conveying. Times like these are when my eight-year Marine Corps Career
really helps with the discipline of embracing these butterflies and staying
objective.
As I saw the ten-year flush down to 125-02, I could feel the market
FOMO fall to the 20 level. This was a level of real trepidation and an
emotional spot I thought it would get to as part of this repricing. My In-Trade
FOMO level went from 40 to 80 as I was minting it, and any edge or
butterflies I had was long gone.
The butterflies were replaced with exuberance and adrenaline, two factors
that affect my ability to objectively assess the environment and how it may
influence price. I made over $130,000 on a $1 million trading level and the
combination of FOMO scores and price action suggested it was time to cover
as the major repricing was finished for the time being.

849
Conclusion
The long-held belief that emotions are your biggest enemy in investing is
undergoing a significant recalibration. Like most misconceptions, tremendous
opportunity exists for those who choose to embrace this paradigm shift, both
in using emotions as trading signals and in identifying what factors contribute
to overall trading talent or manager performance. Between quantifying our
emotions through a FOMO Spectrum, using the TAPx test to identify trading
talent, and complementing these with a strong understanding of the macro
narrative, harnessing our own emotions and the emotions of the market
has the potential to be the single greatest source of alpha for the next
generation of investors.
23 As a note: in working on this book, one of my editors described the Dunning-
Kruger effect to me. In short, this is a psychological phenomenon in which higher-
performing people tend to underestimate their own abilities (as they believe others are
at least as competent as they are, and they know about a lot of factors that can trip them
up) while underperforming people tend to overestimate their own abilities (they don’t
realize what they don’t know). This can cast insecurities in a much better light but,
more than that, I think it adds more empirical credence to my stance that traders should
get nervous when they feel too confident in a trade. They may be missing something.
24 As an added aside—Shull was a real-life model for Maggie Siff’s character of
trading performance coach Wendy Rhoades, M.D. on the television hedge fund drama
Billions, which is popular at the time of publication of The Global Macro Edge.
25 http://news.cqg.com/events/2013/10/live-trading-of-the-global-futures-markets-
recorded-webinar.html October 2013 webinar link
http://news.cqg.com/events/2014/09/webinar-live-trading-using-netto-numbers-and-
emotional-algorithms.html 2014 webinar link
26 http://traderbrainexercise.com/

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CHAPTER
20

851
 The MPACT! of Automation
“Innovation has nothing to do with how many dollars you have. When Apple came
up with the Mac, IBM was spending at least 100 times more money on R&D. It’s
not about money. It’s about the people you have, how you’re led, and how much you
get it.”—Steve Jobs

852
Introduction
In sports, it is not necessarily the most talented team that wins, but the
team that executes the best. The world of investing is no different. It is not
uncommon for one firm to have better strategies, greater resources, and more
talented people than their competition and, despite all this, still considerably
underperform. These situations exist because at the end of the day it all
comes down to one thing—execution. And execution, in turn, often comes
down to the details.
Before I joined the US Marine Corps in 1993, I had very little
appreciation for attention to detail. As a teenager, I was sloppy,
unappreciative, and unaware of the repercussions for failing to be vigilant. As
an 18-year old recruit at MCRD San Diego, I underwent a dramatic
metamorphosis, quickly shedding any inattentive disposition, courtesy of my
indefatigable drill instructors. These gentlemen were mandated to mercilessly
rip me apart for every deviation from protocol they discovered. Despite my
best efforts to conform, the discrepancies they were able to uncover on my
uniform, in my footlocker, on my rack, or inspecting my weapon usually left
me shrouded in despondency. As I would come to appreciate over the course
of my career, their repeated mantra, “It’s the little things that get you killed in
combat, Recruit Netto,” was a profound metaphor for the practice of trading.
This was one of the many life-changing benefits from my service as a Marine
that I would port into my career as a trader.
My personal goal has always been to build a scalable and repeatable
investment process using an infrastructure that would allow me to leverage
the power of a diverse group of robust trading strategies in a risk-controlled
manner. I knew I would not be able to achieve this relying on the methods I
had used in the past to run my operations, analyze the market, and execute
trades. As a “living-room” trader, I am a one-man team who collaborates with
many. But, to remain competitive, I understood the importance of realizing
outsized gains in productivity. To achieve this, I needed to incorporate
technology. What I needed was a plan to automate. From 2007 until the
release of this book in 2016, I have actively sought out technology that could
facilitate this desire. Those efforts become even more concentrated after
2013, when the ill effects of years of work-related stress took a significant
toll on my health. For reasons of both my wellness and durability, I had to

853
streamline all of my processes. Therefore, I committed a substantial segment
of my trading profits to automate every aspect of the UoR Process. To
borrow a poker term, I went “all in” on automation.
At the outset of this concentrated bet on automation in 2013, I posited
there were three potential outcomes: 1) I would build a robust infrastructure
that would significantly improve the breadth, depth, and efficiency with
which I ran the Protean Strategy; 2) I would create software and processes
with the potential to meet an industry-wide need; or 3) I would spend a lot of
time and money failing to build the infrastructure correctly, the software
would have no market value and the processes would be ineffective, thereby
wasting tremendous resources. There were times in this journey where
each one of those scenarios seemed the likely outcome.
Many nights along the way, I asked myself, “What the heck are you
doing, Netto? What were you thinking?” Fortunately, the journey has been a
successful one. It has allowed me to grow in ways, develop strategies, and
make discoveries about the market I never imagined.
The Global Macro Edge has gone to tremendous lengths to bust a number
of Wall Street myths. It is my goal that this chapter will make it clear that
technology and automation do not only benefit super quant traders who can
code in C++ and Matlab. Contrary to the narrative many are familiar with,
technology is equalizing the playing field and bringing greater access.
Automation and technology are something that— with a plan,
commitment to work, and willingness to sacrifice—can be an amazing
bridge between concept and execution. Automation can benefit everyone.
I am a prime example of a Wall Street outsider who operates on an
extremely small technology budget compared to a number of trading firms.
Despite this, I was able to receive an incredible return on investment when
automating critical aspects of the UoR Process. Ironically, the “tuition” I paid
learning how and what to automate was more expensive than the formal costs
of the automation itself. Automation is an essential part of what I do and
those lessons are the basis for the goals of this chapter:

1. Learn from my journey of using automation to maximize return per UoR

2. Outline the pros and cons of automation
3. Provide an overview of the three areas I automated: Operations,
Analytics, and Execution
4. Give key metrics of what to consider when choosing between buy, build,

854
 or a hybrid approach
5. Walk through the general process of building a private application
6. Outline the takeaways of this chapter for investors, managers, and
advisors

855
Automation as the Equalizer
I believe a number of investors are like myself,—what we lack in
resources, we can more than make up for in creativity. When we look through
the annals of corporate history, there has not always been a direct correlation
between a firm’s Research and Development budget and its ability to produce
groundbreaking innovations. Great companies like Apple, Microsoft, and
Dell all started in garages. They flourished because of their ability to spot a
market need that the big, established entities were unable to sense. These
small firms succeeded because of their emphasis on creative innovation. If
you are overwhelmed at the prospect of automating, understand there were
many pioneers who came before us. Therefore, whether you have the luxury
of a large IT budget or are working with limited resources, it is an exciting
time to be alive and innovating in finance.
I have found creative ways to make automation a part of my process at a
reasonable cost. For me, automation represents the ability to let the drive to
innovate flourish. This is just as much the case for large-scale institutional
traders placing thousands of trades a day, totaling up to billions, as it is for
individual day traders placing a small fraction of that. Automating processes
frees up time that would otherwise be dedicated to performing mundane,
repetitive tasks. It allows market practitioners to get more work done, and it
gives them the additional time and breathing room to think about new ways
to interact with markets, new opportunities that have presented themselves,
and new trading ideas. Done right, it also allows a trader greater leeway to
take a step back and reflect on his or her own trades, with the goal of ever-
continuing improvement.
Maximizing return per unit-of-risk can be challenging for any entity. In
order to tip the scales and maintain the returns discussed in Chapter 3 (even
as I scaled up), I had to look at every aspect of the Unit-of-Risk Process to
see where it could improve. Many parts of my trading execution, analytics,
and overall business needed automation.
The process of automating my trading brought with it many hard lessons.
If you notice in 2014 and 2015, my personal performance struggled rather
dramatically when compared to 2010–2013.
Along with a very tough market, many of the growing pains in my attempt
to automate were experienced during this time and were a major contributor

856
to the lower Netto Numbers of 0.79 and 1.86 in 2014 and 2015, respectively.
Paradoxically, despite the lower returns in 2014 and 2015, the UoR Process
and infrastructure are significantly more robust than in 2011, 2012, and 2013,
where my return per UoR was in the stratosphere.

In 2015, my ability to integrate the array of strategies and regime analytics

through automation began to improve considerably. This is not to say that the
growing pains did not continue, but my Netto Number experienced a
significant rebound from the prior year. In 2014, the need to work out the
bugs in my new automated process significantly detracted from my P&L. The
next year, in 2015, things slowly began to gel. As I ironed out more of the
wrinkles, I was able to increase my risk budget by 50 percent (from $1
million to $1.5 million, as described in Chapter 3) and still more than double
my Netto Number.
This chapter is going to discuss my journey of automating aspects of
nearly everything you have read to this point in the book. This includes my
trading strategies, analytics, operations, and execution. The crown jewel of
this was the creation of MPACT!™ and MPACT! Portfolio Simulator™.
This chapter will demonstrate how regardless of your budget, if you can
combine the resources on the market with a vision of where you can improve,
you may be able to enhance the depth and breadth of your trading operations.
If automation is something you have no desire to do, then this chapter can
serve as a primer for understanding who you are competing against and how
your technology infrastructure compares.

857
Why Automate?
Automating comes from a need to improve how people operate their
business, analyze their data, and execute their strategies.
Some of the benefits of automation include:

1. Consistency. Identifying opportunities and having the ability to execute

on them consistently frees up resources to focus on ways to maximize
return per UoR.
2. Scalability. A trading business with a scalable process can expand and
realize a greater return on capital.
3. Speed. What used to take hours or days can now be done in seconds or
minutes. This faster process can save manhours, cut down on costs, and
allow more time to react to market developments.

858
Pros and Cons
So, how should a trading company decide what parts of its trading process
—if any—to automate? Automation conveys several advantages, but it also
imposes costs that do not arise in manual trading.
Advantages of Automation:

Increased speed
Increased capacity
Elimination of tedium
Reduction of errors
Efficient allocation of tasks to humans and machines
Predictable behavior
Warning signs of problems
Disadvantages of Automation:

Need for new skills

Amplification of errors
Mistakes may go undetected
Inability to recognize “obvious” environmental changes
Lack of “common sense” when automated systems deal with an issue

859
Automation in Three Forms
As The Global Macro Edge goes to press in 2016, every part of the UoR
Process has integrated some aspect of automation. My operation, analytics,
and execution side of the business have all received significant investment of
time and resources.
There were three types of automation I embraced in order to improve the
UoR Process. The first thing I did was automate my operations. This included
aggregating and reconciling end-of-day statements, consolidating and
analyzing performance based on strategy in a timely manner, as well as
handling billing and bank reconciliations. While these things may not appear
to be as sexy as having a huge score on a Fed Day, they are the foundation
for strong trading and the focus required to be in position to benefit from
windfall opportunities.
The second thing I automated were my analytics. This allowed me to
improve upon my ability to grab customized insights about my strategies, the
market, and the dynamics of various regimes. To get the specific insights I
was looking for, I blended the power of software I was using with customized
spreadsheets to create a standalone analytical infrastructure that automatically
aggregates the information I deem important. MPACT! Portfolio Simulator is
a proprietary software program I created to increase the robustness of my
analytics. It is an excellent example of the benefits of automating, and more
detail will be provided later in the chapter.
The third area, and most exhaustive to automate, was execution. This
entailed streamlining all of my analytics into a process that could ensure I am
alerted to certain market conditions. This would integrate the analysis of
these market conditions and manage current positions as well as allocate to
regime appropriate strategies based on the implied Netto Number in the UoR
Strategy Grid. It was a tremendous challenge to create a bespoke execution
software to make sure it all transpired effortlessly. This execution software
is called MPACT!, and the events that led up to designing, building, and
applying it is my personal case study and the focus of this chapter.
Chapters 18 and 19 spelled out a lot of the process I use for understanding
market positioning and the collective emotionality of the markets. These are
huge factors in the UoR™ Process and make their way into the three aspects
of automation and how I designed MPACT! and MPACT! Portfolio

860
Simulator.

Figure 20.1 The Three Overlapping Circles of Automation

When it comes to addressing the three aspects of automation, while there
are uniquely independent components to each of the three, they function
more as interlocking circles than as independent variables (see Figure 20.1).
For example, the forthcoming section will describe software in the operation
section that feeds into analytics and ultimately into execution. Therefore,
automation is more about creating overlapping circles than isolated ones.
Those circles of Operations, Analytics, and Execution all feed into each other
and were big factors in the development of MPACT!.

861
Operations
Whether it is aggregating statements, reconciling performance,
streamlining operations, or seamlessly integrating technology, these things
have a major influence on your trading success. In this section, I am going to
outline the two pieces of software I have used to automate my operations:

UoR Software
Stage Five Trade Analyzer

862
Unit-of-Risk Software
As I have emphasized throughout this book, most investors ask, “What
was my return?” The Global Macro Edge, on the other hand, asks, “What
was my return per unit-of-risk?” A critical tool in helping me assess this vital
metric is Unit-of-Risk Software, or UoR™ Software. UoR Software was a
byproduct of my collaboration with Aleksey Matiychenko and Aleksandr
Mazo of Risk-AI, LLC. This connection and the facility with which Risk-AI
produced UoR Software is just another example of how there are more
opportunities available to a more diverse group of people in today’s markets
than at any time in the past. For many years, much of the analysis I had done
of my performance consisted of manually inputting data from my brokerage
statements into Excel on a daily basis. I did not have the resources to hire a
full-blown operations staff to keep track of my general performance, let alone
the performance of my sub-strategies. The time I spent crunching the
numbers took time away from my other trading research.
Therefore, when I came across Aleksey and Aleksandr’s product, I was
impressed with its functionality, analytics, and aesthetics. I approached them
about adding my institutional metrics such as the Netto Number and Return
over Risk Budget onto the software to create a bespoke, white-labeled
product measuring performance on a return per unit-of-risk (UoR) basis.
Thus, UoR Software was born.
While the UoR Software package has been tailored based on what I
personally believe should be a trader’s priorities, there are also many other
packages of performance tracking software out there—each with their own
strengths and weaknesses. In assessing software, it is useful to consider the
functionality that I believe is important.

1. Ability to assess performance on a daily basis. Contemporary

performance reporting only requires performance be updated on a
monthly basis. While I can appreciate the logistical dynamics behind
this, as someone who is acutely aware of changing market regimes, I
need a higher frequency of data to analyze the performance of my
strategies. The evaluation of some of these strategies must, out of
necessity, be much more granular than traditional style box investing
suggests. In many of these cases, monthly data is just too coarse to

863
 present a detailed, accurate picture. Daily data, if not trading session
data itself (encompassing both regular and after-hours trading), is more
appropriate. Whenever possible, the software should be able to capture
intraday P&L swings. Using granular data in assessing my own trading
account becomes even more important because this analysis will
determine how incremental an approach I will take. While at times, I
will gradually allocate risk when incorporating a new strategy, at other
times a more aggressive posture is warranted (for instance, if we are at
an inflection point in a regime and a number of positions must be put on
or exited quickly). Being able to distinguish what variation of this style
is best comes about from good data analysis. This has been one of my
keys to alpha generation in nuanced markets.
2. Customizable library of diverse analytics and metrics. Strategic
edges go away (sometimes they gradually erode and other times they
disappear abruptly), new ones emerge, and this is a consistent
occurrence in the cycles of both nature and the markets. I have identified
certain opportunities where I was richly compensated because I was
properly positioned for the market repricing a new regime. It is
important to realize when you are being richly compensated, as those
situations can be rare. Being able to assess performance through a
variety of metrics goes a long way toward understanding how well one
is doing at any given point. Good performance software should be able
to gauge performance against volatility, risk budget, and benchmarks, as
well as display P&L in absolute dollars. Software should be sufficiently
customizable to display the unit-of-risk analytics I have developed,
including the Netto Number, Return over Risk Budget, and Maximum
Favorable Excursion to Maximum Adverse Excursion. (Note: The UoR
Software displays these analytics as part of its default package.)
3. Intuitive Graphical User Interface (GUI). A difficult-to-use or non-
intuitive GUI can sap precious time and mental energy from traders.
Users would be less likely to utilize beneficial functions (not only
because they are difficult to use but because an abstruse interface may
prevent users from ever discovering them in the first place). Worse, after
exhausting themselves wrangling with the GUI, they’d be able to
dedicate fewer cognitive resources to actually analyzing their
performance. Ideally, a GUI should utilize space efficiently, aggregate
and customize dates to identify performance over specified time frames,

864
 and make it painless to call various functions to crunch data.
Furthermore, it is integral that the GUI has the ability to represent data
visually (line charts, pie charts, scatterplots, as well as more unique
methods of representation), and to generate these in crisp, clean, and
easy-to-understand graphics.
4. Cloud Access. Having access to a “Cloud” (Internet-based memory and
computing resources) is critical in my case, as I move my trading
operations between cities and coasts as I travel. Cloud-based software
allows me to access the same data and capabilities from anywhere, and it
greatly reduces risk stemming from damage to—or malfunction of—my
computer.
The following four charts show the versatility of the UoR Software
powered by Risk AI, as it applies to my portfolio:

1. VAMI Chart with Monthly P&L in Absolute Dollars

2. Rolling Drawdown with Monthly P&L
3. Rolling Correlation with Risk Statistics
4. Monthly Performance in Percent
Figure 20.2 shows a VAMI chart with the absolute monthly P&L from
2010 to 2015, as well as a bottom pane that shows the UoR and the P&L in
absolute dollars for the month and year.

865
Figure 20.2 VAMI Chart with Monthly P&L in Absolute Dollars

866
 Figure 20.3 graphically shows the rolling negative drawdown of my
portfolio on a percent basis compared with the rolling negative drawdown of
the S&P 500.
Figure 20.3

867
 Figure 20.3 Rolling Drawdown with Monthly P&L
Figure 20.4 continues to show the versatility of the UoR Software by
having four panes to choose from on the top and three panes on the bottom.
The top pane shows the Protean Strategy’s 20-day rolling correlation with the
S&P 500 from 2010 to 2015. As you can see, there are periods where the
strategy approaches stronger positive correlations and others where it
approaches stronger negative correlations. Over the long run, however, the
strategy has enjoyed negligible correlations to the S&P 500 (-0.49 percent
over the entire period examined), which means it generates returns
independent of the index. The bottom tab, “risk statistics,” provides bespoke
analytics (Netto Number, Return over Risk Budget), as well as traditional
intuitional analytics (Sharpe Ratio, Sortino, Calmar, kurtosis, skewness, etc.).

868
 Figure 20.4 Rolling Correlation with Risk Statistics
Figure 20.5 shows my monthly returns since 2010 in percent terms. I can
also display this in terms of absolute P&L as shown in Figure 20.2.

Figure 20.5 Monthly Performance in Terms of Percent

869
Stage 5 Trade Analyzer
The Stage 5 Trade Analyzer is a robust analytical tool I use when looking
at taking a deeper view of the trading performance of a particular strategy or
individual trading account. This piece of software aggregates my trade data
from the Stage 5 Trading Interface into a “Master Dashboard” (see Figure
20.6). It measures the information on a trade-by-trade basis and aggregates
daily metrics to help me immediately contextualize the performance of a
strategy on a return per UoR basis by displaying the Netto Number on the
day.

870
 Figure 20.6 The Stage Five “Master Dashboard” Showing UoR Input and
Netto Number Calculation in Upper Right
The MD also displays the individual trades that have been placed, hourly
performance, day of week performance, and a host of traditional performance
statistics.
This is a tremendous time saver compared with having to enter manually
each trade into a spreadsheet. The level of detail is very instructive in
understanding how well a strategy is performing on a return per UoR basis,
and Stage 5 Trade Analyzer feeds directly into CQG, further automating my
operations and analytics.
The Stage 5 Trade Analyzer also comes with a host of visual data tools on
the following analytics:
TIT - Time In Trade. This shows me the time I was in the position. This
might be, an obvious statistic but being able to have all of this information
aggregated makes going back and looking at large bunches of data much
more practical.
TSB - Time Standing By. This is a nice tool for me to record how much
opportunity is in a market by measuring the frequency between trades. If I get
into a trade in the euro and then wait an hour for the next signal, this tells me
a different message about the macro narrative than if signals are coming
every 20 minutes. Recall from Chapter 5 the opportunity ratio, which
measures the realized gamma of a market. The TSB is a factor in determining
how much opportunity is in the market. I can then export this information
into a database for later reference when analyzing different regimes.
MAE - Maximum Adverse Excursion. This was discussed in Chapter 5
as part of the agony/ecstasy ratio and is a key component in the calculation of
the Netto Number. This represents the maximum number of points the euro
moved AGAINST me from the price at which I entered the trade. In the
example from Figure 20.7 below, in trade number 3, the ten lot of the euro I
was in moved a total of 37 ticks against me.
MFE - Maximum Favorable Excursion. This represents the maximum
number of points at which the trade could have been closed for a profit. In
other words, MFE is the furthest the market has gone in favor of the given
trade. For example, you enter a short at the price of 1109 then the market
moves to 1102 before coming back to 1104. The MFE = 7 points, as this was
the maximum profit seen from the point of trade entry.
BSO - Best Scale-Out. This represents the maximum number of points

871
where profits were taken on a given trade, excluding the exit. For me, this
analytic comes into play if I am using multiple exits to manage risk. I can
quickly reference which one of those exits (outside of closing the position)
was the best.
There is a more expansive tutorial on the Stage 5 Trade Analyzer at
www.stage5trading.com.

Figure 20.7 serves as an aggregation grid for trade attribution data such as
MFE, MAE, and Time in Trade.
Figure 20.7 is information taken from three real trades I did in the Euro
FX futures. It grabs information from three different times I was in the Euro.
From line 1, you can see that I was in a one lot for one hour and 22 minutes
and made 16 ticks. I took very little heat with a one tick MAE and was up 18
ticks at the peak of the trade, finally exiting with a 16 tick gain. The last of
the three trades shows the versatility of the S5 Trade Analyzer by giving
information on the Euro position I scaled in and out. In this case, I was in as
many as ten contracts (see “Max Pos” column) and made 189 ticks (see
“Gain/Loss” column). I was only down 37 total ticks as illustrated by the
“MAE” column and was up as much as 433 total ticks (see “MFE” column).
My best scale out, or BSO, was the part of the trade that yielded a 26 tick
profit.

872
 Figure 20.8 graphically illustrates these analytics.
Both the UoR Software and Stage 5 Analyzer offer operational and
analytical value. The idea of having to manually go back at the end of a day
and input it is cumbersome, costly, and impractical. Having automated these
important metrics, I can now focus on analyzing the macro narrative,
specifically, to seek key takeaways from my P&L analysis.

873
Analytics
Whether it has been through the incorporation of economic data, market
price behavior into my UoR Excel dashboards, proprietary databases,
backtesting software, or event simulation software, I have committed
tremendous resources to automating as much of the analytical part of the
UoR Process as possible.
The software for this includes:

UoR Dashboards in Excel

Databasing Proprietary Market Information
Trading Journals and Qualitative Notes
Economic Data Analysis
CQG Backtester
Bloomberg Backtester
MPACT! Portfolio Simulator™

874
UoR Dashboards
I am visual in my analysis. I love the numbers and crunch a lot of data, but
pictures really talk to me and trigger a unique level of subconscious analysis.
Thom Hartle, applications specialist and Excel expert at CQG, has been a
huge help in creating a number of proprietary UoR Dashboards to display a
key market theme I am tracking. To see a complete list of the numerous
dashboards he has created for free to all CQG Integrated Client users, please
visit http://news.cqg.com/workspaces

875
Database Research
I independently track and monitor proprietary studies that require
aggregating a lot of raw data using the feeds within CQG, Bloomberg, or
other third-party front ends. Much of this data is compiled using VBScript in
Excel. This information is then integrated into my UoR process. Without the
ability to automate all of this big data, I would not be able to analyze
idiosyncratic metrics on various markets. These computations go into my
regime scores and are instructive in predicting market direction.

876
Trading Journals
As I alluded to in Chapter 8, the trading journal has gone from being a
notebook scribbled in at night to a database of insight accessible via the
Cloud. The ability to aggregate, archive, query, and integrate information
from Cloud-based trading journals is another aspect of technology and
automation that changed the game for how I construct the UoR Process. The
ability to easily access and query any piece of insight I have ever journaled is
invaluable.

877
Economic Data
Parsing through economic data during key releases used to take a lot of
time. Michael McDonough, Global Director of Economic Research and Chief
Economist at Bloomberg, has been kind enough to share some of the custom
economic spreadsheets he constructed over the years. These spreadsheets
update automatically upon the release of new economic information from a
feed in the Bloomberg Terminal to Excel. This automation allows me to
incorporate the data immediately. The Economic Workbench in Bloomberg,
ECWB <GO> is a very useful tool where one can construct a number of
templates.
I use the ECWB function to easily apply interpretive analysis to economic
indicators and financial market securities, in a format that I find most useful.
This sort of analytical robustness is not something I would have been able to
do in the 2000s. Functions like the Economic Workbench on Bloomberg are
why I feel so strongly that the playing field in the financial markets has never
been more level. By being able to standardize data for chart or tabular
presentation in a unified format, I am able to interpret and compare
fundamental regimes more easily.

878
Backtesting Software
Backtesting is a huge part of analyzing past market regimes to understand
what strategies may work best going forward. There are a litany of choices
available on the market. As I have emphasized throughout this book, great
investing is often about asking the right questions. Therefore, when
looking to automate one’s process, it is critical to have the tools to be able to
ask these questions. This statement could not be truer when it applies to
backtesting. Here are some of the important questions I ask when backtesting.
There are only a few things I know when it comes to understanding the
potential returns of strategies and that is they are almost guaranteed not to
repeat themselves. They may be better or worse but it is highly unlikely they
will be the same. Below are just a handful of questions I ask when attempting
to understand how much of the past may be prologue:

1. What strategy characteristics were most successful in a certain regime?

2. What aspects of that regime are analogous to today?
3. What was the frequency or velocity of the signals of the strategy?
4. Was this better in certain asset classes?
5. Are the factors that contributed to the success of that strategy present
again?
6. How widely used was this strategy?
7. When this strategy began to struggle or go into a drawdown, what were
the personality traits?
Whether it is using the event and data studies outlined in Chapter 17 by
Jessica Hoversen, or digging deep into a backtest, data can either corroborate
or disprove a theory about the market or belief about our strategy. Either of
these outcomes are welcomed in the UoR Process.
I use two different backtesting software programs. The first is the CQG
Backtester available to users of the CQG Integrated Client system. The
second is the Bloomberg Backtester.

879
CQG Backtester
CQG has created a great backtesting tool. There are three pieces of
functionality from CQG’s Backtester I incorporate into the UoR Process. The
first is the ability to easily visualize the results of any system I am
backtesting by overlaying them onto the charts. CQG’s charts are a huge
value proposition in their product offering, and the entire CQG Backtester
displays on their charting package. Visualizing data is a critical component in
my analytical process. Therefore, this functionality is essential in any
backtesting software.
The second factor is the ability to optimize a set of strategies. I am not big
into trying to find the Holy Grail. However, being able to run various
iterations of a strategy and compare the results gives me a much more
realistic sense of how a strategy may perform. This can be instructive in how
I might be able to approach future regimes, all the while realizing there will
be idiosyncratic aspects of every regime that make it very challenging to
create a perfect facsimile. This process of testing different iterations of
multiple strategies helps when generating the regime profitability factor,
RPF, that feeds into the UoR strategy grid.

Figure 20.9 shows how I can optimize strategies to see how changes may affect
the P&L profile.
The third factor is the execution portal embedded in the backtesting

880
software. From here, I can decide which automated strategies to run and what
strategies to just track. This portal has a number of bells and whistles. This
function presents value from both an analytical and execution perspective.
Whether I run the strategies with my capital or simply observe what strategies
are maximizing return per UoR, this is very instructive and actionable.

Figure 20.10 shows the CQG execution engine embedded in the backtesting
portal.
Figure 20.11 is a Microsoft Excel® dashboard that displays trade system
statistics pulled from CQG’s Backtesting module, created by Thom Hartle.

Figure 20.11 – CQG Dashboard of Trading Systems

881
 The dashboard in Figure 20.11 will pull and display 125 bars of market
and trade system statistics using the same parameters employed by the trade
system in CQG. In addition, the live market price data can be formatted for
either decimals or fractions by entering “D” or “F” in the bottom row of the
dashboard.

882
Bloomberg Backtester Tools
Bill Sindel, former commodity trading advisor and Product Specialist at
Bloomberg, was one of the key individuals in 2012 to drive the innovation
behind Bloomberg’s Backtester. I am incredibly appreciative of the time he
has taken to mentor me through its use. He also customized work that was
crucial in incorporating this tool in the UoR Process. Bloomberg’s
backtesting tools are key resources in my regime analysis and ability to
determine the regime profitability factor (RPF). There are three important
functions I focus on in the terminal:

1. BTST <GO> – Bloomberg Backtester

2. OVME <GO> – Click “Backtester”
3. FXSW <GO> – FX Strategy Workbench
The appeal of Bloomberg’s suite of backtesting tools is that it is very
conducive to incorporating the macro narrative on top of testing technical
setups for their effectiveness within the function. The data can also be
exported into Excel easily. It is one thing to be able to test a trend-following
system based on certain technical factors; however, it can shed completely
different light on that system if you can draw context of economic
fundamentals and sentiment that existed as well. As I have outlined before,
applying good strategies in the wrong regime is like driving a fast car without
knowing the directions. The Bloomberg Backtester is a great navigation
tool.
Therefore, when analyzing a trading system both independently and
within the context of a regime, I want to know how it works relative to the
fundamentals and market sentiment. Here is just a sample of the expansive
list of questions I probe for in my regime analysis of a strategy:

How do mean-reversion short trades work in an equity market that is

seeing declining earnings, tightening financial conditions, or slower
growth?
How do trend-following long trades work in a basket of G-10 currencies
in a deflationary environment?
How do certain commodity spread trades perform in an environment
with a strong dollar?

883
 How do certain strategies perform in certain asset classes based on a
custom index I have created?
The Bloomberg Backtesting tools help answer all of these questions and
many more.

Figure 20.12 shows the ability to overlay strategies on the SPX and specify date
ranges, etc. There are five systems in the above example with a range of
performance.
For Bloomberg Terminal users, there are number of FFM tutorials on the
BTST, OVME, and FXSW functions. Dedicate some time to learning how to

884
use these tools.

885
MPACT! Portfolio Simulator™
The preceding part of this chapter revealed critical components in my
UoR Process. Components that feed into UoR Software, CQG UoR
Dashboards, proprietary databases for event studies, Bloomberg and CQG
Backtesting software, and the UoR Strategy Grid were all explained.
The final step in automating my analytics has been to create software to
stress test my theories. To meet this need, I created MPACT! Portfolio
Simulator. In this custom-built application, many factors will be exhaustively
stress tested against a number of exogenous events. Creating MPACT!
Portfolio Simulator took a lot of time, money, and angst (significantly more
than what I had budgeted on all aspects). That said, the chances of me being
blindsided is much lower.
MPACT! Portfolio Simulator gives me the tools to develop an ex-ante
process to account for both outlier and expected events. At its core, it
helps me see what dominoes may fall where. For example, I can test:

What if the ECB doesn’t cut the deposit rate as expected?

What if AAPL misses earnings badly?
What is the “uncertainty premia” in SPX if the US Presidential Election
prices a 50 percent chance of a non-establishment candidate winning?
What if Janet Yellen gives a more hawkish than expected Humphrey
Hawkins testimony?
What if the Tankan Survey in Japan comes in weaker than expected?
The ability to conduct exercises based on macro questions like these is a
huge benefit for me. This ex-ante analysis serves as a great barometer for
what I am doing right in my assessment of the expected Netto Number of a
strategy and where blind spots may exist. This sets up well with the ex-post
analysis done in my trading journal to compare the before and after. After I
run through multiple MPACT! Portfolio Simulator stress tests, I always have
a different perspective on what may happen. However, the analysis does not
end there, as the process continues to marinate in my brain (my obsessiveness
is a double-edged sword). I keep thinking of how I may continue to refine the
UoR strategy grid and contingencies for position management. Following
these exercises, the necessary adjustments are made and they are ready to go
live in MPACT!.

886
 If you are like me and going to base a large degree of your success on the
ability to identify a regime, then understanding what can change that regime
is one of your biggest risks. MPACT! Portfolio Simulator has helped me use
technology and automation to shore up this vulnerability. This private
application is part of my daily UoR Process and the final piece of preparation
before going live for the trading day.

887
Execution
My quest to automate my execution began in 2008 when I was a market
maker on the now defunct US Futures Exchange trading the Mini-Dollar
DAX. This turned out to be a crash course on numerous nuances of liquidity
providing, high-frequency trading, and relative-value strategies. It was the
nascent stage of my journey to automate my execution and opened my eyes
to another world of potential. The on-the-job training introduced me to things
like co-location, exchange rules, and automated market-making software.
While I lost money from this endeavor, it was tuition well paid. In the
process of trying to find a solution for the market-making commitment, I
ended up becoming one of the original beta testers for CQG Spreader. As a
reminder from Chapter 13 on Spread Trading, CQG Spreader allows the user
to automate the process of buying and selling multiple markets in a low
latency manner. Therefore, while I could try to work the bid of the S&P
futures and the offer of the NASDAQ futures manually, CQG Spreader
allowed me to automate this process.
Even though CQG Spreader was still in beta mode, CQG made this
software server-side in 2009. This means the order engine for the spreader
was at the exchange instead of on the computer of the user. Therefore, I could
work orders faster and potentially get better fills. Many competing firms, who
also provided spreading software, did not offer this feature and, as a result, a
vast majority of those who were spreading markets in those days were at a
latency disadvantage. CQG’s server-side robustness gave me a real edge over
many of the people looking to work the same spreads on competing software.
Therefore, I was able to combine market insight with an execution edge. It
was a happy balance between being an HFT trader and a cross-asset class
trader. I am not the type who likes to speed on the highway, but it sure is nice
to have the horsepower and torque to do it when needed.
Aside from the latency edge, now I had the opportunity to take a more
active posture in the world of spread trading. I had always charted spreads,
synthetic and natural, on CQG charts. However, I had used this information
to gain insight on which market to trade, not as a means of expressing a
position. Therefore, thanks to the automation benefits of CQG Spreader, I
could now set predefined parameters in place to work orders on a number of
relative-value spreads. This technology gave me access to a set of strategies

888
in a practical way where I previously was not focused.

889
MPACT!™
Managing risk around large macro events such as key economic releases
or central bank policy decisions can be very problematic for many investors.
This may contribute to underperformance of a portfolio, as the inability to
confidently manage risk and allocate based on the event can prevent many
from maintaining their desired risk exposure. The time it takes me to process
the significance of this information and which markets should be impacted
the most can take me anywhere from a few seconds up to a few hours,
depending upon the variables that accompany the event. Given all of the
factors that are part of the UoR Strategy Grid, I needed to create a more
robust way of recalibrating based on breaking news.
MPACT!, short for “Market Price ACTion,” is my patent-pending,
proprietary software that allows me to synthesize the information around
breaking news events, analyze the significance of those events on my
strategies, and manage my positions accordingly. All of this is done from one
integrated GUI (graphical user interface). MPACT! has a number of
customizable position management features integrated into the UoR strategy
grid, market position premium, and underlying macro narrative.

890
Buy, Build, or Both?
Now that I have walked through how I automated the three key aspects of
my trading infrastructure, I will share with you the three different approaches
I used when establishing it. When looking to automate, there are typically
three approaches.
The first approach in automation usually addresses a general need. There
is generally an off-the-shelf solution that can meet your needs. This software
brings with it many benefits in that you can normally access support staff. If
your need is a common one, then there are usually resources to see how
others solved your particular problem. This is normally the most economical
solution because, if common enough, then a third party has the scale to allow
you to focus on what you do well while they solve your problem. Bloomberg
Professional Terminal, CQG, UoR Software, and Stage 5 Trade Analyzer are
all great examples of off-the-shelf software to begin to automate one’s
operations.
The second approach arises when is you need to build something custom.
You may have a specific hardware and programming need that relates to your
strategy. The need is not currently being met by the market and as a result
you have to find a programmer and systems expert to build you
infrastructure. This is what I did with MPACT! and MPACT! Portfolio
Simulator. There was no product in the market that would allow me to
integrate all of my UoR analytics into an execution portal and incorporate the
results of breaking news events. Therefore, I had to build it from scratch. I
will walk you through this process in the following section.
The last approach of this is a combination of the two. This is where you
take a preexisting technology or trading platform and enhance it through
some customization. Nearly every trading platform on the market has an
application programming interface (API). The API allows you to trade on a
platform, but make enhancements specific to what you need. CQG and
Bloomberg’s API are very flexible and provide documentation and support.
In many cases, they also provide a list of programmers you can refer to in
order to see if they can meet your needs.

891
Building MPACT!™ and MPACT! Portfolio
Simulator™
The development of MPACT! and MPACT! Portfolio Simulator has been
a tremendous educational experience. This multi-year project ran
concurrently with writing The Global Macro Edge. Sharing the experience of
building a private application was not even a consideration for the book until
I realized that all of the tuition I paid developing MPACT! and MPACT!
Portfolio Simulator could really help others in the industry. This was literally
one of the last chapters completed before sending the book to press. I am very
pleased with the software and hope it serves as both good instruction and
inspiration for those considering a similar path. The software allows me to
focus on maximizing return per UoR by having predefined parameters for
multiple contingencies of market-moving events. MPACT! can synthesize the
information from these events and allow me to make objective decisions
about my concentration levels and potential Netto Numbers in the UoR
Strategy Grid.
I used seven phases in developing these two private applications. By
understanding what each phase entails, you will be able to have a more
informed perspective about how to proceed forward when you assess your
investment infrastructure.

892
Seven Phases of Software Development

Phase 1 – Concept
Phase 1 comes about from understanding the need you have cannot be met
by what is currently on the market. Whether it is building a better trading
interface, bespoke order management system software, or a better client
portal, the unique needs of your investment business demand a customized
solution. The first step for me was interviewing programmers and industry
experts as to what options I had and at what price points.
It is important to do a cost-benefit analysis on both a look-back and
forward basis. This will give you an idea of how it would have affected your
bottom line over the past three years. In developing MPACT!, not having the
ability to manage risk around breaking news events represented a significant
risk to my business, as I apply considerable leverage across multiple non-
correlated strategies. The threat to my trading business is that these strategies
become correlated and I experience an outsized loss due to unintended
concentration caused by a regime shift.

893
Budget
My cost-benefit analysis suggested that by not having the ability to
manage risk around breaking news events from 2010 to 2013, I left
approximately between 80 to 250 basis points a month, or 10 to 30 percent a
year, in unrealized P&L on the table.
The rule of thumb I used when allocating resources was to try to get back
15 to 30 times my investment over the next three years. Therefore, if I
invested $100,000 in an application, I could project out a realized benefit of
between $1.5 to $3 million in both commercial value and realized profits over
the next three years. Every situation is different when it comes to the catalyst
for building a private application. However, giving yourself this sort of
cushion is critical. The recurring lesson I took away from this was I usually
spent more than I thought and in the short term realized far less profit than I
projected.
The key to making a realistic budget and getting a realistic quote from a
programmer is to have as detailed a concept of your needs as possible. The
greater specifics you can provide, the better the following phases will
progress. When building MPACT!, I was dealing with a number of health
challenges and figured it would all “work itself out.” I assumed I would
figure it out as we went along. In hindsight, I’m pleased I got the project
going, but very little was done in terms of details. That limited how my
programming team was able to build the framework from which MPACT!
and MPACT! Portfolio Simulator were built.

894
Programmers
There are a few things to keep in mind whenever you are searching for a
programmer. (I was very lucky in that I had a pre-existing relationship, so
there was a level of trust and mutual respect.) The first is their experience in
the area for what you are trying to build. If you are trying to build a low-
latency program, then using someone who does not have experience in this
field may be tough.
The second thing is how “hands on” you want to be. Inquire if the team of
programmers has the infrastructure to allow you to be actively involved in the
project or just to check in once every few weeks. In the initial version of
MPACT!, I had very little involvement; however, as the numerous iterations
followed and I began to understand how software was developed, I became
very involved and was corresponding through the programmers’ portal on
nearly a daily basis. Therefore, when planning the project and interviewing a
programmer, find out what their preference, infrastructure, and experience is
working with both types of clients.
The third thing when contracting with a programming team is who owns
the intellectual property that comes about from the project. While you may
feel that you will be happy to just meet your need, in the process of creating
something for yourself, it is possible to end up creating something of
significant commercial value that can lead to other business. This application
you are building conceivably represents extensive know-how and intellectual
property.
When I started building MPACT!, I was viewing it from the perspective
of someone who could pick up alpha by managing regime risk better around
breaking news events. After going through a multi-year process and
numerous iterations, the commercial potential for the software became clear.
The response from those few individuals who have seen how MPACT!
operates is that this is not an application used by someone who only trades a
few million dollars from his living room. Their unanimous impression is
that MPACT! has the look, feel, and robustness of something one would
see at a billion-dollar hedge fund known for their technology edge. If I
did not wholly own the intellectual property, this could be a very
uncomfortable situation.
Therefore, the agreement you sign with the programmer, or programmers,
should explicitly outline who owns the IP. Having full ownership of the IP

895
may require you to pay more. However, as I have always believed, when
given the chance…bet on yourself!

896
Phase 2 – Build a Beta Version
There is a saying that both the happiest and saddest day of a ship owner’s
life is the day they sell their vessel. The beta testing phase of building your
own application carries with it a similar emotional ambivalence. As one may
gather from reading this book, I am passionate about creating things.
In my experience, the single most important factor in determining the
success of Phase 2 is communication. It is during this phase, that as the end
user, you must clearly articulate what you want and not assume the
programmers understand you. Remember that your language is about trading
and their language is about programming. Things that they may regard as
obvious may be totally foreign to you and vice versa.
Phase 2 is the “early childhood development” phase of building an
application. I break this phase into two parts. The first is constructing a
detailed plan through various schemata to include a flow and sequence
diagram. The second is the initial programming. I will briefly outline some
takeaways and pointers from these two facets.

897
Schemata, Flow, and Sequence Diagrams
Building an application requires a lot of detailed planning. This planning
is conveyed both visually and in writing. This planning begins from a broad
perspective and then becomes very granular. The first step of planning in
designing MPACT! began with a basic one-page illustrative schema. This
schema provided a broad picture of how the different components of
MPACT! integrate to accomplish the mission. The next step was the
sequence diagram. This shows how all of the objects in your application will
interact chronologically. The next step my programmers used was a flow
diagram, or flow chart, to visually represent the entire process of MPACT!
For example, Point A will feed into Point B, which then goes to Point C, etc.
In my experience, the only thing guaranteed from your beta version is
that you will be building a newer version after you realize just how much
more stuff you want to add—things that you never thought of but quickly
become apparent after you start to use it.

898
Phase 3 – Testing
If Phase 2 of building a private application is “early childhood
development,” then Phase 3 is “adolescence.” Methodical and rigorous
testing of your application in a simulation environment may not be the sexiest
thing to do, but it can save you a tremendous amount of heartache and
capital. I am very aggressive when I believe I have an edge. This penchant for
pushing the envelope was only emboldened when I saw what was being
developed with MPACT! in the testing environment. Despite my
programmers’ repeated warnings to hold off and wait before deploying it to
production, on multiple occasions in 2014 and 2015, I made a number of
calculated risks to go live. As I touched on at the top of the chapter, these
risks failed spectacularly! These decisions would cap my P&L in 2014 and
2015, as I set in place strategies and maintained relatively high levels of risk
around news events based on a false sense of security.
I do not regret pushing MPACT! because, at the time, I believed the risk
was worth it. As important, the pain that came from giving back huge chunks
of P&L resonated with me and spawned some great trading discoveries.
These innovations, many of which occurred at two o’clock the morning
following a bloodbath, would probably not have been thought of if the P&L
duress was not as severe. While my net performance in 2014 and 2015 was
solid, had I been using the version of MPACT! I now have in 2016, I am
confident my performance numbers would have been similar to those of 2012
and 2013.

899
 After multiple failed deployments with MPACT!, I needed a better way to
rigorously test the application. While the programmers and I felt confident in
the test protocols we created, too many mistakes were happening in
production and a more dynamic solution was needed. After being reminded
repeatedly that the production environment differs from the simulation
environment, I commissioned my programmers to build me a standalone
application to simulate what takes place in the production environment.
This standalone application was MPACT! Portfolio Simulator, which
would not only help me discover bugs in a much quicker manner, but help
generate new ideas for how MPACT! could aggregate, synthesize, and
disseminate breaking news to my position management software. This first
iteration of MPACT! Portfolio Simulator was done with the sole intent of
finding bugs on MPACT! However, it had a number of second- and third-
order benefits for the rest of my UoR Process. This included asset class
performance analysis, event and regime simulations, and improved execution
techniques. MPACT! Portfolio Simulator now streamlined my test protocol
for MPACT!, as well as serving as a valuable tool in my trade preparation.

900
Phase 4 – Live Execution
Phase 4 is where you take your application live. In continuing with the
theme of a human life, this is your “early to mid-20s.” During this phase,
incrementalism is the key. The reality is you are probably going to discover
bugs in both your software and process when you go live. The key is to make
it so that these bugs do not devastate your P&L. By taking an incremental
approach, you can potentially prevent this from occurring. For example, if
there is an off-the-shelf solution you have used in the past, then continue to
use that concurrently when applying the new application. Only take a small
amount of the workload and run it on this new application.
In my case, I could have started with small size and worked up from there,
understanding there may be mistakes along the way. However, I decided to
be more aggressive and fast-track the implementation process. That was a
costly mistake. Because of those mistakes, before beginning a “live
execution” phase, I lay out a plan in writing that outlines what factors may
speed up or delay the full implementation of my software. By attempting to
have all of these things written down in advance, I reduce the stress of having
to decide what to do. As this plan is determined in advance, I can proceed
from a place of objectivity.

901
Phase 5 – Refine
Making refinements is a huge part of building your own application. This
is the “30s” phase of life. A time when many of us understand who we are as
people and grow into ourselves. Your ability to interact with programmers is
so vital during the refining phase, and essential if you are going to streamline
ideas and enhancements—specifically, have test protocols each new version
must pass. You need to outline what enhancements are mission critical to
perform and which ones are luxuries. Compare what went well in live
execution and what was unexpected. I ask myself these following questions:

How will these refinements align with the original intent of the
application?
What are potential unforeseen risks of coding these enhancements?
What do these refinements do to the stability of the system?
What areas might be further developed to make the refinements a part of
a group, as opposed to a series of one-off programming projects?
Specificity is key when communicating exactly what issues the
refinements should address. I am a big documentation person and attempt to
provide a chronology of everything. The customer interface your
programming team has will determine how well things may go. This interface
allows you to keep a project on track by being able to communicate your
vision every step of the way. As a hands-on leader, I enjoy this sort of
interaction with my team.
Documentation is key because it helps manage expectations. For me,
enhancements are the elixir in the programming punch bowl as I love
innovating and creating new things.
At every stage of the development process, but in particular during the
refinement stage, there are also cultural considerations to keep in mind as
well. Be mindful that a burgeoning population of programmers from around
the world, such as India, China, and Russia, have different cultures and
philosophies. Do not assume that what you say may be understood in the way
you meant it.
Refinement is inherently a critique of what can be improved upon.
Therefore, there may be some egos involved about what went wrong or right.
Programmers have egos just like traders, so keep this in mind as you

902
construct a critique. If you are working with a foreign programmer, do some
research into their culture and learn how to present ideas for improvements.
In addition, it is worth asking if there have been any misunderstandings in the
past with clients. This knowledge of culture and lessons learned from past
experiences may help prevent misinterpretation from happening again.

903
Phase 6 – Repeat Steps 3-5 in Perpetuity
The closest thing you have to a guarantee in developing your automation
is that it will never stop. As we go to press in 2016 (if I did not add one item
to my “to do” list) MPACT! and MPACT! Portfolio Simulator have an
estimated 12 months of work on my list.

904
Phase 7 – Refactor
As I alluded to earlier, when I began building MPACT!, I did not
understand all of the aspects of creating a proprietary trading application. At
the outset, I was hoping it would take care of some basic functions in
managing risk around breaking news events, thereby allowing me to take on
exposures in various strategies. As I faced repeated setbacks, I realized how
much more functionality and integration I needed. Therefore, every
enhancement I added on was done within the context of working on the
existing foundation of the software. Superficially, this is fine because as an
end user I just wanted it to work. However, adding multiple enhancements
that were not part of the original design can create structural problems within
the code itself.
The solution to a common challenge in the programming world is to
retrofit your software for the new workload it is handling. The process is
known as “refactoring.” This happens in the background and as such the end
user is not aware of any changes being made.
If you do build out your own application, there are a few key points to
keep in mind. The first is the point at which point will the foundation need to
be refactored. The second is which provisions your programmers are
allowing for that in their initial plans.
Refactoring is a sign of how much you have embraced automation, as it
represents the expansion and growth of your investment infrastructure. When
I refactored MPACT!, bugs and blind spots were discovered and fixed. It was
a rewarding experience and allowed me to think about exactly where I
wanted to take the software in the future.

905
Conclusion
Automating one’s investment infrastructure is no longer the exotic, high-
tech pursuit it was years ago. Advanced automation technologies are no
longer limited to large institutions—now, even the smallest single-person
operation can computerize much of the minutiae and many of the repetitive
tasks of their day-today operations. While the knowledge of how to go about
instituting such processes is not yet well-known for smaller traders, I hope
that it now seems less daunting than when you started reading this chapter.
There are certainly countless benefits that may be derived from taking
time-wasting, energy-draining tasks out of the hands of market practitioners.
Even the most traditional of operations may derive benefits from automating
some portion of their process. Certainly, automation brings its share of risks,
and optimal implementation requires significant planning and potentially
substantial investment. However, even without tremendous resources, one
can still take steps to automate all three aspects of one’s trading business.
Fortunately, many consultants operate in this space and can help with such
implementation.
The benefits of understanding automation apply to traders, investors, and
advisors alike—it should increase the value proposition for all market
participants. Through automation, traders could enhance their operations and
strengthen their execution process. A robust infrastructure may be appealing
if you are searching for an allocation. Being able to articulate the challenges
you faced in automating some or all of your trading may give a potential
investor comfort in knowing you have left no stone unturned in improving
your execution. However, this does not necessarily mean a discretionary
trader cannot have aspects automated. Pushing any perfunctory task off your
plate can allow you to spend more time on trade ideas.
For investors looking to invest in a hedge fund or third-party manager,
understanding the automation process may provide insight into how well
these entities may maximize return per unit-of-risk. I hope this chapter has
provided you with a template to ask questions, or simply expanded your
knowledge of what is possible (which should also prove useful in assessing a
fund or manager). Automation is simply one more domain to compare
amongst potential investments. When funds or managers have made the
necessary commitment of resources and time to their infrastructure, they are

906
generally better positioned for the long haul. All things being equal, a hedge
fund that has diligently thought through and implemented technology to
improve itself may deserve greater consideration.
For advisors, investing in automation provides a value proposition to your
clients, who are relying upon you to suggest which fund or product makes the
most sense. Understanding where a fund ranks in terms of automation can
help you diligently vet managers and better explain to your clients why a
fund may or may not be a fit and how it compares to its competitors.

907
CHAPTER
21

908
 Risk Budgets – The X Factor in
Investing
Conventional investing asks, “What was my return?” The Global Macro
Edge asks, “What was my return per unit-of-risk?” The Netto Number
provides us with a versatile tool for answering this second question. As
explained throughout this book, the Netto Number measures how well a
strategy, manager, market, or portfolio is maximizing return per unit-of-risk
by showing returns relative to a combination of the ex-ante risk budget and
downside volatility—the Netto Number allows investors to take a three-
dimensional approach to performance assessment. The risk budget, also
called the unit-of-risk, is the predetermined amount one is willing to risk
on a trade, strategy, or portfolio. This ex-ante component is what gives the
Netto Number its multidimensional versatility. The risk budget is the X
Factor in the Netto Number, making it all possible. Therefore, the primary
focus of this chapter is how to construct a portfolio around a risk budget.

Figure 21.1 Netto Number Formula

The risk budget component is an essential element of the Netto Number.
In this chapter we will walk through the various aspects of this vital input to
include:

1. Creating a Risk Budget

2. Portfolio Construction
3. Using the Netto Number to Leverage a Risk Budget
4. Ascertaining Adherence to a Risk Budget

909
5. Trading Around a Risk Budget
6. Enforcing a Risk Budget

910
Part 1: Using Risk Budgets to Build Portfolios
The Global Macro Edge has been the product of input from market
practitioners situated across the investment landscape. I would be especially
remiss if I did not start the discussion of risk budgets by thanking the
individuals whose contributions made the forthcoming content possible.
Steve Hotovec, Mark Rogers, and Tim Jacobson’s research, real-world
investment acumen, and desire to share a better way to build portfolios were
instrumental in bringing this chapter to fruition. Their efforts underscore a
larger passion by all of our contributors to see the readers of The Global
Macro Edge (as well as investors in general) succeed.

911
Defining Risk and Making the Case for Risk Budgets
To begin, let us start with defining “risk,” which can be difficult to pin
down in different contexts. Risk for the endowment is not having the capital
to finance the desired project. Risk for the pension is not having the cash flow
to disperse to its beneficiaries. Risk for the individual is not having the
income to pay for day-today living. Risk for all of us comes down to not
having enough. While this definition of risk should resonate with us all on a
personal level, that definition is a stark difference from what most
practitioners use as their measurement of risk. The common measure of risk
is the volatility (or “vol”) given as a standard deviation. This measures the
likelihood of upswings or downswings. For instance, given normally
distributed returns, if there were a vol of 5 percent over a period, this means
that there is roughly a 65 percent chance that the returns will be within ±5
percent of the average return (that is to say, it would be one standard
deviation above or below). Furthermore, there would be a roughly 95 percent
it would be ±10 percent of the average return.
However, this volatility approach puts too much emphasis on gains. No
one is afraid of making money. What we are afraid of is losing our capital, of
not having enough. As I outlined in Chapter 5 on Unit-of-Risk Ratios, risk
should be measured in terms of loss (both in terms of maximum adverse
excursion and “peak-to-trough drawdown”) and not necessarily the
magnitude of the fluctuations in returns.
Expanding on this concept, consider a portfolio that loses 5 percent and a
portfolio that loses 50 percent. How much would the portfolio that lost 5
percent have to return in order to get back to its breakeven point? The answer
is roughly 5.26 percent—a shade more than 5 percent. Yet, the portfolio that
loses 50 percent has to earn back 100 percent to break even.
Therein lies the real risk—permanent loss of capital. Once capital is lost,
it must be re-earned, dollar for dollar. How long does it take to earn 100
percent? Depending on the market conditions, it could take years. See the
below table to see the required recovery rate to break even from a given loss.
Notice the exponential relationship.

912
 Figure 21.2 Required Recovery Rate for Loss of Capital
At the range of 15-20 percent losses, the required recovery rate begins to
diverge significantly from the corresponding loss rate. Interestingly, this is
the level of risk most institutional investors work within. That most
institutional investors typically prefer investment strategies at or below this
range confirms, in a way, what most investors intuitively understand—losses
beyond this level pose a danger to achieving investment objectives. Not to
beat a dead horse or sound too much like Yogi Berra, but I wholeheartedly
endorse making money versus losing it. Losing capital can wreck the plans
and lives of institutional investors and individual traders alike. In fact, the
whole point of this chapter is to argue that risk should be of first
consideration and not merely an afterthought.
Thinking of risk at the outset is not a new concept. Organizations and
individuals use budgets to ensure that their pursuit of revenue or lifestyle
does not infringe upon their capacity to at least maintain status quo. Investors
should adopt the same mind-set—laying out what they are able to budget in
terms of risk as they pursue their target returns. Therefore, the risk budget is
the predetermined amount one is willing to risk on a trade, strategy, or
portfolio. Once this ex-ante loss level is reached, all positions should be
closed out and the investor, advisor, or trader should reassess the strategy. As
I will outline later in this chapter, I like to pare back positions as the risk
budget is approached—this makes for a more dynamic risk management

913
system, and reduces the impact of liquidity risk (the risk that positions cannot
be closed easily or at market price) if the risk budget is hit.
It is important to note that, although it may be applied in different ways,
the broader concept of a risk budget is universally applicable from the
individual investor trading his IRA to large-scale portfolio managers trading
billions of a fund’s money. The concept carries from prop shops to
investment funds to endowments.
The concept of a risk budget is even applied outside of investing in
markets. For example, suppose you are the CEO of a new company and you
just received venture capital to expand your enterprise. You undoubtedly had
to put together a business plan, complete with an outline for the hires you
would make, the goals you hope to achieve, and the associated timeline to
mark success or failure. Knowing that you have a limit on the resources at
your disposal, executing on your strategy is critical. Otherwise, you will end
up squandering precious capital and time. For this reason, organizations use
budgets and goals not only to direct resources to the right initiative, but also
to isolate the risks of failing to execute in a particular initiative. Now, as the
CEO, imagine one of your new hires is a sales executive. After six months,
this person has done nothing but rack up travel expenses and has delivered
nothing. At this point, you have two decisions: one, heed the temptation to
continue hoping that success is just around the corner (which is what we
often do in investing) or, two, preserve resources to maintain the opportunity
to execute on your plan by replacing that executive.
In the latter scenario, you are effectively putting a stop loss on the
situation. You have given yourself a chance to rethink things without being
caught up throwing good money after bad (through sunk cost accounting and
other behavioral traps). This disciplined mentality is at the heart of risk-
budget investing. We could boil down the thought process into a couple of
bullet points:

Know how much you are willing to lose in pursuit of your objectives.
Quantify that risk of loss into a risk budget.
Stick to your predefined risk budget to cut your losses before they get
out of hand.
Be ready to go with a replacement strategy (or manager) to keep capital
in productive use.
By following this approach, institutions and individual investors can have

914
a framework of action for challenging times and, most importantly, protect
themselves from excessive capital loss. Furthermore, the risk budget provides
a framework for enforcing one of the fundamental pillars the Protean strategy
advocated in The Global Macro Edge—flexibility. Recall that Proteus was a
shape-shifting sea god, fluid like the waters. When one form (for instance, a
lion) no longer fit his needs, he would transform to another (let us say a
hedgehog). The risk budget provides a metric to investors, a trip-wire that
tells them their old strategy is no longer working and it is time to transform.
It is for this reason, as well as the many other portfolio benefits of instituting
and maintaining a risk budget, that the risk budget is a primary component of
the Netto Number (an important tool of the Protean strategy) and
instrumental to why I believe the Netto Number will redefine how we assess
alpha and market performance in general.
Risk budgets can be used as an optimizing factor in the portfolio
construction process. To begin, let us return to our definition of risk as the
loss of capital rather than the magnitude to which returns can fluctuate. If this
is true, then it should logically follow that the portfolio should be constructed
with the risk of loss in mind. Rather than asking, “How much can I make?”
investors should first ask, “How much can I lose?”
If loss of capital is the key consideration, then using risk budgets as the
optimizing factor makes sense. An investor can shape his whole strategy or
portfolio (or selection of managers) with an eye toward the risk budget.
With these two uses for risk budgets (as underlying stop losses and as
portfolio optimizing factors) in mind, let’s work through how risk budgets are
established for underlying managers or strategies and how an investor would
construct a portfolio of such managers or strategies using the risk budget as
the core component of the framework.

915
Setting the Manager Risk Budget
There are many approaches one can take to develop risk budgets, but they
tend to be formulated following one of two philosophies: imposed and
developed.
The imposed risk budget is just as its name implies—it is imposed upon
a portfolio on a one-size-fits-all basis. Implementation is straightforward.
Investors simply identify a set level of risk (i.e., 10 percent) they are willing
to accept, then run their strategy and size their positions at levels
commensurate with the imposed risk budget. I think it is worth noting that
some admirably successful multi-strategy hedge funds have taken this
approach and generated compelling returns. The key advantage of this
approach is that it does not require heavy quantitative methods to develop
risk budgets. They are simply “imposed” by fiat. However, the main
disadvantage to this approach is that investors or managers may need to make
adjustments to their strategies in order to run the capital in a manner
consistent with the limitations implied by the risk budget. Investors may be
more sensitive to the nuances of their own portfolios, but forcing external
managers to adjust the strategy could force awkward constraints on the
managers’ portfolios, creating an environment in which the manager is
terminated prematurely and money is left on the table.
The developed risk budget, on the other hand, is formulated with a
specific strategy in mind. The strategy is analyzed both quantitatively and
qualitatively using the techniques outlined in the three phases of The
Global Macro Edge. The strategies’ natural profit and loss inflection points
are understood. Like the slack that is needed in the fly fisherman’s line, the
developed risk budget seeks to determine how much risk of loss is necessary
for the strategy to operate effectively and at what level losses are
unacceptable.

Imposed Method Developed Method

Investor Investors designate their Requires method to develop a

Impact preferred level of risk on customized approach to formulate
one-size-fits-all basis risk budgets
Strategy Investor or manager will Risk budget is tailored to the

916
 Impact likely have to adjust strategy and does not require the
strategy to meet implied investors or manager to alter the
limitations of risk budget investment process
A number of methods exist to formulate a developed risk budget. For
instance, an investor may analyze various historical metrics, such as historical
drawdown, standard deviation, or Netto Number. However, it is probably
safe to assume that, because for most managers the worst drawdown is in the
future and not in the past, a more sophisticated quantitative process may be
required to develop the risk budget. Such processes can span a range of
complexity.
Some fruitful areas of study that could be applied to formulating
maximum loss risk budgets include27:

1. Monte Carlo simulations aimed at projecting possible likely drawdowns

by running thousands of different scenarios.
2. In-sample testing of actual returns.
3. Cross-strategy analysis comparing drawdowns of strategy with similar
exposure and position sizing disciplines—this can be very useful for
portfolios with shorter track records or track records that don’t span
market regimes.
4. Extreme value theory provides some insight into potential drawdown
scenarios.
5. It is also possible to reverse engineer the risk budget by analyzing short-
term returns and how they correspond to long-term drawdowns.
6. The main challenge with formulating developed risk budgets is that the
process can generally end up being fairly complex. However, if you
possess the acumen, I highly recommend it. Furthermore, there are some
rules of thumb you can apply as a shortcut for a developed risk budget—
for instance, you can set the risk budget as twice of a strategy’s
historical (or backtested) maximum drawdown in order to hedge against
uncontemplated tail events. If you combine this with a manager who can
dynamically size their exposure relative to their real-time risk budget,
then you may have a better chance of not being prematurely stopped out.
Not only does the developed risk budget tailor a more appropriate
approach for the portfolio, but the hands-on analysis lends itself to a greater
understanding of other facets of the portfolio. However, I do want to reiterate
the point that, even if you adopt an imposed risk budget, you should still be in

917
a better position to control the destiny of your portfolio than if you had not
adopted any risk budget. After all, preserving capital is a prerequisite to
compounding it.

918
Using Developed Risk Budgets in the Portfolio
Construction Process
The developed risk budget method can help provide balance in the
portfolio context when you use individual risk budgets as your optimizing
factors. For example, assume we have three strategies we would like to blend
into a portfolio: Strategy 1—a global macro approach focusing on short-term
momentum and trade flow; Strategy 2—an approach trading long-term trends
in the European fixed income and currency markets; and Strategy 3—an
approach trading shares of companies undergoing management changes and
stock repurchases. Each of these strategies has different constraints, so let us
assume the following risk budgets:
Strategy 1: 10 percent; Strategy 2: 20 percent; and Strategy 3: 12.5
percent.
[As a side note, I would also add this represents a good diversification of
strategies. Each strategy is focused on deriving performance from
fundamentally different movements in the markets. The market participants
in each of these domains are in the markets for fundamentally different
reasons and for different time horizons. I prefer to choose and build a
portfolio of strategies based on this kind of qualitative analysis. Relying
solely on quantitative analysis of correlations can cause problems (as
referenced in Chapter 16 by Bob Savage), as mathematical relationships are
highly subject to the length of the time period examined and the market
conditions at play in any given sample of data.]
Using these risk budgets as optimizing factors will allow us to take the
same amount of risk (and performance driver contribution too) from each
strategy even though they have different risk budgets. Optimizing is achieved
through a simple math exercise known as normalizing. Take the reciprocal of
each of the risk budgets: 1/.1 = 10; 1/0.2 = 5, and 1/.125 = 8. Add the results
and divide each reciprocal into the total: 10 / 23 = roughly 43 percent; 5 / 23
= roughly 22 percent; and 8 / 23 = roughly 35 percent, all together, these total
100 percent.

919
 Now let’s check to see if we are balanced from a risk perspective.
Multiply each strategy’s allocation by the assigned risk budget: 43 percent *
10 percent = 4.3 percent; 22 percent * 20 percent = 4.2 percent; and 35
percent * 12.5 percent = 4.4 percent. Given some rounding errors, we can see
that each strategy contributes roughly 4.3 percent of risk to the overall
portfolio.

Figure 21.3
The advantage of this approach is that we have taken three very different
strategies and given them three different risk budgets, but then balanced them
from a risk perspective. No single strategy should drive the overall returns of
the portfolio because each has been sized based on their risk and each
contributes equally to the overall risk of the portfolio. Resultantly, no single
strategy is consuming an unfair share of risk. Combine the normalizing
process with ongoing regime analysis and you could enhance the Netto
Number of the portfolio even more. When investors grasp how strategies
complement one another, and how such strategies should fit into the overall
mix, they stand to build robust portfolios capable of maximizing return per
unit-of-risk. Understanding these concepts is a good way to differentiate
oneself in investing—too many traders and investors lose the forest for the
trees.
Just as strategies should be viewed in the context of a total portfolio, so
should managers. Not only that, but individual managers should understand

920
how they are working as part of a team, how other managers’ strategies
complement their own, and how their strategy fits into the overall portfolio.
Advisors who understand this concept stand to build portfolios with higher
Netto Numbers (indicating higher returns per unit-of-risk). Understanding
these concepts, whether from the manager’s or advisor’s perspective, paves
the way to differentiating yourself in the industry.
Another benefit of the risk budget approach is that if every strategy hits its
respective risk budget at the same time, I have the choice to terminate them
and cut my losses at roughly 13 percent (the total of the strategies’ risk
contributions). In this way, I have cut the left tail of my return distribution
(see Figure 21.4), or at least defined the lower bound. In other words, we
have drawn a line in the sand.

Figure 21.4 Risk budget May Help Reduce “Tail Risk”

In attempting to cut off the left tail, we should expect fewer extreme
returns (not just negative extremes, but also fewer positive ones) and we
should expect the returns to cluster around the mean. This is a potent form of
risk minimization. I would expect that if we were to take these same three
strategies and, instead of risk-weighting, assign the same amount of capital to
each one, such an approach would yield a portfolio with a wider distribution
of returns, a larger drawdown, a higher standard deviation of returns, and
lower Netto Number, albeit a slightly higher return than the risk budget
optimized portfolio.
It is important to keep in mind that, although this optimized portfolio may
give slightly lower overall returns, by lowering the volatility of the portfolio
and strictly limiting the maximum drawdown, it is intended to provide higher
returns per UoR. This provides a foundation for investors seeking higher
returns to apply leverage to gross up the returns to the same level as the non-
optimized portfolio, while still maintaining lower relative risk.

921
 An approach that allows the investor to define the desired level of risk,
balance that risk, and, with the right technology, enforce that risk is very
appealing. The method is elegant in its simplicity and transparency. Success
is easily measured—did you stay under budget or not? In addition, most
importantly, having the ability to define your left tail should limit the “exit
wound” surprise before you ever get shot.

922
Using TAPx Analysis to Ascertain Manager Suitability
and Risk Budget Sizing
The landscape of asset allocation is changing considerably and the
processes we use to allocate to managers are no longer confined to legacy
relationships, backward-looking performance ratios, or the scalability of
one’s strategy. Tools for assessing the qualitative makeup of a manager have
seen some of the most pronounced developments. This is increasingly
recognized as an integral part of the allocation decision, equally worthy of
scrutiny as a manager’s quantitative returns. Psychological assessment is also
a critical tool in setting a developed risk budget. As conceptually profound as
the concept of risk-budget investing (or any quantitative systematic strategy)
is, if a manager does not have the psychological willpower to adhere to the
risk budget, then considerable resources can be lost.
For many allocators, it can be very difficult to assess just how an
individual will react emotionally to P&L duress, which can subject a strategy
to a protracted drawdown. An inability to combine qualitative measurements
of a manager with traditional performance metrics may create blind spots.
As mentioned in Chapter 19, the TAPx exam, a test developed by Denise
Shull at the ReThink Group based on decades of neuroscience research,
offers a solution to this problem. Therefore, as a potential investor, in
addition to utilizing the Netto Number and other relevant quantitative
metrics, I would vet a manager based on its TAPx Score. As outlined at the
end of Chapter 19, the Talent Assessment Protocol (TAPx) test is comprised
of two parts: Cognitive Empathy (a measure of market intuition) and Risk
Differentiation (a measure of individual perceptions of risk). For portfolio
purposes, I tend to pay closer attention to the Risk Differentiation score, as it
specifically pertains to whether a manager can adhere to a risk budget.
More specifically, the Risk Differentiation score measures the potential
ability to avoid impulsive or ill-advised action. It indicates the likelihood that
market professionals will adhere to their predefined risk management
parameters over time. This is useful when gauging the discipline of managers
trading around a risk budget or a systematic strategy. For instance, it can help
to predict managers’ urge to “cheat” (for instance, to say “I guess I can
exceed my budget by 1 percent in this scenario” and then “2 percent beyond
that won’t hurt anybody”).

923
 On a scoring basis of 1 to 100, if a manager does not score higher than 75,
then my enthusiasm about their ability to manage within a risk budget wanes
considerably. A system is only as good as a manager’s willingness to adhere
to it, so a low score is a massive red flag. If a manager scores below my
cutoff, I would strongly consider passing on the allocation or having them
trade at a very minimal risk budget.
The second part of the TAPx is the Cognitive Empathy component. This is
more important than one may initially suspect. Research suggests that the
brain does not primarily tap into its quantitative regions when predicting the
path of future prices. Rather, the most talented market predictors—either
consciously or unconsciously—rely first and foremost on brain regions that
predict the reactions of other people.
The Cognitive Empathy score reflects an individual’s potential to predict
other market participants’ emotions and behavior—i.e., a mental facility also
known as cognitive empathy or “mentalizing.” This thinking style has been
shown in neuroeconomic research to be the elusive “X Factor” in trader
intuition. This part of the test also scores on a scale from 1 to 100. The higher
the score, the greater the probability the manager will be skilled at
recognizing patterns of emotions.
I would be hesitant to invest with someone who scores under 75 on
Cognitive Empathy (though there are always exceptions). There is increasing
evidence demonstrating just how important this skill is to a manager’s long-
term success. Therefore, TAPx can be a viable tool in vetting a group of
managers who all look superficially similar. Because of tools like a risk
budget and TAPx, the way professionals approach portfolio construction is at
an inflection point and filled with tremendous opportunity for those open to
new ways of approaching asset allocation.

924
Trading within a Risk Budget – A Trader’s Perspective
Speaking as someone who has been working with a risk budget for nearly
all of his trading career, it is important to outline the art and science of
trading within a risk budget. Those managers who demonstrate a facility with
this process significantly enhance their value proposition.
Conceptually and in practice, I prefer to scale down my positions as the
risk budget is approached and increase them as I build profits. For example, if
I have a five-million-dollar allocation and am working with a one-million-
dollar risk budget, then my starting risk per trade may be $20,000 (i.e., 2
percent of my risk budget or 40 bps of the total allocation). However, if I am
down $200,000 (i.e., the real-time risk budget is only $800,000), then my
risk-per-trade is going to be closer to $15,000.
You can think of this as a series of layered risk budgets, where the most
immediate ones have the least risk tolerance (the tradeoff for this additional
safety is missed opportunities). I like to think of it as a dynamic approach to
risk budgeting, instead of maintaining a binary in-or-out reaction function.
Easing out of positions as the risk budget is approached helps to reduce
illiquidity risk. Had there been a major market catastrophe forcing (as in
2008) me to liquidate my positions at the risk budget, I may have been forced
to sell at losses significantly exceeding the risk budget. By paring down
positions, I reduce the risk that I will be left holding the bag if a major market
blowup takes me below the risk budget. Furthermore, because I have less
skin in the game, I lose capital at slower rates—thus paring down slows my
descent to the risk budget.28
Another huge factor in my personal style of managing a risk budget is that
I rely heavily on my ability to assess the current market regime. As a 100
percent discretionary trader, if I am struggling to understand what the regime
is in place (as reflected by a relatively protracted decline in my equity curve),
then it is important to pare back risk while this dynamic exists. As outlined in
Chapter 4: “More Risk Doesn’t Always Equal More Return”, and throughout
The Global Macro Edge, taking on risk with strategies that are not congruent
to the regime may create negatively skewed asymmetries for your capital.
These regimes can go on for longer periods, so waiting for your equity curve
to “mean revert” (to move back toward the average) can carry serious risk.
Conversely, when you are running strategies that are regime-congruent,

925
assuming that they will not work anymore because you have already made
some money is equally problematic and can lead to leaving substantial
opportunities on the table.
As such, this risk budget model has me trading less capital when I am not
reading the regimes well and trading more when I am. I like to press winners
when I have seen an opportunity for price discovery due to properly
diagnosing a market regime. This is precisely where managers who do not
have the protocol or acumen for blending market regime assessment with
their money management may struggle.
Chapter 3, outlining the performance of the Protean Strategy, showed that
my ability to do this in 2012 and 2013 was particularly robust, winning 21
out of 24 months with an average Netto Number of over 7.00 for both of
those years. Conversely, 2014 was extremely tough for me as I was flat after
the first nine months and finished the year with a substantially lower Netto
Number of 0.84.
This style of managing a risk budget may not be appropriate for every
manager or strategy. However, it is intended to offer one possibility for how
this might be done. The following is a sample schedule for sizing down a
position as it approaches its risk budget. Just as the risk budget should ideally
be tailored to any given strategy, so should the schedule.
Down Percent of Risk Budget Position Size
0 percent 100 percent
20 percent 90 percent
30 percent 80 percent
40 percent 65 percent
50 percent 50 percent
60 percent 45 percent
70 percent 33 percent
80 percent 25 percent
90 percent 15 percent
95 percent 7 percent
98 percent 2 percent
100 percent 0 percent
You can find the position in terms of the risk budget by multiplying the
percentage down by the risk budget. Thus, for a 15 percent risk budget on a

926
strategy to be down 20 percent, the strategy must be down 15 percent * 20
percent = 3 percent.
Note that paring down a strategy does not mean the money is taken out of
productive use. As illustrated in the Regime Grid from my trading journal in
Chapter 8, while some strategies struggle, others may excel. Whereas one
regime may be very conducive to mean-reverting strategies, others are great
for trend-following and price momentum. There is a natural ebb and flow in
terms of how exposure increases and decreases based on the regime. If the
pared-down strategy regains profitability, it is appropriate to consider paring
up (which is why all of this hinges on the person running the strategy having
the skills and desire to incorporate the regime into their risk management).
Rule of Thumb: As mentioned earlier, my baseline for setting a risk
budget on any new strategy or manager is double the max historical
drawdown. Taking this rough money management approach from the
foregoing example, a money manager would have to hit their max drawdown
three consecutive times for a complete cessation in the trading strategy.
Clearly, if a manager or strategy has gone through a major shift in their
process, then a more bespoke approach may be appropriate. Either way, the
tools outlined throughout this book should help in making this assessment.
The biggest challenge when setting a risk budget is to have enough
flexibility to execute the strategy while feeling confident if you hit your
predetermined risk budget, then the edge in the strategy is gone.

927
Portfolio Benefits of the Risk Budget Approach
As noted earlier, portfolios constructed with the risk budgets and Netto
Numbers as their optimizing factors are intended to maximize return per unit-
of-risk at a better rate. As argued above, cutting off the so-called left tail of
the distribution (the extreme negative returns) of portfolios should produce
not only fewer instances of extreme negative returns, but also of extreme
positive returns. While it is somewhat counterintuitive to expect that fewer
extreme positive returns will result from fewer negative returns, keep in mind
that the mean will be more positive (so large positive returns will be
considered less extreme) and—more than that— portfolios will be less likely
to experience sudden extreme bounce-backs after a dramatic loss. Although
this is logical to me—and has been the case in my own observations—data on
risk budget investing has nonetheless been hard for me to procure as,
currently, risk budgeting is not widely practiced (and even less widely
reported) in the financial services industry.

Figure 21.5
When constructed within a framework with control over capital and
heightened transparency, risk budgets can be easily enforced and capital can
be protected. Such a risk-based and risk-controlled environment is best suited
for utilizing leverage, if desired, to engineer a given risk-return profile. This

928
approach also gives you a very good opportunity to compound capital.
For example, let us say we have allocated to ten underlying strategies—
each one extracting value from a different part of the market and over
different time horizons. What is the chance all ten strategies are hitting their
risk budgets at the same time? Possible, but not very high. Let us suppose
half are breaching their risk budgets while the other half are flat. If you have
a mix of strategies with risk budgets between 8-25 percent, with an average
around 15 percent, you would be down less than half that 15 percent. Play
with some different combinations of the below strategies and see what I am
talking about.

Just from a simple mathematical perspective, even if you had a disaster

requiring you to liquidate half of your strategies and then you miss the
bounce-back in the market, your losses would still be very manageable.
Under this scenario, we are talking a matter of a few months to recover the
lost 6.6 percent. To put this into perspective, some buy-and-hold portfolios
that do not use risk budgets took years to recoup losses incurred during the
last crises of 2008.
By no means does this guarantee a certain result. Still, the overarching
theme is that protecting capital in turbulent markets outweighs the risk of
missing a bounce-back in performance. The exponential relationship that
exists between the required recovery rate and the corresponding loss range
makes the risk of being wrong about a bounce-back far too great.

929
Using the Risk Budget as an Analytical Tool
Responsibly leveraging a diversified portfolio has been a huge part of how
the alternative investment industry has attempted to create alpha for decades.
The idea is to dampen volatility relative to returns by inputting a group of
non-correlated, positive expectation strategies and then leveraging this
portfolio up or down to the desired expected rate of return.
One of the biggest challenges in this approach is controlling the tail risk of
what superficially appears to be a diversified portfolio. Analysts use
historical data to determine correlations, but backward-looking data can be
limiting. Analysts cannot simply look to yesterday’s relationships,
yesterday’s returns, and yesterday’s market regimes, and then project the
same old relationships forward indefinitely. Past results are not necessarily
indicative of performance in future regimes. This can be seen most clearly in
Figure 21.6, which shows trendlines for a simulation of two different market
regimes.

Figure 21.6 The Lifespan of a Regime Varies

One acute constraint faced by those looking to measure future volatility-
adjusted performance by looking at historical metrics like the Sharpe,
Sortino, or Calmar ratios is that none of these figures have the ex-ante

930
context of a risk budget. However, the Netto Number takes the size of the
risk budget as one of its primary factors and can be a versatile analytical
tool.
This is one material advantage the Netto Number has when constructing a
leveraged, risk budget portfolio. The manager’s Netto Number can be the
“X Factor” in deciding not only what manager or strategy to select, but
how much one can responsibly leverage that strategy or the portfolio as a
whole.
It is one thing if a manager has a volatility of 8 percent in a certain market
regime with no formal risk budget. However, what can be difficult to grasp is
how this manager’s volatility would be impacted by running the same
strategy in another regime. It may be difficult to ascertain if the manager
would have the ability to recalibrate their sizing and stay within the risk
budget should a major regime shift happen. If, however, you have a
manager who has successfully traded within a risk budget across
different regimes, then you may confidently assign more leverage to that
strategy, given the manager’s understanding of how to manage position
size and exposure across different regimes. Therefore, the Netto Number
can become an indispensable tool when looking to gear a diversified
portfolio, and why the Netto Number can also be used as a “leverage ratio.”
One can take three general approaches when it comes to leveraging a
diversified portfolio. The first is to leverage a diversified portfolio with no
risk budget. This approach potentially leaves a huge tail risk. The second, and
I believe more responsible approach, is to leverage it with a risk budget
attached to each strategy. This at least makes provisions to address the tail
risk dynamic inherent in leveraged portfolios and the portfolio as a whole.
The third, and I believe most effective, approach is to leverage a
diversified portfolio with a risk budget attached, but use the Netto
Number as a factor in determining the leverage for each manager. You
have now gone to considerable lengths to eliminate the tail risk and assign
capital to managers who have demonstrated skill managing within a risk
budget.
Given the utility of this approach, I believe risk budget investing and
related ratios that captures a strategy’s performance within a risk budget (e.g.,
the Netto Number) will become more common in the years to come.

931
Drawbacks of the Risk Budget Approach
During my military service in the Far East, I became well-acquainted with
the ubiquitous yin-yang symbol. There is a deep philosophy behind that
symbol—the dark does not exist without the light; the masculine does not
exist without the feminine. Not only do these things exist because of their
opposition, but they also exist within one another—in the light there is a little
bit of dark (and vice versa). The risk budget is no exception to this rule. The
selfsame features that make it effective can, taken differently, be seen as a
negative.
Risk budget portfolios, while designed to avoid large drawdowns, may
concede some upside appreciation. However, what I concede in upside
appreciation is something I will hopefully make back in two parts of the
process. The first is building a portfolio of truly non-correlated strategies, and
the second is by leveraging those strategies based on the idea the risk budgets
of those strategies is set at the right threshold for that manager.
None of this can happen if you cannot define your UoR on an ex-ante
basis. Therefore, managers who can demonstrate the ability to trade within a
risk budget markedly increase their chances of winning allocations. Those
managers who cannot trade within a predefined risk budget are not a viable
investment option for me and should have their performance evaluated
accordingly. The Risk Factor Compensation System powered by the Netto
Number elaborates more on this in the next chapter.
Opportunities will always present themselves, but capital, once lost, is lost
and must be re-earned. Even still, when you are liquidating strategies, you
should have others in the portfolio taking risk in the markets.

932
Versatility of Risk Budget Portfolios
To give you a sense for how versatile the risk budget method can be, it is
worth noting it has been the basis for proprietary trading groups and a distinct
group of family offices who outsource manager talent. That is the flexibility
an investor has when he controls the:

1. Capital
2. Risk Level
3. Technology to Enforce Risk Budgets
4. Account Structure; and
5. Capitalization Decisions (to leverage or not).
Once those factors have been accounted for, you have put yourself in a
much better position.
A functional definition of risk is the prospect of permanently losing
capital. Loss limits should be established for each manager, strategy, or trade
for which you want exposure. In the case of managers, weight each one by its
risk budget, TAPx score, and Netto Number. This way all contribute
appropriately to the overall risk of your portfolio and no single manager can
generate an unfair share of losses. Control as much of the account structure,
capital, and funding decisions as you are able to or comfortable with. Stick to
your plan to maximize return per unit-of-risk. Designing portfolios this way
should keep things balanced and give you the best chance to compound
capital and achieve your objectives.

933
Part 2: Measuring, Monitoring, and Enforcing Risk
Parameters in Live Portfolios
Now that we have covered how to construct a portfolio of multiple
strategies, it is time to discuss how we, as investors, should manage that live
portfolio. Namely, this should be accomplished by measuring, monitoring,
and enforcing risk budgets and parameters. Just as thought and research went
into selecting the strategies and constructing the portfolio pre-allocation,
thought should go into formulating the risks and parameters that should be
monitored post-allocation. I stress should because monitoring risk is part of
being a vigilant trader or investor and, as stated above, is the focus of this
section.
Let me set up this discussion by sharing experiences that have heavily
shaped my perspective of the investment industry and my (occasionally
irreverent) voice that you may have picked up on when reading this book. In
spending five years writing The Global Macro Edge, I had the chance to
interview many colleagues who shared experiences with me about both
allocating and managing capital. Throughout this time, I was fascinated to
learn about the complex and innovative strategies deployed by many of these
managers. I enjoyed asking questions and digging into the thought process of
these managers and increasing my market IQ.
However, one of my biggest takeaways was the huge disparity in the
industry when it comes to monitoring risk post allocation. At the proprietary
trading firm level, you have some incredibly sophisticated risk tools.
Programs such as Kill Switch Plus, created by Edge Financial, now bring
proprietary risk management as an off-the-shelf product to protect against
rogue traders and runaway algorithms. Yet, for many endowments, family
offices, and large institutional investors that write a check to a fund, the
money goes off into some black (or at least fairly opaque) box, and it might
be followed by a monthly investment letter or occasional 30-minute phone
call.
Still, times have certainly changed in terms of what is expected, what is
available, and—with the right technology—what is possible. The
aforementioned set of problems is one reason I worked with Aleksey and
Alex at Risk-AI on creating UoR Software. I feel very passionately that risk
budgets must be monitored on a daily basis (and, in some cases, real time).

934
Not having this sort of transparency is where the theory of creating a
risk budget runs into the practical challenges of enforcing it.
This section will lay out an important portion of the investment process
playbook. It addresses formulating, measuring, monitoring, and enforcing
predetermined risk budgets and risk parameters. The following factors are
paramount:
Risk Management: More so now than in years past, instituting true risk
management is critical to successful investing. It is important to go beyond
merely monitoring risk, which entails having risk metrics in place. Managing
risk is putting together a plan of action in a given scenario and executing it.
The plan should be commensurate with your ability (not willingness) to take
risk and should be executed with discipline.
Collateral and Liquidity Management: This is a subset of one of the
things you might include in your Risk Management plan. You might lay out
specific parameters and thresholds required to make sure you never have a
margin call or overextend your risk. This may not be a big point to focus on
unless you have a portfolio margin eligible account or you routinely use
margin.
Capital Protection: Set risk budgets or thresholds to either exit or reduce
exposure to lessen the blow during extreme sell-offs. Furthermore, a proper
risk management framework can specify the exposure levels that are
appropriate to take in any environment. As noted earlier, I prefer to pare back
my positions as I approach a risk budget—this is another form of capital
protection.
Ongoing Strategy Research: Examining and reflecting on the past trades
in a strategy gives you clear insight into a how you build positions, exit
positions, size positions, and hedge positions. Even just taking a quick glance
over the trades from the previous month can give you a sense of the themes
and opportunities the strategy captured and missed during the month, whether
you reacted or held tight during periods of market swings.
Looking at this information lets you ask a set of deeper questions about
your own strategy. Doing so is not just good strategy development but,
believe it or not, it is also good risk management. By reflecting objectively
about your trades, you help to maintain a sense of discipline in the process.
Primary Research: Similar to the point above, if you have the time and
access to sufficient market resources, you can perform your own primary
research on large positions and themes. While it is useful to rely on external

935
sources of resource, it is also useful to formulate your own thesis, find your
own data points, and use this to supplement—or reshape—your view of
external research. This does not mean that external research is useless when
doing your own primary research. The markets are a very large puzzle, and it
is useful to have as many pieces as possible, and to be exposed to as many
theories as possible about how they fit together.
There is a fine line between micromanaging and being a good investor.
Most managers and traders I have collaborated with enjoy working with well-
informed investors and can add perspective as a sounding board. When
managers work with someone who is intellectually invested in their process,
it usually provides for stronger relationships, trust, and respect. The risk
budget component of the Netto Number creates that foundation. We all want
to win and it helps if you can bring value to the table beyond just fee-
generating capital to manage.
With some of the key benefits of this level of risk management in mind,
let’s delve into the process of setting it up.

936
Formulating Risk Guidelines
During the research and selection process, you should have made yourself
aware where a strategy should typically take exposure, and how to manage
market direction and position concentration. You should learn where the
average exposure should be and the range within which it can fluctuate. It is
useful to create a worksheet that helps you capture these parameters. Below is
an example of what it might look like:

Figure 21.7 Instrument and Country Exposure (shown as a percent of NAV)

One should incorporate all appropriate geographies and instruments
including futures, options, fixed income, private securities, cash, etc…

937
Portfolio and Position Limits (shown as a percent of
NAV)

Figure 21.8 Include limits on individual positions (long and short; cost vs
market value; etc… as seen fit)

938
Sector and Market Cap Exposures (shown as a percent
of NAV)

Figure 21.9 For futures, you should capture margin and market value by
market (e.g., grains, metals, equity indices, etc…)
These parameters and levels form the basis for risk guidelines that you
should plan on measuring, monitoring, and enforcing in your strategy
management process. Below is a sample list of some basic risk guidelines and
example values.

Risk Guideline Threshold Value

Max Gross Exposure (Long + Short) 180 percent of allocation value
Max Position Size (at cost) 6 percent of allocation value
Max Top 5 Position Size (at cost) 25 percent of allocation value
Max Non-U.S. Gross Exposure 20 percent of allocation value
Risk Budget 15 percent maximum drawdown
(As a quick side note: for ease of understanding the concepts laid out in
this section, the risk guideline examples will be discussed from the

939
perspective of an equity strategy. So when I am referencing positions and
exposures, it is in regards to stocks as opposed to bonds or futures.)
The purpose of creating these guidelines is to draw the boundaries of fair
play. Every coloring book and sport has lines drawn around the area of fair
play. By going through the exercise of formulating risk guidelines, you are
solidifying the rules to enforce a systematic sense of discipline on yourself.
Even if you are outsourcing to a manager, you can—and should—negotiate
these guidelines. Doing so will likely give you an even better sense of the
manager’s strategy, the manager a better sense of your constraints, and
will enforce an externally imposed sense of discipline on the manager.
In addition to developing risk guidelines, it is also important to institute
dynamic monitoring systems. Working with the right technology can make
monitoring these guidelines as easy as entering a formula and clicking a few
buttons. With the right system, you can confidently formulate more advanced
guidelines such as delta-adjusting29 for options. If you are able to do so, you
can start thinking about it in terms of a matrix with the type of risk you would
like to monitor and enforce down the side and how that risk can be measured
across the top. The following table is an example of one such matrix:

While delta-adjusting is a somewhat more esoteric example, you are free

to formulate whichever risk guidelines make most sense given the strategy,
risk budget, and capital efficiency. To give a specific example—if after a
close review of your strategy, you note that profits tend to collapse after the
VIX implied equity volatility index exceeds historical volatility by a given
percent, then by all means develop a VIX-to-Historical-Volatility ratio.
These regime analytics are what The Global Macro Edge embodies. Never
be dissuaded from taking an approach simply because it is unpopular or
unheard of (though definitely make an effort to understand why this is the

940
case). There are contrarian traders who have made fortunes by going against
the norm.

941
Measuring Risk Guidelines
Before you can measure risk, you must have access to the data to do so.
This is where technology comes in. As discussed in the previous chapter,
“The MPACT! of Automation”, you have a decision to build or buy, rent, or
partner with an existing provider to make a white label product. Building
requires capital, expertise, and people dedicated to maintaining it. Based on
my experience, building a technology from scratch can take extensive time
and resources. Unless you have the resources, building probably makes little
sense.
Buying or renting is the other option, but this can be complicated and
expensive as well. There is no perfect risk management software for all
situations. Many providers will offer some services but not others. All will
differ somewhat in their risk analytics calculations and accounting
methodologies. Some may not provide reconciliation services and others will.
Measuring risk guidelines presumes the necessary data is available to you.
Making data available in a format that allows you to manipulate and analyze
the data is essential. Regardless of what course you choose, the following
steps must be executed in your operational process if you are to work with
reliable and meaningful data that plays on the theme of “aggregate, organize,
and assimilate”:

1. Capture the data – this step is about collecting the data, often from
multiple sources, and mashing it together. You should, whenever
possible, get this data from the source—for instance, if you are
collecting information about a manager, get it from the custodian or
prime broker (data that comes from managers is not official and may be
incomplete).
2. Clean the data – make sure that all the trades and positions are
accounted for in a timely manner (i.e., one day after the trade date) and
account for gaps (e.g., there may be a holiday on one exchange that halts
trading, even as other exchanges continue to operate).
3. Reconcile the data – this step means you are applying the correct costs,
income, and charges associated with the trading so that you are looking
at a true picture of where things stand and are not missing small, but
critical amounts.

942
 4. Process the data – this step takes the data and calculates the necessary
analytics necessary to monitor and enforce the risk budgets and
guidelines set forth prior to investment.
5. Manipulate the data – this step requires you to get into the data and
conduct ad hoc analysis over custom data ranges as necessary.
The above process can be carried out by teams of people or just yourself,
depending on the technology you are using. As noted earlier, technology that
can present data in a format allowing you to manipulate and analyze
information is essential to monitoring risk guidelines and budgets. I suggest
you have an automated process that produces output that is easy to digest and
customizable for your particular risk monitoring and enforcement needs.

943
Monitoring and Enforcing Risk Guidelines
I think it is a universal experience in the investing world to chat up
someone who will rattle through all the reasons why his investment made so
much sense. He will describe when he made his initial investment, reveal that
the price of the investment has since dropped, and then say, almost giddily:
“Yeah, but if I liked it at $50, I should love it at $42.”
This statement is often frustrating to hear. The person is saying he cannot
be wrong. If the investment price falls to $35, will he be feeling something
deeper and more abiding than love about that investment? In addition, if the
price falls to $15? Or $5? In the above scenario, nearly all of us would tap out
at some point along that spectrum, but when? After how much P&L
destruction?
What is also confounding about this scenario is when very smart and
experienced people say, “You have to stay disciplined and hold your
position.” Discipline is certainly the right word here, except it should mean
something different. Discipline means having a framework and a process,
then sticking to it. Discipline does not mean convincing yourself that an
investment is now a better opportunity because it has fallen 16 percent. I have
no issue with having a plan to dollar-cost average into a trade because you
forecasted the prospect for some outsized volatility
Emotional biases may lead investors to “cheat” on their risk guidelines,
rationalizing that it is okay to blow through them a little bit, then a little bit
more, and ultimately a lot more. While it may be okay to compromise on
guidelines when there is a good, well-thought-out reason to do so, these
reasons do not commonly arise. Unless a trader fully has his cognitive and
emotional biases in hand, it is useful to take discretion out of the equation by
never compromising on risk guidelines. This is why the TAP test by the
ReThink Group is so valuable in understanding which manager is likely
to break their risk rules.
The other aspects of monitoring risk sound simple enough, right? Well,
you are right on the surface. Once you have a process in place, whether
manual or technology-based, you need to take the time each morning to run
down your list of strategies and verify they are within acceptable risk
parameters. An investor must have guidelines to monitor all relevant major
risks, regardless of where they come from—when crossing a street, one does

944
not look solely to the right. This process entails constantly thinking about
risk, and instituting new guidelines when necessary.
Most importantly, an investor must stay vigilant!

945
Monitoring and Enforcing Risk with External
Managers
Up until now, we have spoken about how you should put together a
framework for measuring and monitoring risk in a portfolio you manage
yourself. However, there are a few more wrinkles when you outsource to
external managers. An investor may not always have all the trading
information from these managers—it is important to get as granular
information as possible in order to assess risk. Understanding what is going
on in a portfolio is a prerequisite to managing its risk.
Secondly, an investor should agree on risk measures with a manager in
advance. Negotiating these risk measures with the manager should give the
allocating investor a better understanding of the strategy, and it should give
the manager a better understanding of the investor’s concerns and constraints.
Third, as noted briefly above, an investor should seek to get information
from the administrator or prime broker, rather than the manager himself. This
information is often cleaner, and there is no incentive to present it in a
skewed manner (a manager, on the other hand, may give in to the compulsion
to “spin” its performance more favorably).
Importantly, actually enforcing risk with an external manager is a much
more complicated process. While a trader enforcing risk in his own portfolio
has himself or herself to wrangle with, an investor allocating to managers is
in a complicated position. Not only is the information about the portfolio
more delayed and more limited, but appropriate communication and
procedures become paramount.
Let’s use a few examples to show how you could enforce risk as an
allocator to outside strategies.

946
Case 1: Max Position Size Breach
Scenario: You notice that one of your equity managers has long position
sizes above your threshold of 10 percent at market value.

Figure 21.10 Position Concentration Percentages

Action: Call the manager and bring the breach to their attention.
Result: The manager saw the breach as well and was in the middle of
reducing the positions that were not in compliance with the maximum
position size threshold agreed to in the Investment Management Agreement.
Why it matters: Notice a good number of these names are in the
technology sector. Suppose the technology sector goes through a sell-off due
to some news announcement that affects the whole industry. Every
percentage point above the threshold would incrementally hurt performance.
Keep a record: Log the occurrence in a journal. If this becomes a
repeated infraction, you may need to consider discontinuing any investment
with this manager.

947
Case 2: Top 5 Max Position Size Breach
Scenario: You notice that one of your equity managers has five long
position sizes above your threshold of 30 percent at market value.

Figure 21.11 Position Concentration Thresholds

Action: Call the manager and bring the breach to their attention. The
manager knows the breach has occurred but saw “the opportunity of a
lifetime.”
Result: Direct the manager to close the account.
Keep a record: Log the occurrence in a journal and document the details
of the actions taken.
Why it matters: I recall a group based in Southern California in the early
2000s that had experienced a severe drawdown and saw the “opportunity of a
lifetime,” took that opportunity, and made a lot of money on that trade. They
did it again and are no longer in business because they lost so much capital
on that trade. The above illustration is a breach on concentration limits that
could be catastrophic in a given scenario. Sometimes, breaches like these are
material and should be grounds for termination.

948
Case 3: Exposure by Market Cap
Scenario: You notice that one of your equity managers has exposure with
large, mid, and small cap equities. The Investment Management Agreement
states no exposure is allowed with “micro cap” equities.

Figure 21.12
Action: No formal action should be taken as the account is within
compliance. However, dig into the small cap names and see how far away
they are from the “micro cap” limit.
Result: N/A
Keep a record: N/A.
Why it matters: Effective enforcement is often proactive in nature. Keep
an eye on exposures, trades, and positions that could become a problem. As
the saying goes, “People don’t do what’s expected, only what’s
inspected.”
The above scenarios are high level. Depending on how sophisticated you
want to make your process, you can be very granular. For example, if you
could seamlessly delta- and beta-adjust your positions, you could put limits
on each position from a cost, market value, detail- and beta-adjusted
perspective.
The key takeaway here is that if you have the data, the world is your
oyster. You can create as comprehensive of a framework as you desire or as
your bandwidth allows.

949
Conclusion
The process of measuring, monitoring, and enforcing risk should be as
well thought out as your process for allocating capital amongst strategies or
managers. Uncover the risks in the pre-investment process that you will need
to enforce in the post-investment process. Draw up and formalize those risks
into specific limits that you will measure, monitor, and enforce. Make sure
you have the operations and technology process in place to do so effectively.
Strongly consider utilizing third-party resources and technologies.
As I stated in the previous section, keeping to your framework will at
times limit your upside or take away big wins. However, if applied
appropriately, it should keep your exposures in check so that when things
work against you, you will ideally be in a position of strength to preserve
capital. It cannot be said enough—preserving capital is a prerequisite to
compounding it.
As an important note: While this discussion can be viewed as a starting
point, risk management—as much as any other topic—should be tailored to
your specific needs. These concepts on allocation and enforcement will segue
into the next chapter on how to compensate a manager based on their return
per UoR.
27 As a note: Some of these approaches could prove fairly quantitatively complex,
and would take hundreds of pages to describe. It is useful, in this sense, to consult a
quantitative finance textbook or look into specialized software for performing this
analysis.
28 This approach requires we keep assessing the risk budget relative to an initial
position size.
29 Delta-adjusting for options is an exercise that converts options exposure into its
underlying equivalent or equivalent number of underlying shares or contracts while
taking into consideration the current underlying price, strike price, put or call, etc. For
example, one contract of options may equal 50 equity shares, taking into consideration
the mentioned parameters.

950
CHAPTER
22

951
 Paying for Returns in Context:
Manager Compensation Based
on Return per Unit-of-Risk
So far, The Global Macro Edge has provided a number of methods that
readers can use to pursue optimal risk-adjusted returns. I used the methods
described in this book to start with $100,000 in my personal account at
the beginning of 2010 and generate over $3.1 million in profits by the end
of 2015 while experiencing minimal correlation to the S&P 500. However,
this says very little about what an investor who delegates the decisions to a
manager should pay for profits.
As this chapter argues, compensation should be based on returns relative
to maximum adverse excursion and how efficiently the strategy uses
investor’s capital. In other words, the decision to allocate resources to a
strategy should ultimately be based on how well it maximizes return per
unit-of-risk. The question of what is the right price to pay for returns has
been with us since the dawn of the markets. For the majority of investors, the
process of what to pay only looks at the end return, without factoring in the
risk taken to achieve that return.
Despite looking for managers and strategies that embody this statement,
the vast majority of investors do not complete the final step of the investment
process. The final ingredient involves putting in place a goal-congruent
compensation structure. This structure should reward managers for
maintaining superior risk-adjusted returns, while not overpaying them should
their results deteriorate. Instead, most investors follow a Draconian and
outdated compensation protocol. They pay a percentage of nominal
performance while having no provisions to either raise or decrease the
compensation based on other risk measurements of the portfolio. The
absence of a dynamic pay structure punishes both investors and
managers. The inability to incorporate a versatile and equitable
compensation structure can serve as a key obstacle for both an investor and
money manager in consummating a deal.
The solution to this problem—consciously given as the penultimate
chapter in The Global Macro Edge— looks beyond direct trading and
analysis to a method for controlling risk and maximizing return per unit-of-

952
risk when investing with an investment manager or advisor. The approach
outlined in this chapter—risk factor compensation based on the Netto
Number—is not just an analytic tool by which readers can assess a market,
strategy, manager, or portfolio. It is also designed to ensure reasonable
safeguards in the investment management process, to prevent investors from
overpaying for beta, and to encourage managers to allocate capital efficiently
(or at least discourage managers from overcommitting capital to a strategy to
the point of diminishing returns). Furthermore, to the extent that the Netto
Number system requires investors and managers to negotiate the maximum
level of risk exposure at the inception of their relationship (and renegotiate in
each subsequent performance period), investors get a greater say in the risk
management process, and managers are incentivized to set risk controls
efficiently.

953
The Final Step of the Investment Process
The last story of The Global Macro Edge returns us to my San Francisco
Bay Area roots. Before we get into details, please keep in mind that my
desire to take on risk with a positive expected return is innate. For as long as I
can remember, I’ve had it in some form or another—from my earliest days, I
have dedicated a great deal of thought to the matter (though I did not always
have the quantitative sophistication nor the arsenal of analytic tools outlined
in this book). I placed my first bet at the age of eight and, during high school,
evolved into—to use the polite term—a liquidity provider for those wishing
to wager on the outcome of sporting events. A number of indispensable
lessons in my path to becoming a successful trader came as a result of my
“entrepreneurial” experiences at Pinole Valley High School in the early
1990s.
The list of skills that cross over is quite fascinating:

Understanding market sentiment;

Anticipating client order flow;
Recognizing cognitive/emotional biases in others;
Building models to determine spots of value;
Assessing counterparty risk;
Feeling the direct impact of liquidity;
Realizing the importance of discipline in a process;
Acting on imperfect information;
Identifying asymmetrical investment opportunities;
Experiencing a black swan event; and (significantly for this story)
Needing to innovate.
In my case, innovation came in the form of “The Progressive Point
Spread.” While a traditional point spread on a football or basketball game is
very easy to understand, it is not always reflective of how well or poorly my
clients handicapped the outcome of a sporting event. It was too binary. If a
team the client wagered on won by more than the point spread, then the client
won their wager. If the team did not win by more than the point spread, then
the client lost.
While the traditional point spread is simple, it is hardly equitable. For

954
example, if a client had wagered on a team that was a 7-point favorite, they
would win the same amount whether that team won by 8 points or 28 points.
The same binary payout feature existed on losses as well. It seemed ludicrous
that there was not a more dynamic payout system to account for the degree of
a win or loss.
My creation of “The Progressive Point Spread” solved that problem.
If a team was a 7-point favorite and won by only six points, the Progressive
Point Spread ensured that my clients betting for the team would only lose 25
percent of their entire wager, instead of the whole thing. Conversely, if a
client’s team was a 7-point favorite and won by eight, they would only make
25 percent of their original bet instead of the full amount.
This was a far more equitable and representational payout structure based
of the outcome of the game. The response was amazing. In retrospect, it is
too bad the crowning achievement of my high school education could not be
put anywhere on my diploma.
It is with the same spirit of innovation that the “Netto Number” was
conceived. As outlined in Chapter 5, the Netto Number™ is the most
important Unit-of-Risk Ratio that I use. It not only allows me to measure the
performance of a market, strategy, or portfolio on a return per unit-of-risk
basis, but I can also measure the performance of a manager. The versatility of
the Netto Number may help solve a number of problems when attempting to
assess different managers with different strategies on an apples-to-apples
basis. Once you have a viable way to measure and compare performance,
an equitable compensation structure can follow.
The Netto Number is the backbone of a more dynamic and equitable
incentive framework between money managers and investors in the
alternative investment industry. This framework rewards a manager based on
the overarching theme of this book: how well it maximizes return per unit-
of-risk.
As for my extracurricular business? After three years of running a very
successful book, I lost it all a few weeks before my 18th birthday when a
number of clients won multiple five, six, and seven team parlay bets. A
record number of favorites in the NFL and college football covered the point
spread over the four-day Thanksgiving weekend in November 1992. This
required me to pay anywhere from 20 to 100 times the amount wagered by
my clients, and taught me another enduring lesson that has made its way into
this book: manage your downside risk.

955
The Current Compensation System for Hedge Funds
The standard compensation system in the hedge fund industry and the
traditional point spread have a lot in common. They are both accepted as the
standard and used by the majority of participants in those respective markets.
They are also both very simple and straightforward. Lastly, they both may
perpetuate the problem of conflating skill with luck.
Traditionally, hedge fund managers receive two types of compensation:

1. Management Fee: a percentage fee paid on the value of a fund’s assets

under management (AUM). It is usually stated on an annual basis, but
paid on a monthly basis. Thus, a 2 percent management fee would mean
that investors pay 2 percent divided by 12, or 0.17 percent, of the value
of their portfolio each month.
2. Performance Fee: An incentive award based on the results achieved.
This is usually a significantly higher percentage than the management
fee (e.g., 20 percent) and is paid on profits above a certain level. The
profits are generally gauged over a high-water mark (the last highest
level of AUM—this is to avoid double paying on profits if AUM dips
down and then regains its losses) or above a hurdle rate (such as the
growth of the S&P 500 index over the hurdle period—this ensures that
the manager is only paid when it beats the market or some other
benchmark).
For example, a “1 and 20” fund has a 1 percent management fee and a 20
percent performance (incentive) fee. The management fees are taken out first,
before the performance fee is assessed on net return (return post-performance
fee is typically called “net-net return”). If, after the management fee is
assessed, the manager makes $1,000,000 for the year above the trigger level,
he will earn $200,000 as an incentive fee. If the account loses money, then
the manager earns no performance fee but does not have to pay anything
either.
The management fee may pay for day-to-day operations, but a hedge
fund’s success generally revolves around the performance fee, through which
the manager may produce outsized absolute returns. Some have argued this
structure is skewed toward the manager. Specifically, the manager is well
rewarded for success but does not suffer direct monetary losses for failure

956
(i.e., negative returns for the investor).
The History of the 20 Percent Performance Fee
The 20 percent performance fee has become an institution as old as
hedge funds themselves. Alfred Winslow Jones, who established the
first “hedged fund” in 1949, insisted on keeping 20 percent of all profits.
Jones arrived at this figure using the precedent of Phoenician sea
captains roughly two and a half millennia earlier. As payment for the
safe passage of the assets they transported, Jones claimed these captains
pocketed one-fifth of the profits from their voyages.30
Given The Global Macro Edge’s emphasis on adapting with
different market conditions, it seems absurd that the 20 percent
performance fee should even hold steady from market regime to market
regime (let alone for thousands of years!). Consider the wisdom of R.
Buckminster Fuller, who famously said: “If you are in a shipwreck and
all the boats are gone, a piano top… that comes along makes a fortuitous
life preserver. But this is not to say that the best way to design a life
preserver is in the form of a piano top. I think that we are clinging to a
great many piano tops in accepting yesterday’s fortuitous contrivings.”31

957
Shortcomings and Challenges
The example below highlights a fundamental flaw in the current
compensation system. It will begin the process of illustrating how a failure to
incorporate a dynamic pay structure may undermine the entire investment
process. This failure occurs because manager compensation is not directly
linked to a unit-of-risk metric. Leaving out this final step can cause incentive
misalignments even when investors are already utilizing a process of
identifying and selecting managers based on their ability to maximize return
per unit-of-risk. This failure can lead to paying active money management
fees for passive investment performance.
Example:
Two managers were given a $10 million allocation and were
assigned a unit-of-risk of $1.5 million to trade for one year. A unit-of-
risk (or risk budget) of $1.5 million, i.e., the account goes down to $8.5
million from $10 million, all trading will stop. After a year, the
performance was as follows:

Using this philosophy, several things stand out in the foregoing example.
The first is that the return profile of Manager A had much greater downside
volatility than Manager B. Manager A also came closer to hitting the risk
budget, or RB. Lastly, after the 20 percent incentive fee (not factoring in the
management fees that came first), the investor who had chosen Manager A
made no more than a net $800k profit while being down $1 million at some
point. To put it another way: after accounting for fees, the investor did not
even earn as much as it had been down.
Meanwhile, Manager A is paid the same percentage of profits as
Manager B. They are paid on the same schedule despite Manager A only
making half the overall return, incurring a substantially higher max adverse
excursion, and coming much closer to hitting the predetermined $1.5 million
RB. The flat 20 percent incentive fee ensured that Manager A received too
much compensation for his return per unit-of-risk. There are a lot of
“Manager A’s” in the hedge fund industry.

958
 The foregoing example illustrates why the current hedge fund
compensation system is woefully inadequate. Compensation based solely on
returns takes a one-dimensional view of a three-dimensional process.
Instead, compensation should be based on three factors (or dimensions):

1. Overall Returns
2. A Predetermined Level of Capital at Risk (e.g., How Well the
Strategy Performs Relative to Its Risk Budget)
3. Risk Adjustments (e.g., Adjustments for Actual Volatility,
Downswings, or Drawdowns)
For nearly all investors, the determination of what to pay a manager only
looks at factor 1, without having the knowledge—much less the process—to
take into account factors 2 and 3.
It is easy to see why so many investors in absolute return strategies have
grown disillusioned and circumspect—they simply do not want to pay a
manager to gamble with their money. The current system of fee generation
allows managers to take oversized risks with the knowledge that they will
receive a set proportion of any win and will be insulated from the effect of
any loss.
The high-water mark and hurdle rate systems, both of which were
designed to eradicate other problems in the traditional performance fee
system (paying for performance that simply recoups a loss and paying for
market performance, respectively) are not without their problems. Managers
under their high-water mark are not properly penalized for taking on excess
risk, so they may double down (or worse) on risk in a desperate bid to make it
back above the high-water mark and to once again begin pocketing high
performance fees.
The hurdle rate system has even more problems. In a hurdle system,
manager performance is typically judged against an index like the S&P
500 or a predetermined percentage, neither of which have a risk budget.
This is a true apples-to-oranges comparison that can lead to paying active
management fees for passive management performance. For example, let us
take a hurdle rate system where the manager is paid for exceeding the S&P
500. If the manager simply takes a 3X levered position in the S&P 500 and
leaves it alone (a pure beta position32), then it will be paid on 2X the S&P
500 every time the index gains over a performance period. For instance, if the
S&P 500 gains 5 percent and the 3X position gains 15 percent, then the

959
manager will be paid on the 10 percent excess. Here, the manager pockets
large profits simply for having made a risky bet with heavy potential
downside, using the investor’s money.
Not surprisingly, some major pension funds and institutions have become
more vocal in their frustrations. In response, as this book was going to press
in 2016, some funds have significantly lowered their management and
incentive fees. I think this is an overreaction. A far simpler solution is to
utilize a compensation structure that pays a manager based on how it
maximizes return per unit-of-risk (as opposed to the nominal returns
embraced under the current structure).

960
SOLUTION: Compensate on Return Per Unit-of-Risk
As someone who supported his family from 2010 through 2015 based
almost entirely on the P&L of his personal trading account, I have a special
place in my heart for the adage “you eat what you kill.” Proper
incentivization has many benefits and is, after all, an essential part of the
alternative investment industry. This chapter is not suggesting whether you
should pay an incentive fee; instead, it focuses on finding an efficient and
equitable way of paying out incentives that properly aligns the interests of
investors and managers. However, this can only happen if investors have
the tools and desire to take a more granular approach toward both
assessing the real return per unit-of-risk in their portfolio and how they
should pay for that alpha.
I am not alone in my thoughts on this. Peter Hecht, Managing Director of
Evanston Capital Management and former Professor of Finance at Harvard
Business School, has an interesting paper on the problems in the active
management industry relating to overpaying for beta. Mr. Hecht has proposed
various solutions to help strip out exogenous factors that distort manager
skill. These solutions could be applied on a bespoke basis and are one of
many possibilities to evolve the current way we assess and pay for alpha.33
It is my hope this chapter is a starting point for a more protracted
discussion of innovating the active management industry. In that spirit, I
have laid out my own five-step process. This will explain why creating a
compensation structure based on how well a manager maximizes return per
unit-of-risk will allow the investor to attract top manager talent, while, at the
same time, provide the proverbial carrot to spur on managers with true
investment acumen. In fact, if a manager is not open to a structure like the
one in this chapter, it may be a red flag about the manager’s own perceptions
of its strategy.
The five steps to be outlined are as follows:

1. Determine Factors in Measuring Return Per Unit-of-Risk

2. Incorporate the Factors into a Single Ratio: The Netto Number
3. Create a Payout Grid
4. Application
5. Integrate into a Portfolio

961
Step 1 – Determine Factors in Measuring Return Per
Unit-of-Risk
1. Measure how well a manager is maximizing return per unit-of-risk by
focusing on two factors:
A. Amount of the Risk Budget
B. Max Adverse Excursion (the “Heat”)
The goal is to attract top manager talent by incentivizing them through a
dynamic three-dimensional approach to compensation. As noted above, these
three dimensions encompass overall returns (which just about all systems
gauge), the predetermined level of capital risked (which can be gauged by the
risk budget), and adjustments for actual risk experienced (which can be
gauged by the max adverse excursion). This process is called “The Risk
Factor Compensation System” and the Netto Number is the base of it.

962
A. Risk Budget
The risk budget (RB), covered extensively in the previous chapter, is the
predetermined amount of capital an investor is willing to commit to an
investment, i.e., the investor’s risk budget. If the manager loses this amount,
then all trading action is terminated. Under the system this chapter proposes,
the amount of the RB must be agreed upon in advance by the investor and
the manager and then held constant throughout the performance period.
Every performance period, it can be renegotiated. Measuring a return relative
to this predetermined RB is very instructive about the robustness of a
manager, strategy, or portfolio. Furthermore, agreeing to an RB provides
investors with control over an important element of risk protection.
It should be noted that deciding on an RB must take into account many
considerations, as the size of the RB plays a factor in the manager’s
flexibility. The greater the RB, the more leeway a manager has in running his
strategy; the smaller the RB, the less maneuverability. Having this in place in
advance forces some real thought about how a manager can size a strategy to
keep itself in the game without being taken out by hitting the stop loss.
This is why measuring a manager’s performance when they have been
forced to work around a predetermined risk budget may tell a much different
story than simply looking to historical drawdowns of a strategy. Drawdowns
of a strategy that did not have the context of a risk budget do not tell the
complete story about the robustness of a strategy. However, if we can see
how a manager or strategy dynamically adjusted their position sizing to
prevent themselves from hitting a predetermined risk budget, then this
sheds a much broader light on their investment acumen.
To illustrate, let us return to our prior example of two managers each
given a $10 million allocation. The investor assigned an RB of $2 million to
Manager A and $1 million to Manager B (presumably after careful
negotiation and based on consideration of the important analytic factors
discussed in this book). In this instance, if both managers had made the
account $2 million, then Manager B—who was working on half the RB—
delivered $2 of return for every dollar of risk budget while Manager A
delivered only $1 of return for every dollar of risk budget. Manager B in this
scenario did a much better job of maximizing return against the risk budget
(which is a good proxy for return per unit-of-risk).

963
B. Maximum Adverse Excursion
While measuring return relative to the RB, as outlined above, is
undeniably important, it only gives part of the picture. We should consider
maximum adverse excursion (MAE) as an equally important factor in
determining how well a manager is maximizing return per unit-of-risk. MAE
is the maximum level an account was down from its starting point (or
baseline) during a performance period. For instance, for a $10 million
allocation, if $9,800,000 is the lowest the account falls, then the MAE is
going to be $200,000, or 2 percent (calculated as $200,000 / $10 million)
worth of “heat.”
Keep in mind that MAE only concerns itself with drawdowns below the
starting point. It is not the same measurement as maximum drawdown, which
measures the largest peak-to-trough anywhere on the equity curve. For
instance, if an account that started at $10 million goes to $11 million and
then falls to $10.5 million, that $500k decline is important to note, but it
would not be recorded anywhere in the MAE.
It is interesting to compare the emphasis on the MAE, or negative
drawdown, to the Agony-to-Ecstasy Ratio (outlined in Chapter 5), which
measures how much “joy” versus how much “pain” markets were providing.
Most of us would agree our temperament is different if a manager or strategy
is pressing his P&L versus if it cuts into our original investment. Path
dependence is a real world phenomenon and an important consideration in
the construction of this system.

964
Step 2 – Incorporate The Factors into a Single Ratio:
The Netto Number!
It’s wonderful to talk about paying a manager based on how they
maximize return per unit-of-risk, but it’s another thing to come up with a way
to do this. How do we incorporate the two most important factors in
measuring how well a portfolio is maximizing return per unit-of-risk? The
Netto Number. As reitereated throughout this book, the Netto Number
provides the third dimension of measuring performance of a manager or
strategy. In the case of assessing manager skill, it does this by dividing profits
by the average of the RB and the maximum adverse excursion (this average is
also referred to as the “risk factor”). By combining the two, we are giving
weight to both the predetermined risk budget and the largest amount lost
from the initial investment. This creates a very robust denominator to
measure against the numerator, which is composed of the profits of the
account (see Figure 22.1).

965
 Figure 22.1 Netto Number Formula and Example Applied to Manager
Performance
By having a denominator that can increase or decrease based on the size
of the “heat” and “risk budget” of a strategy, the ability to measure manager
talent takes on a third dimension that widely used risk measures like the
Sortino, Sharpe, Calmar, and Information Ratios cannot account for.
However, these ratios were still an inspiration in the Netto Number’s
development. For instance, the emphasis on MAE is similar to how the
Sortino Ratio was meant to improve upon the Sharpe Ratio by focusing only
on how excess returns cover the standard deviation of only negative moves.
Similarly, the Calmar Ratio’s emphasis on the level of drawdown was an
inspiration. However, the Netto Number further modifies the Calmar with the
emphasis on negative drawdown and the inclusion of the ex-ante risk budget.

966
 The inclusion of a negotiated RB folds in a strategic dimension to risk
management meant to benefit both investors and managers. If there is no
predetermined RB then, for the sake of measuring the Netto Number, the RB
is set at the value of the entire portfolio. This has a profound impact on a
manager’s potential Netto Number, as it can significantly lower it. Imagine,
for example, that a manager pursues a strategy that would avoid a max
drawdown of more than 10 percent of the entire portfolio, but the manager
declines to commit to an RB in order to maintain flexibility—the RB would
end up being 100 percent of the portfolio, fully ten times what is required. In
the absence of any MAE, multiplying the RB by ten times would lead to a
Netto Number “up to five times” smaller than it would have been. If, as
described below, compensation is linked to the Netto Number, then it is
strongly in the manager’s interest to negotiate a lower risk budget
(though—as indicated earlier—not one so low as to restrict trading).
Therefore, the Netto Number serves as a potent tool to force the issue of
trading around a budget and to keep managers from taking on too much
AUM.

967
Step 3 – Create a Payout Grid
The next step in the Risk Factor Compensation System process is to set up
a payout grid based on the Netto Number. The grid shown below is a starting
point, but it can be adjusted based on the bespoke situations of the
investor and manager. When constructing this grid, I used the feedback of
managers, investors, traders, and advisors to set up levels in which there
would be an equitable distribution (see Figure 22.2).
As you notice from this grid, a traditional 20 percent incentive fee would
be based on Netto Numbers of 0.96 to 1.00. The consensus of my fieldwork
was that if a score of 1 was achieved, given the parameters of the Netto
Number, then a traditional payout of 20 percent would be equitable. After all,
this would imply profits of anywhere from 50 percent of the RB with zero
drawdown, to profits approaching 100 percent of RB.34 Please note that a
Netto Number of less than .01 would imply an incentive fee of 0 percent.

Figure 22.2 Netto Number Payout Grid35

968
 At the highest levels in the sample grid, the incentive fee ratchets up to 50
percent. While this may—at first glance—seem like an inequitably high level
for the manager, keep in mind that the manager is being paid for either
delivering extremely high profits in the performance period relative to the RB
and MAE, or for committing to an extremely low RB and delivering more
modest returns (meaning that the investor is compensating the manager for
putting very little capital at risk).

969
Step 4 – Application
Let’s run through some examples of how this would be implemented. The
examples in the following table assume an account with:

$10 million allocation;

Risk Budget of $1 million; and
Max Adverse Excursion of $500 thousand.
The Risk Factor is ($1,000,000 + $500,000)/2 = $750,000.

Figure 22.3 Examples of Incentive Percentage Based on Netto Number

Figures 22.4 and 22.5 further illustrate the application of the Netto
Number in practice. By holding maximum adverse excursion constant at $1
million and risk budget constant at $10 million in the following chart, we see
how incentive fees rise with profits. Whereas a conventional incentive fee
would grow linearly at 20 percent once profits during a performance period
are positive, the Netto Number grows extremely slowly at lower levels of
profits and then grows much more rapidly as profits become outsized relative
to risk taken on. At $1 million in profits, the account has made 10 percent on
its risk budget and has dipped below the starting point exactly as much as it
rose above the starting point. This pays out only 4 percent (or $40,000),
compared with 20 percent (or $200,000) from a conventional fee. At $10
million, the portfolio has impressively returned 100 percent of the amount it
put at risk (and its maximum loss below starting point was only 10 percent of
that amount), so it is rewarded with a 35 percent ($3.5 million) incentive fee,
compared with 20 percent ($2.0 million) from a conventional fee. At $16.53
million profits, the portfolio below achieves the maximum payout range of 50
percent, and profits grow linearly from there onward.

970
 Figure 22.4 Incentive Fee Increasing as Profits Rise Relative to Risk Budget and
Increasing Netto Number
By holding profit constant at $5 million and risk budget constant at $10
million, we see how incentive fees fall with larger drawdowns. Keep in mind
that this shows a scenario where profits are locked at 50 percent of risk
budget—a fairly respectable number, but one that grows less desirable as
swings to the downside increase. The effect is more gradual than that of
profits, but we can clearly see what is going on. At a $0 MAE, the Netto
Number is determined entirely by profits and risk budget. Here, the Netto
Number is 1.0, and the payout is 20 percent of profits ($1,000,000). As the
MAE approaches the RB level, the Netto Number drops in half. At just
before the RB, the Netto Number is slightly greater than 0.50, and the payout
has dropped to 10 percent ($500,000). This relationship holds true with all
Netto Number calculations— holding all else constant, the NN will drop in
half as MAE approaches RB.36 Still, bear in mind that this chart simplifies
matters by holding profits constant. It is generally unrealistic for profits to
spring back so dramatically from more extreme max adverse excursions. As a
result, much higher MAEs can be expected to be associated with much lower
Netto Numbers and, consequently, much lower incentive payouts. This is an
appropriate consequence of taking on too much risk, even if that risk pays
off.

971
 Figure 22.5 Decline of Incentive Fee as Maximum Adverse Excursion Increases
Finally, by holding profit constant at $5 million and MAE constant at $1
million, we see how incentive fees fall with larger drawdowns. Setting a
relatively very low level for the risk budget maximizes the payout. For
instance, when the RB is just over $1 million37 or sits $2 million, but profits
are, respectively, 5X risk budget or 2.5X risk budget, the payout is set at 50
percent ($2.5 million) despite the fact that the MAE, respectively, nearly hits
the RB or reaches 50 percent of the RB. That kind of outsized profit relative
to money put at risk calls for outsized payouts. However, as the RB grows
(see Figure 22.6), the payout level quickly drops, and does not start to slow
down significantly until RB is at $10 million (twice the profits). At that level,
the payout is 19 percent ($950 thousand)—a far cry from the $2.5 million
pocketed at a $2 million risk budget. As the RB grows, and profits become a
smaller and smaller percent of risk taken on, the payout continues to drop, but
more subtly. Under this scenario, an RB of $18.81 million pays out the same
$500,000 in incentive fees as an RB of $20,970,000. This is not to say that
managers should be indifferent between the two—they should try to stick to
smaller risk budgets to maximize their payout while minimizing risk for their
investors. However, when they do choose an outsized risk budget (perhaps
because of the large amount of AUM they manage), the Risk Factor
Compensation System encourages them to target an appropriately sized
amount of profits while continuing to minimize MAE.

972
Figure 22.6 The Netto Number incentive fee drops quickly as the risk budget
increases.

973
Final Step – The Netto Number on a Portfolio Level
Risk Factor Compensation using the Netto Number may be a more
effective way to determine fair compensation. However, when incorporated
at the portfolio level, this approach may still face some of the same
challenges affecting a conventional compensation structure. Specifically, as
will be addressed in this section, the “Netting Effect” may nonetheless draw
from profits.
The Netting Effect is a phenomenon that occurs when investors combine
multiple strategies or accounts. Profits and losses offset each other across
these investments, but costs are still incurred on all sides. This leaves a
greater proportion of costs and fees relative to profits. For example, the
Netting Effect can be seen on a cross-strategy level in the following example.
Imagine that an investor invests in Strategy A and Strategy B. Strategy A
goes long exactly one S&P 500 futures contract and, at the exact same time,
Strategy B goes short one S&P 500 futures contract. To engage in the
transaction, Strategy A and Strategy B each pay a brokerage fee of $0.01 for
the trade (we are not even counting the others costs incurred in operating the
strategy, which can include regulatory and legal fees, rents, equipment fees,
taxes, salaries, etc.—all of which gets proportionally attributed to this trade).
Strategy A and Strategy B each unwind the trade at the exact same time.
As a result of the trade, Strategy A experiences gross profit of $100, which
must mean that Strategy B (which took the exact opposite trade) experiences
a corresponding gross loss of $100.The profit and loss cancel (or net) each
other out to zero, but each of the $0.01 brokerage fees remain, for a net loss
of $0.02.
The profit need not have been canceled out entirely to see the Netting
Effect at play. Even if Strategy A had bought two futures contracts, at a profit
of $200 and brokerage fee of $0.02 (a cent for each contract), after counting
Strategy B there still would have been total net profits of only $100 with total
net fees of $0.03.
This Netting Effect can arise to an even stronger degree when investing
between multiple managers. First, strategies between managers may offset
each other just as in the example above. (Though it is harder to see the
constituent parts. If Manager A invests in Strategy A, it would simply report
profit of $99.99; if Manager B invests in Strategy B, it would report a loss of

974
$100.01. The net result is still a loss of $0.02.) Second, the asymmetrical
incentive fee structure among managers described earlier (where managers
pay a percentage of their profits, but do not generally pay back any
percentage of their losses) makes the Netting Effect even more extreme.
Look at a portfolio of two managers, where Manager A earns $350k in
incentive fees on a million dollars in profits and Manager B loses $200k. The
gross profits of the portfolio are $800k and the portfolio paid out $350k in
incentive fees. You are still on the hook to pay the other manager its normal
fees and, as a result, your net incentive fee for the profits is much higher.
The portfolio of managers in Figure 22.7 illustrates the Netting Effect on a
Netto Number incentive system. In a perfect world, you would pay an
incentive fee based on the Netto Number of the entire portfolio. Here, the
Netto Number for the combined portfolio of $80 million—with $20 million
of combined risk budget, $7.3 million combined maximum adverse
excursion, and $5.7 million combined P&L—would be about 0.42, so that the
“collection” of managers would be owed a 9 percent incentive fee. However,
it is logistically challenging to arrange something like this, so the sum of the
incentive fees paid out to Managers 1-10 is given, rather than 9 percent of
total profits. Under this system, $1,045,000 (18.33 percent) is paid in total
NN fees, which would suggest a Netto Number of roughly 0.87. Under the
traditional 20 percent incentive fee system, $1,250,000 (21.9 percent—note
that this is higher than a flat 20 percent of profits due to the Netting Effect) is
paid in fees, suggesting a Netto Number of roughly 1.05.
In short, the combined Netto Number approach implies a Netto Number
2.1 times the actual Netto Number, and the combined 20 percent fee implies a
Netto Number 2.4 times the actual Netto Number. Here, both are subject to
the Netting Effect, but the combined Netto Number approach given below
tends to reduce the strength of the effect.

975
 Figure 22.7 Netto Number Applied at the Portfolio Level38
KEY
Manager = Number assigned to a manager.
Level = Total size of allocation in millions of US dollars.
RB = Risk Budget—a predetermined loss threshold at
which trading ceases.
MAE = Max Adverse Excursion that account suffered
from starting point during performance period.
P&L = Final profits and loss of account at conclusion of
performance period.
Netto # = Netto Number at conclusion of performance
period.
Fee = Fee using conventional 20 percent incentive fee.
NN Fee = Fee due to manager using Netto Number
compensation metric.
Difference = Difference between conventional incentive
fee and Netto Number fee.
One potential solution to solve the Netting Effect problem is to incentivize
a group of independent managers to pool together “virtually” to apply the
Risk Factor Compensation model using the Netto Number to their aggregate
returns. If managers have already accepted a Netto Number based allocation,
it is possible to show them how it makes business sense to pool their returns.
Blended returns may be more stable, potentially producing a higher
Netto Number than their individual strategy and therefore earning them
higher incentive fees (there is an element of insurance in pooling
performance for the Netto Number calculation). Managers who are more

976
flexible may also be more likely to win allocations in a competitive
environment (since a pooled system would be more appealing to investors).
More complex arrangements can be negotiated to suit both investors and
managers. For example, it is possible to structure a deal with five blended
managers, where each manager will receive 10 percent of the total incentive
fee profits (collectively, 50 percent the total incentive fee) and then the other
50 percent will be paid out ratably based on each manager’s P&L. This has a
lot of potential and could really strike a nerve, but it first requires managers
to overcome decades of incentive fee dogma.
It is immediately clear why this approach would appeal to investors, as
well. If the approach were applied to the ten managers in the previously given
table, then the investor would only have to pay out $513,000 in incentive fees
(associated with a 9 percent rate) on $5.7 million in profit, rather than
$1,250,000 under a traditional fee structure or $1,045,500 under the
combined Netto Number fee structure. This leads to savings of $713,000
and $532,500, respectively—a monstrous amount either way you cut it.

977
The Netto Number in Practice
Many of the benefits of the Netto Number have been fleshed out earlier in
the chapter, but they bear repeating.
First and foremost, the Netto Number is a tool for providing appropriate
risk-factor compensation—this is the primary use of the Netto Number laid
out in the chapter. By changing the way returns are assessed, the Netto
Number may also alter managers’ approach to leverage compared to other
institutional risk ratios. Leverage can lead to both upside and downside
volatility—both of these are discouraged by traditional ratios like the Sharpe
Ratio, but the Netto Number focuses only on the risk of loss.
Furthermore, this approach recognizes that gearing (or leveraging) a
portfolio is an art. The Netto Number can be used as a tool to see how well
a manager trades around its own risk budget, whereas the traditional
ratios aren’t able to account for that because they lack an exante input.
If you have a clear understanding of how well a manager can operate within a
budget, you stand a better chance to responsibly leverage and size that
strategy on an absolute value basis within the context of an overall portfolio.
There is nothing more destructive than thinking, simply because a manager
has historical volatility of 10 percent, that it cannot have a downside year of
25 percent. If that volatility came without a risk budget, the investor may be
left unprepared for when markets enter a different regime. If an investor is
improperly sized based on volatility metrics from a previous market regime,
you can see outsized losses. The Netto Number’s emphasis on absolute risk
values and periodic renegotiation of risk can help identify and sidestep this
issue.

978
 Figure 22.7 Seth Godin’s “Gulf of Disapproval” chart as applied to the
implementation of The Netto Number
The Netto Number also disincentivizes managers from maximizing the
dollar figure of overall returns, as these strategies may involve
overcommitting capital at the cost of diminishing returns or of taking on
excessive drawdowns. Both those approaches would lead to smaller Netto
Numbers, reducing the cut that managers would take. Similarly, managers
are discouraged from raising excessive funds at the cost of overall
returns—using the Netto Number, a manager can conceivably earn the same
incentive fees as a fund with 10X the AUM. This shifts managers’ focus
from gross aggregation of assets to maximizing return per unit-of-risk
for their investors.
Even more of the benefits of the Netto Number emerge when it is used to
establish an incentive fee for money managers. By relying on a
predetermined RB, the Netto Number requires a much-needed conversation
on risk budgets between investors and managers. The budget is a negotiated
figure, so the investors get a say in just how much the RB is set at and,
consequently, they get a greater say in risk controls. Furthermore, managers
are incentivized to set just the right level—too great an RB will minimize
their Netto Number, too small will limit their ability to trade. (As an

979
added benefit, a manager’s proposed RB at the onset of a relationship can be
a potent signal to investors of whether risk management is being done right or
whether they should run for the hills.)
Beyond its function in risk-factor compensation and setting a risk budget,
the Netto Number is also a versatile analytic tool. Given a predefined risk
budget, the Netto Number provides a useful quantitative gauge of the
risk-adjusted performance of a strategy, portfolio, or manager. By
expressing returns in the context of the RB and MAE, the Netto Number
accounts for risk taken on and drawdowns of baseline capital. The Netto
Number even provides a good rubric for whether using a traditional fee
structure is overcharging or undercharging for its services.
A previously unexamined benefit—but one that is nonetheless equally
important—is that the Netto Number encourages investors to be educated
about their investments, despite the fact that they have delegated the
decisions. Negotiating a proper RB is an educative experience in and of itself,
and it allows investors to have knowledge of a major risk management
process from Day 1. Furthermore, the Netto Number presents a much more
comprehensive figure than a mere return, and it encourages managers to
explain to their investors all the factors that led to a specific Netto Number in
a given period.
Finally, the Netto Number can be retooled to other disciplines, such as
establishing the appropriate compensation to real estate brokers. The custom
in real estate is to pay a broker 6 percent of the selling price of a home.
However, using the Netto Number Compensation System, it is possible to
develop new Netto Number metrics to pay a broker based on the two most
important things when selling a home. The first is what price your home sold
for relative to a predetermined price and the second factor is the relative
speed of the sale. Brokers who sell homes for higher than a predetermined
price and faster than average listing times would make a higher commission
than the standard six percent, while brokers who sell homes for below a
predetermined price and take longer times receive a lower commission.
In the same way the Netto Number may help prevent money managers
from taking on too much AUM, it also may help create a more realistic
framework for both the broker and homeowner when looking to sell a home.

980
Takeaway
I strongly suspect that the alternative investment industry has clung to the
traditional performance fee system for so long due to a combination of
dogma and inertia. New methods were not adopted (nor even examined)
because of a sense that an emphasis on nominal performance is how it has
always been, how it will always be, and is the only fair way to do it.
However, even as this book is going to press, many traditional funds have
begun to reduce their 20 percent performance fees in response to waning
investor demand at those prices and, perhaps, a growing sense that the system
is not attuned to the realities of the market.
30 Mallaby, Sebastian. “Learning to Love Hedge Funds.” The Wall Street Journal,
June 11, 2010.
31 Kolbert, Elizabeth. “Dymaxion Man.” The New Yorker, June 9, 2008.
32 Ignoring the effect of any additional costs (borrowing, trading, etc.), the beta of
3X the S&P 500 position would be 3.0 and the alpha would be 0.
33 Hecht, P. (2014). The structure, NOT the level, of hedge fund fees need to change
(Evanston Capital Working Paper). Evanston, IL: Evanston Capital.
34 Note that profits approaching 100% of RB in this situation is a theoretical limit
for a Netto Number of 1.00. Here, a Netto Number of 1.00 could be achieved with
profits at 100% of RB only if the MAE equaled the RB. Mathematically expressed, this
would be RB/(½(RB+RB)) = RB/RB = 1, since profits equaling 100% RB could be
replaced with RB and an MAE equaling 100% could be replaced with RB. However, in
this situation, an MAE of 100% of RB would mean that the manager would be stopped
out. Profits would be halted at –RB (the loss from the MAE), and the Netto Number
would be -RB/(½(RB+RB)) = -RB/RB = -1. This is just another disincentive to flirt
with the limits of the risk budget.
35 In the sample grid above, Netto Numbers should be rounded to the second
decimal place (or third decimal place, if appropriate). For instance, a value of 0.70499
would be rounded down to 0.70, and a value of 0.70500 would be rounded to 0.71. A
value of 2.627 would be rounded down to 2.625, and a value of 2.628 would be
rounded up to 2.63.
36 However, the NN should be -1 when MAE equals RB, since the investments
would be stopped out and the amount of losses would also equal RB (in other words, (-
RB/(0.5*2RB) = 1).
37 As noted previously, the Netto Number should be equal to -1 when RB = MND.
38 Total Netto Number of roughly 0.42 is calculated based on a $20 million RB,
$7.3 million MAE, and $5.7 million profits. However, the NN Fee is given as the sum
of all NN Fees paid out to Managers 1-10. The NN Fee implied by the Netto Number of
0.42 is $513 thousand (9% of $5.7 million).

981
CHAPTER
23

982
 Where Do We Go From Here?
“Man never made any material as resilient as the human spirit.”—Bernard
Williams
After reading this lengthy tome and learning to view an investment from a
return per unit-of-risk basis, my final suggestion is to take a step back and let
the concepts resonate. If you’ve hit every preceding chapter by now, take a
breath and enjoy the view from the summit—there was a LOT of material to
wade through. There is also a lot to take in. Some concepts may take a while
simply because of the novelty of the terminology, but I have found some to
be difficult on a much deeper level—they represent a different mode of
thinking than instinct dictates; they sometimes directly stand against the
financial wisdom we have been taught our entire lives; and they may just take
a while to “click” and make sense. There needs to be a period of reflection
that follows while you absorb these methods. During this reflection, let these
ideas process. A lot of powerful information was presented, and each reader
will have different ways of piecing these things together, creating your own
narratives, integrating them into your financial understanding, enriching your
unique perspectives on—and insights into—the markets.
While you digest what you read in this book, think about the perceptions
you had about the markets. Write down your own “before and after” with
respect to your investment process. One of the major things The Global
Macro Edge promised to do was bust six of the biggest myths that exist in
the markets:

983
Six Myths

1. More risk equals more return.

2. Money always finds its most efficient home.
3. Emotions are your biggest enemy.
4. Diversification is the only strategy you need.
5. Today’s markets offer fewer opportunities.
6. Compensation should be based on returns.

984
The Real Deal

1. Smarter risk equals more return.

2. Money may never find its most efficient home.
3. Emotions are your biggest ally.
4. True diversification is a dynamic endeavor.
5. Today’s markets offer more opportunities.
6. Compensation should be based on return per unit-of-risk.
Many more misconceptions exist. Think about what misconceptions you
see on a day-to-day basis, and whether more scrutiny of these beliefs would
be appropriate.39 It is the failure to question rigorously that allows
misconceptions to perpetuate; the failure to ask whether common practices
still make sense that allows customs to live on long past their useful lives; the
failure to take a close look at ourselves that prevents our growth as traders
and as people. All of this perpetuates inefficiency. When this failure to ask
questions happens on a systemic scale, tremendous wealth transfers can
occur. Those who neither have the right answers nor even know what the
question should be are always ultimately on the losing end.
All of the resources and intellectual know-how in this book will help in
your recalibration process. You have the opportunity to materially enhance
your value proposition on multiple levels. From reading this book, you can
analyze your investment process from a return per unit-of-risk basis. You are
part of a movement that is not only redefining what alpha is, but what to
pay for it. It is my strong belief that the movement fed by this book, the
contributing authors, and its readers will have trillion-dollar implications in
the decades to come—both in and out of the world of finance. We will be
part of a revolution that will set a solid foundation for future generations. A
revolution that many who are passionate about investing, both in and out of
Wall Street, want to see happen. A revolution that both enhances Wall
Street and empowers Main Street through classic free market ideas of
innovation and education.
Stepping back from whatever generational implications may result, you
now can assess the value on a return per unit-of risk basis for the following
things:

individual stocks

985
 sectors
the overall market
strategies
research you use
operations
financial advisors
manager selection
your portfolio
As you conduct your own bespoke UoR™ analysis, understand the
information in this book represents hundreds of years of collective market
knowledge and that patience is critical. This book took me five years to write
and tremendous trial and error, spanning decades (even before my trading
career), in refining and implementing the ideas.
Incrementalism is key. Make sure you are comfortable with one
approach and have fine-tuned it to your individual needs before adding
another to it. Layer on new approaches slowly—if you adopt a number of
changes all at once, it will be difficult to identify the source of changes to
your alpha. And, most importantly, create a plan.

986
Creating a Plan
From a practical standpoint, setting goals by creating a plan is the first
step in integrating the ideas of this book. After your mini-sabbatical
following reading The Global Macro Edge (as noted above, I earnestly hope
readers will first meditate on these ideas before implementing them), set a
hard date for when you will have a formalized plan in place. The end of the
month or quarter are some natural spots on the calendar to select. In keeping
with the spirit of incrementalism, try to keep your first plan less than a
page long. Simply lay out a few items of each goal, identified by
urgency/importance:

Primary
Secondary
Tertiary
Here is an example of how this might look:

987
Plan for Integrating UoR Process for a Hedge Fund:

Primary
Incorporate Risk-Budget Investing mantra into company ethos (12
months)40
Develop Regime Analysis Protocol to overlay on core strategies (6-
9 months)
Incorporate Risk Factor Compensation eusing Netto Number (6-12
months)

Secondary
Build on both virtual and human network to create a cognitive
empathy grid, to include attending Track.com Idea Dinner (within
next 12 months)
Use TAPx test from ReThink Group to see how our managers score
and to identify potential strengths and weaknesses (3 months)
Conduct holistic evaluation of trading space to include ergonomics
of desks, keyboard, lighting, rest area, etc. (6 months)
Perform UoR assessment of all our research and quantify value (3-
6 months)

Tertiary
Further automate aspects of operations, analysis, and execution (9-
12 months)
Use technology to enhance trading journals and improve overall
trade idea sourcing (3 months)
Take a trial to Sight Beyond Sight Newsletter by Neil Azous in an
effort to more actively incorporate macro narrative into process (1
month)

The above example provides a simple framework and gets the ball rolling.
Each one of those items can be described in much further detail. This will
help budget the appropriate resources. From there it is all about
accountability and commitment.

988
Why Write The Global Macro Edge?
Finally, I would like to share some of my personal goals for writing The
Global Macro Edge. I have a tremendous amount of passion for music of all
varieties. When I hear music that inspires me, it is priceless and more
valuable than any material possession. One particular artistic inspiration for
The Global Macro Edge was the song “Hello” by Adele. Not that I want to
pass the essence of such a somber tone to the reader, but the raw nature of
Adele’s work and the authenticity you feel when you hear her voice
transcends explanation.
I bring up Adele’s song because, in 2015 and 2016, the efforts to finish
this book took on a completely new level of commitment. In the second half
of 2015, I moved out of Las Vegas with my wife and into my mom’s house
with only one goal: finish this book. My mother has a beautiful home in Bear
Valley Springs, California, located in the Tehachapi Mountains, about two
hours northeast of Los Angeles. My supportive wife and I saw more elk,
deer, and rabbits on most days than I did people. I needed to put myself in as
much seclusion as possible, and Bear Valley Springs was my Walden Pond.
After writing a few hours in the morning, I would go on a walk to gather
my thoughts and listen to that song. Every single time, it would give me
goose bumps. I told my wife many times that one of my goals was for The
Global Macro Edge to give us “market musicians” goose bumps every time
we read it. I hope you “as a reader” feel my passion and love of the markets
—I hope it resonated in every word, that the intangible feelings I experienced
(the very X Factor I draw upon in my personal trading) would come across in
addition to the naked exchange of knowledge.
Using this medium to express my passion for the markets has been
tremendously cathartic. I believe in a higher power and that I have been
blessed with a very talented group of friends and colleagues. Synthesizing
this great collection of people and ideas into a format that would help a
diverse group of market participants change their lives is wildly fulfilling I
feel I owe the markets and my network at least that much. As they say: to
whom much is given, much is expected…
Over the course of this literary journey, I received many questions from
colleagues:

Why would you share all of this?

989
 What compels you to spend ve years writing a book that reveals so much
about how you maximize return per UoR?
Are you worried about compromising the sanctity of your intellectual
property?
Do you have any concerns the ideas will be adopted and “crowd you
out” of a profitable strategy, potentially sacrificing your edge to others?
What I touched on above with regards to music explains a great deal of
what my thinking is regarding this book. However, it should surprise no one
that I like doing preposterously counterintuitive things. By sharing the
various methods and tactics I use in the market and helping others gain a
deeper understanding of how they may prosper, I hope it will get potentially
numerous inspired individuals sharing different perspectives with me in the
form of feedback (email me at info@theproteantrader.com). The UoR
Process will be “open-source investing.” My history shows from my first
book, One Shot – One Kill Trading, that I respond to nearly every email I
receive. I carry the belief that an inspired individual is a powerful force of
innovation. This group of “UoR Adopters” will think of iterations of the
methods in this book and enhance my process further. I believe this is a true
win-win situation for all involved.
I thought, instead of the lonely burden of developing these methods
individually and all the business risk that comes with such a concentrated
outcome, why not seed relationships with numerous individuals? Individuals
who will now be engaged in this development process because of their own
direct experience.
Experience that will only occur if the reader feels compelled to act based
on a genuine sense of opportunity in the UoR process and The Global Macro
Edge.
On that final note, the contributing authors and I thank you for your time
and wish you good luck in the markets. May your portfolios all achieve high
Netto Numbers!
39 And don’t hesitate to find me and share it if you have a good one!
40 Parentheses indicate estimated time to completion.

990
ACKNOWLEDGMENTS
The Global Macro Edge is the byproduct of a tremendous team effort. I
have numerous people to thank, as without their help, this literary marathon
would not have been possible.
Thanks to all the active duty military and veterans in the US and around
the world, who know the price of freedom isn’t free. God bless you all…
My loving and supportive wife, Taygra. My newborn baby girl, Octavia.
My mother, Marie Ellwood, for her hospitality and grace. My late father, FJ
Netto, whose spirit, passion, and example he set years ago were a driving
force in finishing this book. Scott Newiger, whose unselfishness, tenacity,
and loyalty for over 15 years were instrumental in the book’s completion…
this is part of your legacy. My brother, Alex, for sharing new angles. My
Godparents Manuel Netto and Sally Burns.
I would like to thank my editor, Michael Golik, and all of the contributing
authors and your families who endured your sacrifice. Jeff Anderson, Gayle
Lee, and Abel Guillen, who brought Delta, my golden retriever, into my life
and carried me through some rough times. Nazy Massoud, whose coaching,
spirit, and willingness to believe in me were instrumental in raising my
mental game.
Spencer Staples for the morning calls which prepped, the nightly calls
which recapped, and all the calls in between which make this so much fun.
Jason Roney for being a great mentor and an even better friend. Steve
Hotovec and Mark Rogers for epic brainstorming sessions that generated
ideas to change an industry. Sharon Epperson for your trust, faith, and
confidence. Denise Shull and Bill Long for helping discover the X Factor.
Brenda Guzman for the opportunity to share my views with a greater
audience. Ryan and Sharon Shah for just being awesome.
Fotis Papatheofanous for being the ultimate team player. Neil Azous for
raising my game. Anthony Giacomin, whose hospitality in Chicago is
unsurpassed. George Dowd for the life-changing introductions. Alicia Larue,
whose chiropractic adjustments helped me stay aligned. Walter Hubler for
leading from the front. Thom Hartle for bringing UoR Ratios to life. Jamie

991
Weisman, whose talks about health, relationships, and everything in between
continue to inspire. Bob Savage for satiating my appetite for great food and
market insight. Annmarie Hordern for poppin’ the collar. Sepideh Ghajar for
your love and support. Christopher Bennett and Jennifer Fralick for being our
home away from home. Sergeant Major Vic Martin for teaching me how to
look after the troops.
The United States Marines Corps – Semper Fi. Joel and Heidi Roberts for
teaching me about passion, providence, and the power of a message. Angela
Trostle for inspiring me to look at the stars. George Molsbarger for being a
great father figure. Jitesh Thakkar for your vision and impact. Gina Noel
D’Ambrosia, whose instruction in Salsa and life provided balance. John
Singer for being the ultimate aficionado of Boston sports. Ted Mermel for
being my gateway drug to macro. Bill Glenn for teaching me “bond speak.”
Scott Tafel at Trading Computers for keeping me trading. Joe DiNapoli for
teaching me how to endure. Cameron Crise for your versatility. Jessica
Kurjakovic, Joe Perrone, Gary Deduke and the rest of my family at Trade the
News for covering my six. Isaac Feder for involving me in Life on the Line.
John Kelly for letting an overly charismatic kid share his oddsmaking opinion
on Las Vegas sports radio. Ted Sevransky for covering and Erin Rynning for
winning. Eddie Kwong for Evernote. Sergio Santizo for putting people first.
Karen Mracek for asking the right questions. Doctor Gary Emery for always
knowing the right thing to say. Vin Scully for teaching a young Dodger fan
the power of a story. Julia LaRoche for being a great sleuth. To the late
Prince, whose musical genius and love of humanity inspired us all. Edmund
DeSouza for the trust and faith. Steve Mayeda for elevating my awareness of
social intelligence. Kevin Dressel for the bespoke research. Ken Duffy for
great insight on the grain markets. Dante DeJulius for being a great
ambassador. Robb Ross for getting the joke.
My family at CQG (Melody Baker, Stan Yabroff, Jo Ashton, Rod Giffin,
Lisa Ouaknine, D’Artagnan Hutchinson “Hutch,” David Brown Eyes, Laurie
Sutliff, Gene O’Sullivan, Amie Bergeson, Matt Schenk, and Doug Janson).
Family at Bloomberg: Pete Orlando, Eric Leininger, Matt Miller, Bill Sindel.
Family at CNBC: Judy Gee, Mary Duffy, Dom Chu, Amanda Drury,
Courtney Reagan, and Sara Eisen.
To Scott Brindley “Delta for Life.” My family at Advantage Futures
(Margie DeLorme, Mike O’Malley, Bill Harrington, Joe Guinan, Jennifer
Szalay, Katie Yukich, Nadine Tomasovich, Amanda Dunkel, Marisol

992
Guereca, Linda Berghdahl).
I would be remiss if I did not mention: Lilly Abbo, Javad Baharian,
Ashley Bete, Denise Buckenheimer, Abe Cofnas, Mark Rogers, Boonsri
Dickinson, David Widerhorn, Will Dickson, Gino D’Alessio, Robert Pennell,
Erika Wasser, Jim Mayer, Jason Urquhart, Professor Jeffrey Pontiff, Meagan
Cignoli, Doctor Jones, Peter Hecht, Julian Marchese, Marisol Banuelos,
Carley Garner, Boris Schlossberg, Kathy Lien, Shaun Hess, Michael
Sedacca, Jackie Cohen, Adam Sheldon, Ryan Gagne, Jonathan Peris, Natasha
Solis, Herbert McGurk, Tim Bourquin, Stacey Mankoff, Michelle Cousins,
Alexandra Poulakis, Devyn Simone, Pilar Ortiz, Christopher Terry, Raj Sethi,
Chris Cannon, Robert Baxter, Tim Colby, Bill McKenna, John Scozzafava,
Max Knobel, Aaron Virchis, Andrew Stemmer, Alan Schimmel, Angelo
Ongpin, Victoria Liang, Mike Bellafiore, Kristof Szentivanyi, John Floyd,
Scott Elkovitch, Adam Urbanczyk, Mark Ruddy, Jonathan Peris, Stuart
Brazell, Anatoly Veltman, Jim Morphy, Andres and Maria Alegria, Joao Luiz
Vieira, Zack Ziliak and The Plascencia Family.

993
GLOSSARY OF TERMS
Agony/Ecstasy Ratio: A UoR Ratio that provides a metric of the nature
of trading in a given market by comparing the Maximum Adverse Excursion
over a period to the Maximum Favorable Excursion over the same period.
The Agony/Ecstasy Ratio does not use net change as a factor—it is focused
solely on the max realized downside compared to the max realized upside
over a given period. See UoR Ratios; Maximum Adverse Excursion;
Maximum Favorable Excursion.
Alpha (α): In its simplest form, Alpha measures what is returned by a
fund or strategy independent of any linear relationship to an underlying
benchmark. It is computed alongside Beta by regressing the performance of a
portfolio, strategy, or instrument against a market benchmark (generally the
S&P 500). The (i) Alpha coefficient is added to (ii) the Beta coefficient times
the underlying benchmark to estimate underlying return in a period. For
example, say a portfolio’s monthly returns are regressed against the S&P 500,
generating an Alpha of 0.5 and a Beta of 1.0. That means that, in any given
month, the portfolio can be expected to return 0.5% more than the S&P 500.
If the Alpha were 0 and the Beta were 1.0, the portfolio is expected to return
exactly as much as the S&P 500 in any given month. If Alpha were 1.0 and
Beta were 0.5, that means that Alpha can be expected to return 1% more than
one half of what the S&P gained or lost in that month.
Alpha can also be defined as the excess return over that expected by the
Capital Asset Pricing Model (CAPM), which uses Beta to estimate a required
rate of return. For instance, if CAPM estimates a return of 3% and 7% is
earned, then Alpha is 4%.
In its colloquial sense, Alpha can also refer to any returns unrelated to
market returns that are generated through an investor’s edge or skill. Alpha
for any given period can be annualized using the same formula given in the
definition for Annualized Return. See also Beta.
Annualized Return: This is return on a percentage basis, adjusted to
reflect performance over a single year. In the context of The Global Macro
Edge, the compound annual growth rate (or CAGR) is used. This approach

994
reflects the assumption that money is reinvested once it is grown, so returns
over time increase exponentially. For instance, 10% return on a $100
portfolio in year 1 is $10. At the beginning of year 2, the portfolio has $110,
and $10% return would be $11. From the beginning of year 1 to the end of
year 2, the portfolio has grown by $21 (or 21%). Nonetheless, it has grown
by only 10% a year.
The formula to compute CAGR from the starting and ending value of an
investment or portfolio is , where n = number of
years. The formula to compute CAGR for a return r, given in %, over time
period n is Either formula can be used for partial years
utilizing a decimal (or fractional) value for n.
Automation: Generally speaking, Automation is the process of taking
certain rote or repetitive actions out of the hands of humans and
systematizing them in an automatic / computerized process. In terms of
trading, Automation is the process of systematizing one’s investment
operations, execution, and analytics through the use of computer
programming to improve consistency, scalability, and speed.
Backtesting: The process of applying a current trading strategy to past
data, to determine how it would have performed in previous time periods.
Benchmark: A basis for comparing returns. For instance, equity
portfolios usually use the S&P 500 index (an index of 500 large-cap equities)
as a benchmark and fixed income security portfolios usually use US Treasury
bonds and bills (providing yields with negligible risk) as a benchmark.
Beta (β): This is a volatility measure that will indicate how a stock or
fund will perform in relation to the stock market. It is computed alongside
Alpha by regressing the performance of a portfolio, strategy, or instrument
against a market benchmark (generally the S&P 500). Beta is the numerical
coefficient of the relationship of the benchmark to the instrument. For
example: if a stock has a Beta of 1.20, then it would be expected to move 20
percent further in any upmove or downmove than the benchmark. Thus if the
index moves up 10 percent, the stock should move up 12 percent (1.2 x 10).
Investors looking for less volatile stocks or funds would therefore look for a
Beta coefficient between 1 and -1 (negative Betas indicate negative
correlation), as these moves would be less extreme than the market. Notably,
Beta is used in the Capital Asset Pricing Model (CAPM), which prescribes a

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required rate of return on an investment given Beta, benchmark return, and
risk-free return. See also Alpha.
Bottom-up Investing: A form of investing that involves looking at the
fundamental, often idiosyncratic elements of an individual instrument or
investment opportunity. For instance, in the case of equities, this can involve
analyzing the individual strategic plan of a company (or reacting to the news
that a wildly effective CEO has stepped down); in the case of wheat futures,
it can involve scrutinizing weather forecasts to predict crop yield; and so on.
Bottom-up Investing is the opposite of Top-Down Investing, which
involves looking at global trends to make general conclusions about a whole
asset class or family of investments.
Breakout Strategy: A strategy focused on markets or instruments that
have moved above (or below) a key technical resistance point. Moving
beyond the resistance point is called a “breakout”, and this is treated as
technical confirmation that the market or instrument will continue to move
higher (or lower). Generally speaking, the stronger the resistance point (the
longer it has held at a level or the more times markets have bumped up
against the level without moving past it) that is broken through, the stronger
the post-breakout upmove (or downmove).
Business Cycle: This refers to recurring business booms and contractions
that are the direct result of cyclical fluctuations in credit, business
inventories, and corporate profits. Business cycles can occur over a span of
several months (these are generally considered minor cycles) to a number of
years (in the case of the overarching business cycle). The importance of the
business cycle is that it tracks the changes in the rates of economic growth (in
a broader sense, the business cycle can be thought of as the economic cycle
or expansion and recession—it affects employment, spending, and a nation’s
GDP in general). The Business Cycle determines the returns of markets as a
whole as well as individual sectors within these markets.
Butterfly: A spread trade that takes positions across three points of the
Yield Curve, known as the “wings” (the longest and shortest maturity dates)
and the “body” (the middle maturity date). The body is sized at twice the
DV01 of each of the wings, rendering the entire spread duration-neutral.
One’s position in the butterfly is the same as that of the body, i.e. if you are
long the body and short the wings, you are long the butterfly, and vice versa.
Calmar Ratio: This is a risk-adjusted measure of investment performance
of a portfolio or strategy. It is calculated by taking a fund’s compound annual

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growth rate, usually over a three-year period and dividing it by the fund’s
maximum drawdown (expressed as a percent). The higher the number, the
better the investment performed relative to drawdown. Calmar is an acronym
for California Managed Account Reports.
Capital Flows: measure the net amount of a currency that is being
purchased or sold due to capital investments into a given asset class or
currency/country. Capital flows can be divided into “Physical Flows” and
“Portfolio Flows.” Physical Flows are actual Foreign Direct Investments,
such as real estate, manufacturing, local acquisitions, etc. Portfolio Flows are
investments into national equity and fixed income markets.
Capital Market Pricing Model (CAPM): This model prescribes a
required rate of return for an equity based on that equity’s Beta and risk-free
rate. It is calculated so that required rate of return equals (i) the risk-free rate
plus (ii) Beta of the asset times the market risk premium. The market risk
premium is calculated as market return for the asset (e.g. the S&P 500 could
be used for an equity) minus the risk-free rate. See also Beta.
Carry: The interest earned from owning a fixed income investment
(bond, money market account, etc.) less the cost of financing it in the repo
market. See also Carry Trade.
Carry Trade: A trade that involves borrowing money in a country with a
relatively low interest rate, selling the currency in exchange for the currency
of a country with a relatively high interest rate, then lending money in the
high interest rate country (usually through deposits). When traders engage in
the carry trade en masse, profits are increased because the low-interest
currency tends to depreciate compared to the high-interest currency. Thus,
profit is made from the currency trade when the carry trade is unwound (the
high-yielding currency is sold and the low-interest currency is bought to
settle debt obligations). However, the currency differential also tends to
reverse quickly if too many market participants are unwinding their trades at
once, thus potentially wiping out currency profits (and then some) if the
timing is not right.
Catalyst: A global macroeconomic event leading to shifts in the markets.
The Reaction Ratio can be used to gauge the significance of a catalyst.
CFTC Commitment of Traders (CoT) Report: A weekly report, issued
each Friday, that shows a breakdown of positions held in major futures
contract markets (those with 20 or more traders with positions reaching cutoff
levels) on the Tuesday prior to the report. The report gives longs, shorts, and

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open interest for commercial traders (e.g. bonafide hedgers), non-commercial
traders (larger speculators), and a nonreportable category (generally smaller
speculators).
Cheap/Rich on the Curve: When a given bond or maturity sector is
cheap on the curve, it has a higher yield/lower price than expected according
to an idealized model of the yield curve. When it is rich, it has a lower
yield/higher price than that implied by the curve model.
Coefficient of Determination: See R-Squared.
Cognitive Empathy: This describes the ability to understand the biases
and emotions of one’s self and others in order to trade in a disciplined
manner (instead of falling subject to biases) and predict the actions of others.
Cognitive empathy approaches can be used to predict the actions of large
groups of other actors (e.g. the general tendency of traders in a given market
taken as a whole). Also referred to as Theory of Mind; Mentalizing; or
Metacognition.
Cognitive Empathy Grid (CEG): A visual representation of various
parts comprising the market ecosystem. There are eight categories assessed in
the Protean Strategy CEG: participants, strategies, bias, asset class, time
horizon, emphasis, technical regime, and fundamental regime.
Compound Annual Growth Rate (CAGR): See Annualized Return.
Concession: The tendency of the bond market to weaken slightly before a
Treasury auction in order to make prices more attractive to buyers.
Correlation: Fund managers and investors use correlation as a measure of
how two instruments move in relation to one another. A correlation
coefficient can range from +1 to -1. A reading of +1 indicates that a positive
(negative) move in one instrument is always accompanied by a positive
(negative) move in the other instrument. A reading of -1 indicates that
instruments always move in opposite directions, so that a positive (negative)
move in one instrument is always accompanied by a negative (positive) move
in the other instrument. A reading of 0 indicates that there is no relationship
between the two instruments, and their movements are perfectly randomly to
one another.
Curve Flattening: When the spread between the yield on shorter- and
longer-maturity bonds narrows. A flattening as yields decline is known as a
bull flattening, and generally represents either concerns about low growth and
inflation or a flight to quality/risk aversion. A flattening in which yields go
higher is known as a bear flattening and is consistent with a belief in

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forthcoming interest rate hikes. Note that when the yield curve is inverted, a
flattening represents a rise in short-term yields relative to long-term yields,
i.e. an increase in the inversion. See also Curve Steepening.
Curve Steepening: When the spread between the yield on shorter- and
longer-maturity bonds widens. A steepening as yields decline is known as a
bull steepening and is consistent with a belief in imminent rate cuts or policy
easing. A steepening that occurs as yields rise is known as a bear steepening
and can represent pending Fed Funds increases, or belief in the central bank’s
ability to control inflation. Note that when the yield curve is inverted, a
steepening represents a rise in long-term yields relative to short-term yields,
i.e. a decrease in the inversion. See also Curve Flattening.
Downside Deviation: This is a measure of the volatility of downward
moves (losses). It is computed by taking the standard deviation of only the
negative returns in the sample of a portfolio’s returns, while ignoring all
positive returns. See Sortino Ratio.
DV01: The dollar value of a one basis point move in a fixed income
security. This is used to determine the desired size of a position. For instance,
a trader may ask to buy 5 year notes in $150k of DV01.
Efficient Market Hypothesis (EMH): The theory that investment dollars
are necessarily allocated efficiently and that markets instantly adjust to new
information. The implication is that it is impossible to have a true edge (or a
legal true edge).
Elliott Wave Theory: Created by R.N. Elliott in the first half of the 20th
century to account for the range of emotions and animal spirits embedded in
market price action. The theory is rooted in Dow Theory and identifies the
tendency for markets to trend in three separate phases (accumulation, public
participation, and distribution). Beyond those three phases, the theory also
provides a framework for identifying where the market is in those phases.
Elliott Wave Theory has classified these phases into five distinct “waves” (or
trends of price movement), which always occur in a specific five-part
sequence called the Motive Pattern. The Motive Pattern can occur on many
different scales (for instance, a smaller-scale Motive Pattern can occur in its
entirety while, on a larger scale of price movement, the market has remained
in just a single wave).
Event-Driven Trading: A strategy predicated upon analysis of how a
particular event will move the market on both an immediate and delayed
basis. Some of these events include: central bank announcements; key

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economic releases; geopolitical conflict; Chinese PMI; earnings; and
elections. Compare Opportunistic Trading. See also Top-Down Investing.
Eurodollars: A strip of futures contracts that settle into 3-month dollar
LIBOR. They can be used to speculate on the future level of short-term
interest rates or to hedge exposures in other products such as Treasuries. The
futures have quarterly expirations, and traders often refer to them in “packs”
of four, or a “strip”. The first 4 contracts are known as the white pack,
followed by reds, greens, blues, and golds.
Fear of Missing Out (FOMO): The sentiment of aversion to missing out
on a potentially profitable trade and the investment behavior that happens as
a result of those feelings. FOMO can be measured before entering, managing,
or exiting a trade. See also FOMO Spectrum.
Fed Funds: The unsecured interbank lending market in which eligible
institutions can lend their excess reserve balances at the Fed. After Fed asset
purchase programs created a substantial supply of excess reserves, the Fed
instituted IOER to effectively eliminate commercial banks’ participation in
the Fed Funds Market. Federal Reserve policy is conducted by guiding the
Fed Funds rate to a given level or range.
Fibonacci Analysis: The process of using mathematical ratios that exist
commonly throughout nature as a means of determining potential support and
resistance levels, as well as predicting future price movement. Two such
common Fibonacci ratios are 0.382 and 0.618. Fibonacci Analysis may
incorporate retracements, extensions, and time cycles.
FRA/OIS spread: The spread between the lending rate on unsecured
interbank borrowing, such as LIBOR, and that of an equivalent-maturity OIS
swap. This spread provides a proxy for pressure on funding markets and/or
bank credit risk.
FOMO Spectrum: An approach toward quantifying Pre-Trade, In-Trade,
and Market FOMO on a scale from 0-100 for analytic purposes. See Fear of
Missing Out.
Game Theory: An economic field that applies mathematical optimization
and strategic analysis to situations where decision-makers act based on how
they think others will act (but keeping in mind that those others will, in turn,
act based on how they think the decision-makers will act—this can go on
back-and-forth ad infinitum).
General Collateral (GC): Treasury securities used in repo market
transactions.

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 Golden Age of Passive Investing: The period from 2010 to 2014 where a
50/50 combination of stocks and bonds yielded the highest five-year Sharpe
ratio (5.22) of any 5-year period since 1977.
Global Macro Edge: The ability to combine the underlying
macroeconomic narrative with robust trading strategies and dynamically
allocate to them based on their probability of success in the current market
regime. This is admittedly a broad field, but the entire book is—in one way
or another—dedicated to giving strategies to attain the Global Macro Edge.
Global Macro Investing: A form of Top-Down Investing that involves
structuring trades based on Macro Narratives—large-scale themes tied to
global economic, political, fiscal, and monetary policy events. These themes
(broad-based narratives that explain trends and families of events occurring
globally) are derived based on forecasts, the outcome of data releases, and the
interconnectivity of global events. The themes can be used both to predict
events and as a filter with which to understand them.
Heat: See Maximum Adverse Execution.
Inflection Point: A turning point at which some significant change is
made in an instrument’s trading. For instance, this can be the point at which
the long-term moving average of prices outstrips the short-term moving
average or at which a support level becomes a resistance level.
Implied Volatility: The future volatility that markets price into an
instrument’s option price. After this measure is mathematically backed out of
options prices, it is a useful trading signal and input. The VIX volatility index
is the annualized implied volatility of the S&P 500, computed as the portfolio
volatility of the weighted implied volatilities of the index’s 500 equities.
Information Ratio (IR): This is a measure of risk-adjusted returns
focusing on a manager’s ability to outperform a benchmark. It is calculated
by dividing (1) a portfolio or strategy’s return (or expected return) in excess
of a benchmark rate by (2) the standard deviation of the differences between
the portfolio’s returns and the benchmark’s returns (this standard deviation is
also called “Tracking Error”). In this way, the information ratio provides a
measure of how much return above the benchmark is achieved per unit-of-
risk (in this case, the standard deviation of a portfolio’s moves above a
benchmark). See also Sharpe Ratio.
Implied Spread: The process of creating a synthetic value to represent
the price relationship between two or more independent products. This value
is used as the reference point to track, analyze, and trade the relationship

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between these products. An example is the “implied spread” between the
S&P 500 and Dow Jones Industrial Average. Once such a spread is created, it
serves as a frame of reference for future price movement and decisions as to
whether to buy or sell. Also referred to as a Synthetic Spread. See Relative
Value Strategy
Institute of Supply Management (ISM) Manufacturing Index: A
composite Purchasing Managers Index (PMI) based on surveys of more than
300 manufacturing firms by the Institute of Supply Management. The ISM
Manufacturing Index monitors an array of components to including
employment, production inventories, new orders and supplier deliveries.
Outside of the United States, other PMIs fulfill the same function— for
instance, the Markit Group produces metrics based on information for over
30 countries worldwide.
Interest on Excess Reserves (IOER): The interest on excess reserves
that the Federal Reserve pays banks on reserve balances above those required
by law. Established in 2008 to allow the Fed to maintain control of the Fed
Funds rate by ensuring that eligible banks lend money to the Fed at the IOER
rate rather than lending it in the Fed Funds Market.
Interest Rate Swap: A derivative contract in which cash flows are
periodically exchanged for a predetermined period of time. Although there
are many kinds of swaps, they typically entail one party agreeing to pay or
receive a fixed rate, while the other party receives or pays a floating rate.
Inversion of the Yield Curve: A situation where shorter term yields are
higher than longer term yields. Widely used as a signal for a forthcoming
economic slowdown or recession.
Kurtosis: This is a statistical measure of the distribution of a set of data.
The name comes from a Greek word meaning “bulging” or “convexity.” A
normal distribution (or “mesokurtic” distribution, with “meso” coming from
the Greek word for “middle”) has kurtosis of 3. A kurtosis of greater than 3
indicates that there are fewer incidents of an event around the mean (leading
to a thinner peak in the chart of the distribution) and fatter tails (meaning that
a greater incidence of extreme events are expected). A kurtosis of less than 3
indicates that there are more incidents occurring around the mean, and fewer
tail events. Kurtosis differing from 3 implies that the standard distribution
(which is based around a normal distribution) is less informative. In finance,
kurtosis is usually used to examine the distribution of returns. See also
Standard Deviation; Skewness.

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 Largest Daily Gain (Loss) Percent: This expresses a strategy’s largest
one-day percentage gain (or loss) over a time period.
Long: A “long” position involves buying or holding an instrument (or, in
the case of futures and forwards, entering into an obligation to buy at a set
price at some future date) with the expectation that prices will rise. “Being
long” means holding long positions. See also Short (this is the polar opposite
of long).
London InterBank Offered Rate (LIBOR): This is the rate that a panel
of banks estimate that they can procure unsecured funding in the interbank
lending market. Administered by the British Bankers’ Association until 2013
and subsequently by the ICE exchange. While many interest rate swaps settle
into LIBOR, the actual volume of unsecured interbank lending has almost
completely vanished.
Macro Narrative: The overall story (complete with cause-and-effect, and
complex interrelationships) that can be pieced together from the totality of
global political, economic, social, technological, military, and demographic
events. The global financial crisis of 2008 was a macro narrative, as was
central banks trying to contain the effects, central banks trying to exit from
accommodative policy, China’s growing economic and political power—
along with its attempts to develop its domestic market, threats to the cohesive
economy of the Eurozone or (more broadly) EU or the slow shift from
traditional energy production (either through the development of alternatives
or through new sources of gas and crude instigated by high price of
traditional sources). These are all macro narratives with broad-reaching
effects for the global economy. The Macro Narrative can be used to explain
broader trends (as well as sudden movements) in asset prices. See Global
Macro Investing for additional definition.
Management Fee: A percentage fee paid on the value of a fund’s assets
under management (AUM). It is usually stated on an annual basis, but paid
on a monthly basis. Thus, a 2% management fee would mean that investors
pay 2% divided by 12, or 0.17%, of the value of their portfolio each month.
Market Position: The exposure, or positions, the market holds based on
expectations of a certain event. This describes the way market participants
have bought and sold assets (e.g. they may be heavily invested in fixed
income securities, but selling equities).
Market Position Premium (MPP): This is the expected value of a
market’s shift after some significant event (e.g. a major economic data

1003
release). It is calculated by summing the probabilities of different discrete
events multiplied by the expected market shift of each event. These
probabilities and markets shifts are, in turn, estimated using a combination of
quantitative and qualitative inputs.
Max Drawdown (MDD): The maximum level an account was down
during a performance period. This is measured from (1) its highest point
preceding its lowest point to (2) its lowest point following it during the
performance period. The MDD does not account for a new high achieved
after the lowest point, as it simply seeks to gauge the largest downward
move.
For example, imagine the following ultra-volatile portfolio, starting on
Day 1:
Day 1: $100,000
Day 2: $120,000
Day 3: $60,000
Day 4: $110,000
Day 5: $50,000
Day 6: $180,000
The MDD will be $70,000 (measured as $120,000 - $50,000). For
comparison purposes, the MDD is often presented as a percent of the highest
point used—here, this would be accomplished by dividing $70,000 by
$120,000 to arrive at a Max Drawdown of 58.3%.
Maximum Adverse Excursion (MAE): The maximum level an account
was down from its starting point (or baseline) during a performance period.
This is measured from (1) its starting point to (2) its lowest point below the
starting point.
For example, imagine the following ultra-volatile portfolio, starting on
Day 1:
Day 1: $100,000
Day 2: $120,000
Day 3: $60,000,
Day 4: $110,000
Day 5: $50,000
Day 6: $180,000
Day 7: $175,00
The MAE will be $50,000 (measured as $100,000 on Day 1 - $50,000 on
Day 5). Note that the MAE can be expressed in percentage terms, by using

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the baseline as the denominator. Also referred to as Maximum Negative
Drawdown (MND) or Heat; see also Maximum Favorable Excursion.
Maximum Favorable Excursion (MFE): The maximum level an
account was up from its starting point (or baseline) during a performance
period. This is measured from (1) its starting point (2) its highest point above
the starting point.
For example, imagine the following ultra-volatile portfolio, starting on
Day 1:
Day 1: $100,000
Day 2: $120,000
Day 3: $60,000,
Day 4: $110,000
Day 5: $50,000
Day 6: $180,000
Day 7: $175,00
The MFE will be $80,000 (measured as $180,000 on Day 6 - $100,000 on
Day 1). Note that the MFE can be expressed in percentage terms, by using
the baseline as the denominator. See also Maximum Adverse Execution.
Maximum Negative Drawdown: See Maximum Adverse Excursion.
Mean Reversion Strategy: A set of strategies that presuppose that prices
ebb and flow around a certain area, generally reflecting all the information in
the market. Therefore, any major movement in price, particularly to an
extreme, represents an opportunity to take on exposure opposite to this move,
with the expectation that the market will move back toward its original levels
(i.e., revert to its mean).
Mentalizing: See Cognitive Empathy.
Metacognition: See Cognitive Empathy.
Motive Pattern: See Elliott Wave Theory.
MPACT!™: Short for “Market Price ACTion”, MPACT!™ is patent
pending, proprietary software created by John Netto that synthesizes the
information around breaking news events, analyzes the significance of those
events on various strategies, and manages portfolio positions accordingly. All
of this is done from one Integrated GUI (Graphical User Interface). MPACT!
™ has a number of customizable position management features that work off
the UoR Strategy grid, Market Positioning Premium, and underlying macro
narrative.
MPACT! Portfolio Simulator™: Proprietary software created by John

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Netto to run multiple stress tests on an array of potential breaking news
events and market environments to see how a strategy or asset class may
perform. For example, being able to see 20 different iterations of an FOMC
statement before the release or how a UK inflation report may influence
different asset classes—essentially running simulated training exercises—
means that, when an event occurs, it’s not the first time a trader has been
through it.
MPACT! Ratio: A ratio created by John Netto to measure where certain
asset classes may trade based on the outcome of economic news, central bank
policy decisions, and other one-off events on an ex-ante basis. The MPACT!
Ratio does this by forecasting how many Risk Multiples a market may move
based on the outcome of the event.
Netto Number (NN): A three-dimensional quantification of the return per
UoR of a trade, strategy, portfolio, or manager. It is calculated by measuring
how well an investment is performing on a volatility-adjusted basis relative to
its predetermined risk budget. Specifically, the Netto Number is the return on
a strategy over a performance period divided by the average of the unit-of-
risk and ADVERSE EXCURSION (this average is also referred to as the
“Risk Factor”). The higher the Netto Number, the better the return per UoR.
The lower the Netto Number, the worse the return per UoR.
Netting Effect: A phenomenon that occurs when profits and losses offset
each other across investments, but costs are still incurred on all sides. The
profits and losses “net” out while the costs remain constant on both sides,
leaving a greater proportion of costs and fees relative to profits.
On-the-Run/Off-the-Run: On-the-run bonds are the benchmark
securities for a given maturity sector, and are the most recently auctioned
securities in that sector. They tend to be highly liquid and easy to finance.
Off-the-run bonds are non-benchmark securities that enjoy much less market
liquidity. During times of market stress the yield spread between on-the-run
and off-the-run bonds tends to widen.
Opportunity Ratio: A ratio created by John Netto to provide context on
how much price movement there was within a given trading range. Most
derivative traders measure realized and implied volatility to value and trade
options. The Opportunity Ratio helps measure the “realized gamma” that a
market delivers over a period of time, providing an insight to the benefit or
cost of delta hedging on a relatively high frequency basis.
Opportunistic Trading: A trading strategy focused on opportunities

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arising from the day-to-day machinations that come about due to a variety of
short-term factors. These opportunities typically work around the following
drivers: calendar events; expiration week tendencies; market positions into
key events; relative value spread extremes; policy changes; and the
inefficiency of overnight price movements. Compare Event-Driven
Trading.
Optionality: This describes exposure to a trade where risk is capped at a
given limit but potential profit is not capped. “Optionality” gets its name
because it is functionally similar to taking a long position in an option (where
downside is limited to the price of the option, but potential payoff is
theoretically unlimited).
Overnight Index Swap (OIS): An interest rate swap where the floating
rate is an overnight rate that is heavily influenced by official policy rates.
Examples of the rates used in OIS swaps include the Fed Funds rate, EONIA
(Europe), and SONIA (UK). Because there is no exchange of principal, OIS
incur little credit risk (unlike LIBOR which is based off of unsecured
interbank lending).
Percent Losing Days: This percentage is computed as the number of
losing trading days divided by total trading days. The same critique applies to
this measure as to Percent Winning Days.
Percent Winning Days: This percentage is computed as the number of
profitable trading days divided by total trading days. Because this measure
does not account for the scope or amplitude of any profits, it is often thought
to be misleading and therefore of no great value. “Winning” does not
necessarily equate with overall profitability, as you can have a 60% win rate
and still lose money. Equally, a 40% win rate can produce a profit. It all
comes down to money management and risk/reward ratios. This measure can
be strengthened by comparing the average percent gain on winning days and
average percent loss on losing days.
Performance Fee: An incentive award based on the results achieved. This
is usually a significantly higher percentage than the management fee (is
common 20%) and is paid on profits above a certain level. The profits are
generally gauged over a high-water mark (the last highest level of AUM—
this is to avoid double paying on profits if AUM dips down and then regains
its losses) or above a hurdle rate (such as the growth of the S&P 500 index
over the hurdle period—this ensures that the manager is only paid for beating
the market or some other benchmark).

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 Physical Flows: See Capital Flows.
Portfolio Flows: See Capital Flows.
Protean Strategy: John Netto’s discretionary investment approach of
dynamically allocating to a range of technical, fundamental, and sentiment
strategies based on their probability to maximize return per UoR given the
current market regime. The performance of Netto’s personal trading in the
Protean Strategy is outlined in Chapter 3.
R-Squared (R2): This measure is used when analyzing ordinary (sum of
least squares) regressions, and it shares the definition provided in general
statistical usage. R-squared can be between 0 and 100, and it indicates what
percentage of total variation in the regressed dependent variable (for instance,
portfolio returns) can be explained by the independent variable(s). In a simple
linear regression (one with one independent variable), R-squared is also equal
to the squared correlation times 100. R-squared can be interpreted alongside
Alpha and Beta for greater breadth of analysis also called Coefficient of
Determination.
Reaction Ratio: A ratio used to gauge the significance of catalysts. The
Reaction Ratio is computed as (R + S)/T, where each input is a score graded
from 1-10 for R: relevance, T: timing, and S: scope. The higher the ratio, the
more significant the catalyst.
Refactoring: The process of recoding, or “retrofitting,” custom-built
software to handle its new workload. Proprietary software can go through
multiple iterations and enhancements. As a result, the original design may not
be the most ideal to handle the current structure. Refactoring addresses these
inefficiencies.
Regime: The technical and fundamental environment of the market. It
describes a pattern of market factors (e.g. volatility, liquidity, turnover, high-
performing asset classes, etc.), relationships (correlations, patterns of capital
flow, etc.), and attitudes over a given timeframe.
Regime Profitability Factor (RPF): The multiplier that projects how a
given strategy will perform in a given asset class.
Relative Value Strategy: A strategy of longing one instrument or set of
instruments and shorting another instrument or set of instruments with the
anticipation that the long instrument will go up relative to the short one. This
strategy can make money even when both instruments go down, so long as
the short drops more than the long (or the position in the short exceeds the
long).

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 Repo: See Repurchase Agreement.
Repurchase Agreement: A type of agreement that is used to fund bonds
on a leveraged balance sheet. The bonds are lent to customers in return for
loans of a specified (usually short-term) period. At a later point the
transaction is unwound and the bonds are “repurchased” by the dealer, who
returns the cash to the client. If a dealer sells a bond short and needs to
borrow it to deliver, this process works in reverse. Also referred to as Repo.
Return over Max Drawdown (RoMaD): This measure expresses
portfolio or strategy return as a percentage of the Max Drawdown, by
dividing portfolio return (in currency) over MDD. RoMaD allows an investor
to gauge whether a return is acceptable relative to the amount of drawdown
experienced.
Return over Maximum Adverse Excursion (MAE)/Max Favorable
Excursion (MFE): A UoR Ratio that measures the net change of an asset
price relative to its MAE or MFE. For example, if the S&P 500 is up 10
points on the day and had an MAE of 5, then its Return over MAE would be
2, i.e. 10/5. See UoR Ratios, See MAE, see MFE
Return over Risk Budget: This measure expresses portfolio or strategy
return as a percentage of the Risk Budget, by dividing portfolio return (in
currency) over the Risk Budget. Return over Risk Budget allows an investor
to gauge whether a return is acceptable relative to the amount of capital put at
risk.
Reverse Repo Facility (RRP): Reverse repo facility conducted by the
New York Fed. By paying a fixed rate for short term funding to cash-rich
counterparties, including money market funds, the Fed puts an implicit floor
on the level of short term interest rates.
Risk Budget (RB): The RB is a pre-assigned level of drawdown that,
when exceeded, triggers an end to trading. As used in the context of the Netto
Number, the risk budget is given as a dollar value. For example, an RB of
$1.5 million means that if a $10 million portfolio loses $1.5 million, (i.e. the
account goes down to $8.5 million), all trading will stop. In other contexts,
the RB may be presented as either a dollar value or as a percent of total AUM
(e.g. a 15% risk budget on a $10 million portfolio would be $1.5 million).
Risk Factor: The average of the Risk Budget and Maximum Adverse
Excursion.
Risk Factor Compensation System: An incentive system that pays a
manager according to their performance on a return per Unit-of-Risk basis.

1009
This is done by keying incentive fees to the Netto Number. The higher the
Netto Number, the higher the incentive fee, and vice versa. The system helps
investors pay managers for true skill while not overpaying them for natural
market performance.
Risk Multiple: A single unit of price movement in an asset class as
defined by a predetermined set of criteria. For example, if, coming into the
day, it was determined 20 points on the S&P 500 was equal to one risk
multiple and the S&P 500 was up 30 points, it would be deemed as being up
1.5 (30/20) risk multiples. Risk multiples are defined and measured by the
Roney Ratio and are another tool for assessing performance on an individual
or relative basis. See Roney Ratio.
Risk Reversals: A measure of the skew in the demand for out-of-the-
money options. It is defined as the implied volatility for Call Options minus
the implied volatility for Put Options with the same delta (commonly 0.25)
and expiration date. A positive Risk Reversal indicates the market
expectation that the underlying will see fewer, but larger up-moves relative to
down-moves; a negative Risk Reversal indicates the market expectation that
the underlying will see fewer, but larger down-moves relative to up-moves.
Risk Profile: Amount of risk an investor deems acceptable after
incorporating factors such as investment objective, risk budget, volatility
appetite, and resources.
Roney Ratio: A UoR Ratio created by Jason Roney to measure the
performance of a market in terms of Risk Multiples. See Risk Multiple.
Compare Z-Score.
Roll-down: The capital appreciation that a bond exhibits as time passes
and it moves from a higher- to a lower-yielding point on the yield curve.
Sentiment Indicator: A quantitative measure giving some sign of what
market participants are thinking or feeling. Sentiment indicators include the
VIX volatility index, Risk Reversals, and CFTC Commitment of Traders
Reports.
Sharpe Ratio: This measure calculates risk-adjusted return by dividing
(1) a portfolio or strategy’s return (or expected return) in excess of a risk-free
rate by (2) the standard deviation of the returns in the portfolio or strategy.
Calculating the difference of portfolio return and the risk-free rate (this
difference is also known as the “risk premium”) isolates the portion of returns
achieved by taking on risk. Dividing by the standard deviation norms the risk
premium to indicate how much extra return is achieved per unit of risk (in

1010
this case, portfolio standard deviation) taken on.
For example, in the following scenario:
Portfolio Return is 7.5%
One-Year Treasury Yield (a proxy for risk-free rate) is
2.5%
Portfolio Standard Deviation is 4%
The Sharpe ratio is (7.5%-2.5%)/4% = 1.37.
By establishing a uniform measure for risk-adjusted returns, the Sharpe
ratio enables risk comparisons among a broad array of portfolios. Here, a
higher Sharpe ratio would be more favorable, as this would indicate greater
return for risk taken on.
Short: A “short” position involves selling an instrument (or, in the case of
futures and forwards, entering into an obligation to sell at a set price at some
future date) with the expectation that prices will fall. “Being short” means
holding short positions. Because there is theoretically no limit for price
increases in some instruments (as opposed to a bottom of $0.00 for falls in
prices), short positions are sometimes described as having unlimited risk and
limited upside. See also Long (this is the polar opposite of short).
Skewness: This is a statistical measure of the symmetry of the distribution
of a set of data. A positive skew indicates that the tail exceeding (to the right
of) the median is long, encompassing some outsized numbers, but the tail
exceeding (to the left of) the median is far (it has a heavy number of
incidences clustered just below the median, but it is less likely to have
incidences far out in the tail). A negative skew indicates that the tail to the
left of the median is long, but the tail to the right is fat. The presence of
skewness implies that the standard distribution (which is based around a
normal distribution) is less informative. See also Kurtosis; Standard
Deviation.
Sortino Ratio: The Sortino ratio is a variation of the Sharpe ratio, using
only downside deviation instead of standard deviation. This measure
calculates risk-adjusted return by dividing (1) a portfolio or strategy’s return
(or expected return) in excess of a risk-free rate by (2) the downside deviation
of the returns in the portfolio or strategy. The Sortino ratio is often seen as
more realistic and appropriate than the Sharpe ratio, as most investors are
only concerned with downside risk. See also Downside Deviation; Sharpe
Ratio.
Special: When a Treasury security becomes difficult to borrow, it is

1011
known as trading special. In this case dealers will offer to lend cash at rates
below the GC repo rate, including negative rates, in an attempt to secure
bonds to borrow.
Standard Deviation (SD, s, or σ): This is a mathematical measure of
variability and shares the same definition used in mathematical statistics. In
an investment context, the standard deviation is the most common
quantitative measure used to show the volatility of returns, where a higher
standard deviation indicates a higher volatility. In a normally distributed
sample of returns, roughly 68% of all returns are within one standard
deviations of the mean (or expected) return; roughly 95% of all returns are
within two standard deviations; and roughly 99.7% are within three standard
deviations. For instance, if the average daily return was 0.2% and the
standard deviation was 0.05%, then roughly 68% of daily returns should be
between 0.15% and 0.25% in a normally distributed environment. See also
Kurtosis; Sharpe Ratio; Skewness.
Swap Curve: A yield curve built from swap rates rather than government
bond securities.
Summary of Economic Projections (SEP): A quarterly report released
by the FOMC. The projections include summaries of FOMC members’
forecasts for economic growth, inflation, and unemployment several years
into the future. The SEP also includes a “dot plot” of where committee
members, both voting and non-voting, believe an appropriate level of the Fed
Funds rate to be at the end of each of the next several years.
Supply Chain Trading (SCT): Catalyst-driven, equity-based strategy
that takes positions in companies that may be impacted by a major
macroeconomic event. Each event brings with it unique aspects requiring a
qualitative understanding of the companies involved. For instance, a sudden
supply glut in a given commodity may cause an SCT trader to sell producers
of the commodity and buy consumers of the commodity in the short-term,
and then reverse the position in the longer term (for producers, it pays to stick
with those most likely to remain in business).
Synthetic Spread: See Implied Spread.
Talent Assessment Protocol exam (TAPx): An exam created by the
ReThink Group to measure the “X Factor” potential for traders and asset
managers to produce superior long-run performance. The exam assesses and
scores the degree to which an individual possesses two traits that research has
shown to be related to the abilities to read markets and manage risk:

1012
Cognitive Empathy (a measure of market intuition) and Risk Differentiation
(a measure of individual perceptions of risk).
Tail: When an auction results in bonds being issued at a higher yield than
that at which the When-Issued bond was trading immediately before the
auction. When an auction results in bonds being issued at a lower yield, it is
said to have been “through” the When-Issued yield.
Technical Indicators: Quantitative indicators that make calculations
based on the past trading activity of an instrument or set of instruments. They
are held in contrast to Macroeconomic Indicators, which gives measures of
the broader economy, but Technical Indicators are often used as a
complementary set of data.
Theory of Mind: See Cognitive Empathy.
Top-Down Investing: Another term for macro trading or looking at the
big picture. A top-down approach is focused on the macro factors at play in
any given investment or class of investments (think of it as having a God’s-
Eye View—looking at all the broad factors from far above, without much
attention on the idiosyncratic factors in specific investments within the class).
This is the opposite of Bottom-Up Investing. See also Event-Driven
Trading; Global Macro Investing.
Total Return: This is the amount, expressed as a percent, that a portfolio,
strategy, or instrument returned over a period. It can be calculated as

Trading Journal: This is where a trader can keep a record of trades,

performance, rationale of trade ideas, further explanation of current
conditions, and other factors (e.g., emotional/psychological introspection).
The Trading Journal not only helps traders focus their thoughts by identifying
them and putting them into words, but it also provides a valuable resource for
later analysis as it helps to identify elements present in successful trades and
unsuccessful ones, detect patterns, relate then-current conditions to trades,
and so on. Keeping a Trading Journal is a recommended practice for traders.
Treasury Future Basis Trade: Trading government bond futures against
the underlying securities to exploit discrepancies in their relative pricing.
Going long bonds and short futures is going long the basis; short bonds and
long futures is going short the basis.
Unit-of-Risk (UoR): The predetermined amount one is willing to risk on
a trade, strategy, or portfolio. Also known as the “Risk Budget.”

1013
 Unit-of-Risk (UoR) Dashboard: A distillation mechanism for providing
a one-stop snapshot of which markets are delivering tradeable opportunities
for the Protean Strategy. The UoR Dashboard can display number of UoR
ratios at once, and can be used to visually contextualize several hundred asset
prices in a matter of moments.
Unit-of-Risk (UoR) Process: The rigorous quantitative and qualitative
approach to every aspect of one’s operational, analytical, and execution
methodologies in the investment process.
Unit-of-Risk (UoR) Ratios: A proprietary set of ratios, measurements,
and formulas used to assess how well an asset, strategy, or portfolio is
performing on a return per UoR basis. UoR Ratios can function as a
standalone tool as well as provide comparative analysis.
Unit-of-Risk (UoR) Strategy Grid: A grid comprised of aggregated
strategies that have received their Regime Profitability Factor. The UoR
Strategy Grid allows an investor to assess which strategies are likely to
perform in a given regime on a UoR basis.
Value-at-Risk (VaR): A probabilistic approach to assessing risk, VaR
can state a probability of a specified loss in a specified time frame (e.g. a 2%
chance of losing $100,000 or more in the next three months). VaR can be
calculated via historical simulation (modeling the likelihood of moves in a
current portfolio based on running numerous sets of past market moves in
those assets); Monte Carlo simulation (running a very large number of
modeled market scenarios based on random number generation, which is then
used to generate a probabilistic distribution of returns); and the variance-
covariance method (which estimates the probability of various returns based
on statistical assumptions of a normal distribution utilizing an estimated
mean return and standard deviation of returns).
Value Added Monthly Index (VAMI). An approach to representing
performance in terms of a dollar amount, rather than a percentage amount.
Thus, a portfolio could be represented as starting with $100. After a 10%
gain, it will be at $110; if a 10% loss on that $110 follows, it will go down to
$99; and so on.
Volatility Path: The number of times a market or spread moves a
specified amount within a given range and interval. This is a factor that
overlays with the “realized gamma” of a market. See Opportunity Ratio.
When-Issued (WI): A new bond that has not been auctioned yet. In the
run up to a Treasury auction, the new bonds can be traded WI on a yield

1014
basis, then delivered after the auction.
Whisper Number: The unofficial forecasted number for a
macroeconomic event. This projection differs from the official “Consensus”
number submitted by expert forecasters, and is spread throughout the market
by word of mouth and unofficial channels.
Yield curve: An actual or virtual plot of the yields of government bond
securities across the range of maturities, ranging from a month on the short
end to decades (often 30 years) on the long end.
Z-Score: The number of standard deviations from the mean a data point
is. Thus, if the mean is 10%, the standard deviation is 5%, and a data point is
at 2.5%, then it has a Z-Score of -1.5 (it is 2.5%-10%, or -7.5%, from the
mean and that is -7.5%/5%, or -1.5, standard deviations). Z-Scores can be
used to describe data, or to estimate the probability of a certain item (for
instance, roughly 16% of data points in a normal distribution should have a
Z-Score of -1 or less).

1015
APPENDIX I

UoR Macro Trading Calendar -

Eastern Time

1016
1017
APPENDIX II
Country or Central Bank Website Other Sites of Interest
Region
Australia Reserve Bank of Australia - http://www.rba.gov.au/schedules-
http://www.rba.gov.au/ events/schedule.html
releases.

Brazil Central Bank of Brazil -
https://www.bcb.gov.br/?ENGLISH
www.abs.gov.au/ - Australian Bu
Gives Australian GDP data
http://www.abs.gov.au/ausstats/
abs@.nsf/mf/5206.0/
(http://www.abs.gov.au/ausstats/
abs@.nsf/mf/6401.0/
(http://www.abs.gov.au/AUSSTA
abs@.nsf/mf/5368.0), and employ
(http://www.abs.gov.au/ausstats/
abs@.nsf/mf/6202.0).
https://www.bcb.gov.br/?COMM
calendars of Copom meetings, mi
and reports.

http://www.bcb.gov.br/?INDICA
Central Bank of Brazil website al
of economic indicators, including
and employment. The list of data
spreadsheets) can all be found on
Canada Bank of Canada - http://www.bankofcanada.ca/core
http://www.bankofcanada.ca/ functions/monetary-policy/key-in
Calendar listing past and future G
key rate decisions, targets, and re

1018

China People’s Bank of China -
http://www.pbc.gov.cn/english/
130712/index.html
http://www.statcan.gc.ca/start-deb
Statistics Canada website giving
(http://www.statcan.gc.ca
/eng/nea/list/gdp), trade data
(http://www.statcan.gc.ca/tables-
tableaux/sumsom/l01/cst01/econ0
CPI (http://www.statcan.gc.ca/tab
tableaux/sum-som/l01/cst01/cpis0
http://www.pbc.gov.cn/english/
130724/index.html - Calendar of
the PBOC.

http://www.stats.gov.cn/english/
National Bureau of Statistics. Inc
specific links to GDP, trade, and
Quarterly data repository
(http://data.stats.gov.cn/english/e
cn=B01) Gives up-to-date GDP d
monthly data repository
(http://data.stats.gov.cn/english/e
cn=A01) gives CPI and trade data
traditionally taken with a large gr
Eurozone European Central Bank - https://www.ecb.europa.eu/press/
(EU https://www.ecb.europa.eu/ calendars/mgcgc/html/index.en.h
Countries Governing Council meetings, also
Using Euro to calendar of data releases, text o
as etc.
Currency)
http://ec.europa.eu/eurostat
repository of European Union Ec
(beyond just the Eurozone). This
European employment data
(http://ec.europa.eu/eurostat/statis
index.php/employment_statistics
(http://ec.europa.eu/eurostat/statis
index.php/National_accounts_and
Inflation data (http://ec.europa.eu

1019
 table.do?tab=table&plugin=1&
language=en&pcode=tec00118
Japan Bank of Japan - http://www.boj.or.jp/en/mopo/
https://www.boj.or.jp/en/ mpmsche_minu/index.htm
and future Monetary Policy Meet
MPM minutes, and MPM reports

http://www.stat.go.jp/english/
of Japan. Includes employment d
http://www.stat.go.jp/
english/data/roudou/results/month
(http://www.stat.go.jp/english
/data/cpi/1581.htm), and Consum
(http://www.stat.go.jp/english/dat

http://www.soumu.go.jp/english/
Ministry of Internal Affairs and C
Includes GDP data and other econ
(http://www.soumu.go.jp/
english/dgpp_ss/nsdp.htm
Mexico Bank of Mexico - http://www.banxico.org.mx/politi
http://www.banxico.org.mx/indexEn.html inflacion/informacion-
general/percent7B04B839AD-BC
3522-09A5DE7219F6percent7D.
Bank of Mexico policy statement

Switzerland Swiss National Bank -
https://www.snb.ch/en/
http://www.inegi.org.mx/
Institute of Statistics and Geograp
untranslated GDP, trade, labor, an
translating service (such as Goog
helpful.
http://www.snb.ch/
en/ifor/media/id/media
planned SNB statements and even

http://www.bfs.admin.ch

1020
 /bfs/portal/en/index.html
Office. Gives GDP data (
bfs/portal/en/index/themen/04/02
data (http://www.bfs.admin.ch/
bfs/portal/en/index/themen/04/05
data (http://www.bfs.admin.ch/bf
themen/05/02/blank/key/basis_ak
United Bank of England - http://www.bankofengland.co.uk/
Kingdom http://www.bankofengland.co.uk/ publications/Pages/news/2015/06
of Monetary Policy Committee m
through 2017.

http://www.bankofengland.co.uk/
monetarypolicy/pages/decisions.a
Monetary Policy Committee Dec
and Forecasts.

http://www.ons.gov.uk/ons/index
for National Statistics. Site includ
links to GDP data, trade data, and
data.
United US Federal Reserve - http://www.federalreserve.gov/
States of http://www.federalreserve.gov/ monetarypolicy/fomccalendars.ht
America FOMC Meetings, gives text of pa
minutes of statements, and press
materials.

http://www.bls.gov/ - US Bureau
Statistics. Among other items, pro
payrolls
(http://www.bls.gov/news.release
and official monthly CPI figures
(http://www.bls.gov/news.release

http://www.bea.gov/ - US Bureau
Analysis. Among other items, pro
GDP (http://www.bea.gov/newsre

1021
 national/gdp/gdpnewsrelease.htm
(http://www.bea.gov/newsrelease
international/trade/tradnewsreleas
consumer spending figures
(http://www.bea.gov/newsrelease
national/pi/pinewsrelease.htm
Other http://www.cbrates.com/ -- Central Bank Rates data listing for central banks
Sources of world. List of central bank key interest rates, calendar of past rate decisions
Information policy committee meetings.

https://research.stlouisfed.org/fred2/ -- FRED database from Federal Reserv

Louis. Massive repository of up-to-date macroeconomic data information. P
information, but data series are included from around the world.

http://www.tradingeconomics.com/ -- Trading Economics database of macro

and projections.

http://www.bloomberg.com/ -- Bloomberg news gives top-breaking busines

stories from around the world.

http://finviz.com/news.ashx -- FinViz (a financial visualization site) gives a

financial news and blog postings.

http://www.fxstreet.com/economic-calendar/ -- The FXStreet economic rele

gives release dates from around the world, and posts corresponding release i

1022
1023