Quotation Of The Day - What Is A Macro Manager?

Mike Novogratz, Co-Chief Investment Officer of Fortress Investment Group, and manager of one of the world's largest global macro funds:

“A famous macro manager said that the reason you join macro management, rather than a really hard business like equities, is that all you need to do is look at a bunch of charts and read “The Wall Street Journal”. 

“What we do in reality is look at news from a whole variety of sources, we meet with government officials and we travel a great deal. We try to catch the big waves of market sentiment and the business cycle. A lot of it is trying to catch the bottom of the valley of prices.”

Chart of the Day is the Technical Position of the Aussie Dollar

 A recent article here cited a short in the Australian Dollar as a position held by Bridgewater Associates at the turn of the year. Often global macro investors like both a fundamental case and a technical case for their positions - the bias one way or the other is a style point for differentiating between managers. The previous article gave a fundamental case for a position, this article gives a technical case based on a re-test of a (very short term) key level. 

In another article here about macro trading the (at-the-time) CIO of a $9bn global macro shop (he is now CEO and CIO) disclosed how he traded FX in 2010. He explained how observing the technical developments allowed him to change position size as markets unfold through time. A key attribute of a successful (macro) trader is to reflect the probabilities of gain/loss on a position through sizing. When the investment hypothesis on which a position is taken is confirmed by market action macro traders either initiate a position or add to it. In pattern or trend terms these could be the break-point (of a trend), a key reversal, or a successful re-test (see second graphic here). A successful re-test is very powerful because the odds of success shift considerably - the amount that can be lost is much smaller than the amount that can be gained because the spot price is much nearer the stop (just through the key support/resistance level) than the first take-profit level. This set up is illustrated below for the A$ - US$ rate.

Graphic 1. A$ v US$ over the last year
source: www.fxstreet.com

The set up is that an ascending triangle formed from October through early February with  some acceleration in the uptrend (Graphic 2). This took the rate into the significant price band shown on the 1 year chart (Graphic 1). Note there was not a close above 1.0808 - the A$ traded above there versus the US$ intraday once but did not hold above that level. And the low close relative to the high that day (29th February) is a weak reversal signal.

 Graphic 2. A$ v US$ over the last six months
source: www.fxstreet.com

The short horizontal lines at the 1.0668/1.0633 levels bound a narrow band of resistance - reflecting the candle body of the 22nd February and the market action on the 5th and 6th of March (the second and third of the three down days in a row).

The investment hypothesis is that the A$ is going down based on a fundamental case. The consolidation after the ascending triangle - the break of the uptrend on the 10th February, and sideways move since - has been done with lower lows and only one day of a minor new high (which was the weak reversal signal mentioned above).  The rate has broken below 1.0668 this week and markets have tested that level yesterday and today, and bounced off it. A weak close today (on a Friday too) would increase confidence for a trader that the A$ is reversing, and is a good short against the US Dollar now - as Bridgewater Associates have been looking for for some months.

A good macro trader would also use technical inputs other than chartism to support/undermine the assessment of market condition. Flow information, market positioning data, volume and market action all feed into the view.

All the above are used to illustrate when a global macro trader would turn a long-to-medium term fundamental view into an actual position - when the market begins to show that it is acting the same way. That is when the probabilities of upside/downside begin to tilt towards the profit potential. So it is game on for Bridgewater's A$ short position.

Top Macro Manager Talks Through Set-Ups, Triggers and Sizing Positions

This week I heard a presentation by a senior trader at one of the large global macro hedge funds which has been in business for nearly 20 years. He put across several insights into the way of working of those who engage in the strategy. The particular trades under discussion were in foreign exchange, in the Euro/U.S. Dollar, during last year.



Fundamental Set-Up

In FX there are three elements to the fundamentals that should be aligned for putting on a position, according to the trader. The first is valuation. In FX there are several valuation models which are commonly used though each has limitations. Purchasing power parity (PPP) for a currency pair is a value which is unobservable in markets, and is a conceptual level that actual FX rates pass through without pausing. Extreme deviation from PPP is taken as an under or over-valuation. The Economist uses the price of the ubiquitous McDonald's meal to calculate the "Big Mac Index", a guide showing how far from fair value different world currencies are. The Big Mac theory, which is based on an observable purchasing-power parity, says that exchange rates should even out the prices of Big Macs sold across the world.

The second element of the fundamentals to consider is the interest rate differential between the two countries on each side of the currency pair. This is not a static element, as the FX markets (spot rate) move with forward forward rates. So expectations of future interest rate differentials are what count. The relative growth outlooks of the two economies is what the senior trader emphasised in getting a handle on interest rate differentials. For my part I would say that the perceived prospects for medium term inflation are now taking a much bigger role in the mind of the market than hithertofor in looking at interest rate differentials.

The third fundamental element to a good FX set up for a macro trader is the policy environment. Last year presented a classic opportunity (in looking at Euro related trades) in that European politicians/central bankers commented on levels and movements in traded rates (CDSs as well as bond auctions and FX parities). Some of the great macro trades have been set up by governments attempting to talk down markets when their policy objectives clash with what the markets discount as sustainable. So last year was a classic of its type in this regard, though interest rate policy specifically was a stale issue according to the bulge-bracket macro trader. That is, changes to interest rate policy were not expected to be a driver of the market condition for the trade under consideration in the time-frame envisaged. For trades at the market level like those illustrated here, and particularly in FX it is very important to understand the market drivers at the time. The graphic below indicates what the macro trader stated were the major drivers for the €/$ level last year through the different phases.

Technical Set-Up

The technical set up for a macro trade can be about flows and positioning by the various categories of market participants (say hedgers, speculators and governments). For example, the Commitments of Traders report for listed US futures showed there were very high levels of Dollar bear positions just before the monthly employment report for July 2010 released on the 6^th August last year. So the positioning in the market shifted the odds of the labour market data being bad enough to move the Euro up further versus the Dollar. That date marked an interim top for the Euro versus the Dollar.

The other form of commonly used technical set up is pattern recognition, which in its crudest form is chartism. Along with the rest of the market, the senior trader from the well-known global macro firm was onto the break in the multi-quarter uptrend for the Euro (versus the Dollar) that occurred in December 2009. The Greek debt crisis powered the multi-month fall in the Euro which lasted into the middle of 2010. The break in trend of itself is often a good entry point for a trade, but as FX markets have lots of minor reversals against the major trend traders have to have tools to identify the second and third high quality entry points as the new major trend unfolds. In the middle of January 2010 there was a good secondary entry point on such a short term reversal – as is typical the secondary entry point corresponds to a support/reversal level on the previous major trend – in this case around 1.45 on the €/$ in the period 13-15^th January.

This secondary, high-quality entry point can be illustrated in another trade mentioned on this website – in Gilt futures (see here and here).

Technical Set Up for Trade in Gilt Futures Showing High-Quality Entry Point

The significance from a money management perspective is that the second entry point - as the security price accelerates away from a key support or resistance level - can be a higher conviction entry point than the first. This is because the investment hypothesis ("the market is going to go down", say) has been tested by market action and passed the test. So depending on style, the macro trader can trade in several risk units at the second entry point. In no way is the second entry point a secondary entry point!

The global macro trader also disclosed the use of a particular tool to assess sentiment – the world wide web. The fund monitored the occurrence of the phrase "quantitative easing" on the web in August, September and October to ascertain the degree of dominance in the minds of investors.


Trigger

Global macro trading is often about assessing the persistence of action by the various actors in the market drama. It was interesting that the senior macro trader said that the trigger for putting on the position was often the behaviour of the markets themselves. Note that the crucial observations are across markets, not necessarily from market action within the market under consideration. So for the €/$ last year the maturity of the Euro rally that began in June was under consideration in August by the trader because the co-movements of the S&P500 (as a proxy for global equities) and the fx rate diverged. The €/$ and the SPX had synchronised price changes for a period of some months, but over the first few trading days of August days the S&P was flat whilst the € was still appreciating against the $. For the macro trader this signalled a change of behaviour was imminent for the Euro/Dollar relationship because the S&P action signalled at least a pause in the driver for the FX rate (the slowing US economy). To quote the trader directly, "divergences between markets are the best clue for market behaviour. A correlation break that lasts for one-to-two days and can indicate a movement to follow that lasts for 2-3 months." He also stated that more than 50% of a macro trader's insight comes from understanding the message of the markets, that is the behavioural inference is key. Like many traders, including those with a macro framework, the presenting macro trader only puts capital to work if the market has already started to move in the direction he wants to play.


Sizing

Sizing of positions in macro is usually a function of risk/reward and correlation. The senior trader didn't mention correlation himself in this regard, so we'll concentrate on the potential profit and loss as the key input to position sizing. The target price and stop loss levels for positions in markets are typically placed at or near significant support and resistance levels – the difference between current price levels and these two levels gives the upside/downside ratio for the potential trade. The potential loss between current levels and the stop is used to scale the maximum position size. A loss of say 5% on a position that is 20% of the gross equity of the fund would give a portfolio level loss of 1%. If two percent loss at the fund level for a single position is the outer bound then a 3% loss to the stop would equate to a 24% of equity maximum position size. The principle is determine how much you are prepared to lose – "anything else is bad discipline, or has ego in it," admonishes the trader.

This particular macro fund also uses drawdown from peak as an additional risk limiter at the level of the individual trader. So the risk capital of the trader will be reduced if his P&L is down 5% from his own peak, and he will be out of the market for a period if he loses 10% from his peak P&L, even if he is still positive on the year.


Closing the Position

The macro trader acknowledged his belief in the concept of reflexivity – Soros' concept that positive price changes themselves impact how positively investors think about the market – such that prices can waterfall down or continue upwards way beyond most expectations. Conceptualising potential price changes and unusual market impacts helps macro traders mentally prepare for a range of market outcomes. But still an all, positions have to be closed even after exceptional profits – so what feeds into the decision making at the closing of a trade? "A position should be reviewed when a price target is hit, and should be closed for sure when a lot of the market has joined you in that position."

How do you make money in macro trading? – "You need to take risk aggressively to make money, but you need to take it well." 



One of the reasons I posted this article is that the trader uses several methods I use in my own style of investing. If you run a hedge fund and would welcome input on your processes (investment, research and risk management) from my consultancy or want to persuade me to share my expertise full-time contact me on s-kerr@tiscali.co.uk 

Long Gilt Future Confirms Downside Break - Increasing Position Conviction

A week ago I suggested that Gilts had broken down at the long end. The successful test of the resistance at 120 (overhead supply) increases confidence in the short position. The standard trader response is to increase the position size, as the hypothesis of a breakdown has been confirmed.

Today there is also cross-asset confirmation - Sterling has depreciation against the Euro and $ in a break of previous action. That Sterling is doing this independently of other currencies is significant. 

source:Bloomberg LLP

PODCAST FOUR – CTA Beach Horizon

A Discussion with Head of Research of Beach Horizon, Dr. Paul Netherwood.
Dr. Netherwood spent four years in the Nineties in trading systems research and development at AHL (Adams, Harding and Lueck, now part of Man Group), and for the last 9 years he has been at Beach Capital Management and Beach Horizon LLP, a systematic fund management partnership. Beach Horizon is based in the City of London.

 
Clicking on the link will open a page containing the sound file - download or play in your browser



Part One (Link Here) (15 minutes)


 0.00 Introduction to Beach Horizon and sytematic CTAs
 5.50 Portfolio construction and diversification including milk and pork bellies
 9.20 Targets for outputs return and volatility
 10.50 Upside volatility
 11.55 Margin-to-equity as a proxy for risk

Part Two (Link Here) (13 minutes)

 0.00 The team - an advantage in being able to tap into a trader with a discretionary background for idea creation  and assessing research ideas.
 4.45 An FX research project
 6.20 Prioritising research, co-opting the sciences
7.35 Research productivity
10.00 People power - intellect is not scalable
12.05 Beyond trend-following - different frequencies

Part Three (Link Here) (8 minutes) 

0.00  Different time horizons of investors - a dominant frequency
1:06 Performance of CTAs in 2008
3.40 Performance in 2009
5.06 Current Drawdown - when will we see outperformance of CTAs? Influence of QE?
 

 
Drawdown Analysis for Beach Horizon May 2005 to December 2009

   

Source: Beach Horizon Database

 

My thanks go to Dr. Paul Netherwood for his contribution to this podcast.

Non-Confirmations Dissipated

Well, we are here again: another signal day near market highs on an index. The index is the NYSE Composite this time. The same short term sell signal came up on the COB 21st October on the S&P.

However, there is a different set-up:

*The market has been in a trading range for 3 weeks rather than running up and then giving a reversal signal. This gives a reversal signal less predictive success.

* You may recall that recently Bob Prechter was pointing out some non-confirmations - some indices were failing to hit new highs at the same time as the broader market indices. Apart from the AMEX, all the major indices have hit new highs since Prechter's comment, so those non-confirmations have gone. The DJ Transports and Utilities indices appear to be breaking out to the upside.

* There is not a clear non-confirmation on the advancing - declining issues indicator (second graphic). So breadth is in line with price at the broad index level.

* The market is going up with less short term thrust on each up-leg. Volume confirms this.

*Yesterday's down day was on the biggest volume for a month on NYSE trading. Was that a clean-out cathartic day? Even on the big volume down day there were a lot more new highs than new lows on the various stock exchanges.


The probabilities have shifted to less negative scenarios by market action over the last week or so. In particular the break outs to new rally highs by various industry sub-groups allows for some market leadership. The postive seasonal bias may kick in this month, particularly after a positive November. Some hedge funds are still gunning to make their year, though others will be planning how to spend their performance fee bounty already. On balance a trading environment with a positive bias.


relevant link: 'December Effect' Bodes Well for Hedge Funds, Equities'