Category: Best Of

In capital markets, size matters a lot, even more than you probably think. It could define not only the assets you could trade, but also your buying and selling strategy.

If you manage 200 million and your average allocation is 5%, you are very limited to the type of stocks you could engage with. With an average allocation of 10 million dollars, you cannot afford to by a ten-dollar stock that trades 200k shares a day. Even if this $10 stock trades 1 million shares a day, you would have hard time buying 100% of its daily dollar volume without getting substantial slippage. This is why we say that when elephants dance, they leave traces. When big funds buy, they show their hands, they reveal their intentions. It is almost impossible for a big fund to buy its entire position in a mid-cap in one day.

Because of liquidity constraints, large funds:

1) cannot swing-trade. It takes several days/weeks to establish a new position and just as many to sell one.

2) cannot own individual small cap names, because they cannot establish position that is big enough to make a difference; guess where the best performing stocks come from, every single year.

3) sell on strength when there is enough demand to absorb their supply. If they wait to exit their entire position on a trend break (weakness), they will get a lot lower price as liquidity tends to magically disappear just when they need it the most.

4) buy established trends on weakness (pullbacks) or accumulate in anticipation of a a new trend – they realize that they won’t be able to build a big enough position when the stock of interest breaks out.

5) love market corrections. The two most favorite words of many value investors are forced liquidation. They live for that once a 2-3 years deep market pullback that allows them to accumulate positions of interest on the cheap. Momentum investors also embrace deep market corrections as they reset many bases and facilitate the discovery of big future winners.

Smaller market participants have an incredible advantage.

We could chose to wait and buy a breakout, because we don’t have the liquidity constraints to build our positions. By waiting for a breakout, we optimize our capital allocation – we are making sure that we are invested only in names that are already moving in our direction. We could be in and out of a name inside a day.

Or we could buy a trending stock in anticipation of a breakout, knowing that institutions are likely to support it. Bull flags are typical trend continuation patterns. Do you know how they are formed? Basically the process is the following:

1) there is a catalyst (earnings or price related) that causes a stock to break out;

2) let’s say that in our example, our stock of interest runs from 30 to 40 in a week;

3) it is normal to expect some form of mean-reversion after such an explosive move – either through time or through price

4) Institutions that are not willing to chase, could just put a big bid at 38, so every time this particular stock drops to 38, supply will be absorbed.

5) The stock will remain in this 38 to 40 range until the entire supply is absorbed and there is enough demand to push the stock higher.

We don’t need that much liquidity to exit. We could sell on strength or we we could sell on weakness, when there is a clear technical indication that the trend is over.

When people judge the performance of billion-dollar hedge funds, they need to realize how constraint those funds are in terms of opportunities. Which brings the question – why would you even consider allocating money to what is essentially a big huge asset gatherer? You are buying a ticket for almost guaranteed under-performance.

It is said that the definition of insanity is doing the same thing over and over again and expecting different results. The thing is that if you do the same thing over and over again in the market, you will get very different results, because the market environment constantly changes. The same type of swing setups that have 80% success rate and average 20% returns in a healthy bull market, could have 15% success rate and 10% returns in a choppy market. The same market approach (process) could have extremely positive or extremely negative expectancy, depending on the market environment.

Expectancy is the average gain per every taken signal. Highly positive expectancy means that you have an edge.

Expectancy = %of winners * Avrg. return of winners – % of losers * Average return of losers

Let’s assume that no matter what the market environment is, we keep our losses to 6% on average. What are the results in a healthy and in a choppy market?

Healthy market

Expectancy = 0.8*0.2 – 0.2*0.06 = 14.8%, which means that if your average capital allocation per signal is 10%, the average profit per every taken trade will be 1.48% of your capital. If you take 100 trades in this environment, your return will be 148%. (not taking into account that the absolute capital allocation will change as your capital grow).

Choppy Market

Expectancy = 0.15*0.10 – 0.85*0.06 = -0.036 or -3.6%. If your average capital allocation is 10%, then your average return per every single taken trade will be -0.36% of your capital. The more active you are in this environment, the more money you are likely to lose. In this case, we basically have 4 options to help us mitigate the damage:

1) trade less

2) use smaller position size (1/3 to 1/2 of your usual)

3) sit on the sidelines

4) use another approach that has a positive expectancy in this market environment (also known as an edge)

We don’t know in advance what trade is going to work, but we could have a very good idea when we have an edge and when we don’t.

I like to repeat that sometimes being wrong in the market is not a choice, but staying wrong always is. The truth is that more often than not being wrong in the market is a choice, kind of. If you know when your bread & butter process does not deliver in certain market environment and that you are very likely to encounter a loss, don’t push it, don’t be more active.

Many people know when their market approach is not likely to deliver good results, but most don’t have the discipline to step away and watch mostly from the sidelines. I have to admit that I have been one of those people. I am very good at knowing when to trade less and cut my position size, but at the end of the day when I draw the line, it turns out that in this specific environment I would have been better off doing nothing and sitting on the sidelines.

When asked about the most important lessons that Stan Druckenmiller learned from George Soros, he says the following:

I’ve learned many things from him, but perhaps the most significant is that it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong. The few times that Soros has ever criticized me was when I was really right on a market and didn’t maximize the opportunity

Soros has taught me that when you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig. It takes courage to ride a profit with huge leverage. As far as Soros is concerned, when you’re right on something, you can’t own enough.

In my previous post, I talked about the incredible power of using small position sizes. I also mentioned that some of the best performing and most popular investors in the world, have made names for themselves by using ginormous position sizes. George Soros is one of those investors.

On September 16, 1992, Soros’ fund sold short more than $10 billion in pounds, profiting from the UK government’s reluctance to either raise its interest rates to levels comparable to those of other European Exchange Rate Mechanism countries or to float its currency.

Finally, the UK withdrew from the European Exchange Rate Mechanism, devaluing the pound. Soros’s profit on the bet was estimated at over $1 billion. He was dubbed “the man who broke the Bank of England”.

Stanley Druckenmiller, who traded under Soros,  was the genius behind the idea. Soros just pushed him to take a bigger size. In this case, the bigger size was one of the reasons why this trade worked. What is more important here is to highlight their position size. They risked their entire YTD gain (they were up 12%).

Just to give you a perspective of how ballsy it is to risk 12% of your capital on one trade, consider the following simplified example:

Let’s assume that your trading capital is 200k and you want to buy a stock at $50 with a stop at 47; hence you risk $3 per share.

Risking 12% of your capital, means 12% * 200k = 24,000.

Divide 24,000 by the amount you risk per share ($3) to get the total number of shares you could afford to buy, which in this case is 8000 shares.

8000 shares * Current Market price of $50 = 400k. You would have to take on a 100% margin in order to risk 12% of your capital.

It is said that concentration creates wealth, diversification helps to protect it. The reality is that big returns are often just the opposite coin’s side of big drawdowns. Trading big position sizes is not for most market participants. If you still want to do it, you could learn a lot from people that have actually done it for a living. What are the four lessons from Soros’ s adventure with the British Pound:

1. Size matters.

When you manage billions of dollars, there are only a few great, high-liquid opportunities each year that will allow you to achieve substantial returns. The only way to achieve those bigger returns is to take on a bigger position size. The smaller your capital base, the more great trading opportunities you have in the market and you won’t have to risk big on any one of them.

2. Earn the “right” to trade Big first

They were up 12% for the year.  It wasn’t an incredible return, but it wasn’t bad either. In their eyes, they were able to afford the luxury to trade big. Here’s what Stanley Druckenmiller says on the subject:

It’s my philosophy, which has been reinforced by Mr. Soros, that when you earn the right to be aggressive, you should be aggressive. The years that you start off with a large gain are the times that you should go for it.

The way to build long-term returns is through preservation of capital and home runs. You can be far more aggressive when you’re making good profits. Many managers, once they’re up 30 or 40 percent, will book their year [i.e., trade very cautiously for the remainder of the year so as not to jeopardize the very good return that has already been realized]. The way to attain truly superior long-term returns is to grind it out until you’re up 30 or 40 percent, and then if you have the convictions, go for a 100 percent year. If you can put together a few near-100 percent years and avoid down years, then you can achieve really outstanding long-term returns.

3. Proper Timing is Everything when you Trade Big

A good entry point allows you to go through normal market reactions.  An amazing entry point allows to use tighter stop and therefore bigger position size. Here’s hedge fund manager Scott Bessent on Stan Druckenmiller:

One of the things that I learned from Stan Druckenmiller is how to enter a trade. The great thing about Stan is that he can be wrong, but he rarely loses money because his entry point is so good.

4. Have a contingency plan

They were prepared for the worse case scenario. Despite their conviction, they knew that they might lose money, so they had an exit plan.  They made sure that they could afford the loss and stay in business.

Soros is also the best loss taker I’ve ever seen. He doesn’t care whether he wins or loses on a trade. If a trade doesn’t work, he’s confident enough about his ability to win on other trades that he can easily walk away from the position. There are a lot of shoes on the shelf; wear only the ones that fit. If you’re extremely confident, taking a loss doesn’t bother you.

 SOURCES:

INSIDE THE HOUSE OF MONEY, STEVEN DROBNEY, WILEY, 2008

Schwager, Jack D. (2009-10-13). The New Market Wizards: Conversations with America’s Top Traders. HarperBusiness. Kindle Edition.

Wikipedia – George Soros