Fat Right Tails & Quant Tactics

Tyler here with this week’s Macro Musings.

As always, if you come across something cool during the week, shoot us an email at [email protected] and I’ll share it with the group.

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Article I’m reading —

One of my favorite traders of all time, Ed Thorp, sat down for an interview with the guys over at AQR. There’s some great stuff in their talk on quant investing and the efficient market hypothesis. (Link here)

Here’s my favorite excerpt from the interview:

I tell people that EMH is not true, but for you it probably is true. That is, most people don’t have an edge. If you think you have an edge, it needs to be logically demonstrable. You’ve got to be able to defend it against a good devil’s advocate. If you can’t do that, you probably don’t have an edge. So, I think people should act as though it’s true until they can demonstrate otherwise. Having said that, in reality, markets are not perfectly efficient. There are many inefficiencies. But most of us can’t see them.

Podcast I’m listening to —

This episode of the Meb Faber show with Blair Hull was my favorite listen of the week. Blair Hull was a big market maker back in the day before he sold his firm to Goldman in 1999 for $531 million. He now runs a family office which has been putting in an enormous effort to turn macroeconomic data into quantifiable trade signals.

I like how his research focuses on more than the classic quant factors like value and momentum. Hull’s trading strategy looks at things like the Baltic Dry Index and the FRB Loan Officer Survey. If you want to dig in a little more I recommend checking out this link to his website.

Video I’m Watching  —

Morgan Housel gave a fantastic talk on the investment process that is now up on youtube for public viewing. Click here for the video and here for the transcript.

It’s a long presentation (50 minutes), but I promise you it’s well worth the time cost. He shows that successful investing is all about how you behave rather than what you know. Focused simplicity trumps scattered complexity.

Chart(s) I’m looking at —

One of the things I always keep a careful eye on is credit spreads. An uptrend in credit spreads signals turbulence ahead. And vice-versa. A downtrend in spreads means the market isn’t worried about much and risk-on asset should stay bid.

Spreads in the U.S. continue to tighten and break into new lows. This confirms the miraculous strength we’ve seen in stocks so far this January.

Trade I’m looking at —

We’ve been doing a ton of digging into a strategy we call “DOTM”. Basically it involves finding deep out of the money calls on things that have strong momentum and cheap vol.

During my research I found some SPY calls from earlier in the year that had mind-blowing returns. Check out the below graphic.

A $0.12 option purchased on the first trading day of the year with a Jan 19 expiry expired at a value of $6.70! That’s a 55x return in a few weeks….

I’m stunned by these returns. The option market is severely underpricing the strength of this market. People have been afraid of the “black swan” risk-off event for over a decade now. But the real black swan is happening right before our very eyes to the upside.

This late phase market action combined with low volatility is creating some incredible opportunities to get some cheap upside optionality.

I’m loving calls on strong names in this market environment.

Quote I’m pondering —

So, to sum this up, I think my advice from all this is take a simple idea and take it seriously. I think that’s the best investment advice that anyone can give, particularly as you become more advanced and more successful in your investment career.  ~ Morgan Housel

I more than anyone need to take this advice. I constantly have the itch to go out and find the next hot trade or the next sexy strategy when in reality sticking with something boring that works is usually the most profitable.

That’s it for this week’s Macro Musings.

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