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The Next Perfect Trade: A Magic Sword of Necessity
The Next Perfect Trade: A Magic Sword of Necessity
The Next Perfect Trade: A Magic Sword of Necessity
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The Next Perfect Trade: A Magic Sword of Necessity

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'The Next Perfect Trade' articulates a set of principles that can be applied in discovering superior trades; those that will be profitable in the broadest range of economic scenarios. The book shifts focus from forces that drive markets to forces that drive successful trades. The robust performance of this approach has inspired the subtitle 'A Magic Sword of Necessity'.

If you think of investing as a rigorous intellectual battle, you need to prepare for it thoroughly. Get in proper shape. Learn your moves, acquire your armor, your shield, your helmet and your battle horse. A magic weapon will be wasted if you get killed by the market's first arrow. Every chapter in this book represents a step towards mastering the sword of necessity. Taking each of those steps has its own merit. Both aspiring and experienced investors can find value in this book long before the advanced concepts, such as "necessity" and "dominance," are fully introduced. And with complete training and equipment, this weapon may give you a devastating advantage.
LanguageEnglish
PublishereBookIt.com
Release dateApr 26, 2016
ISBN9781456625559
The Next Perfect Trade: A Magic Sword of Necessity

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    The Next Perfect Trade - Alex Gurevich

    calculations.

    INTRODUCTION

    The Next Perfect Trade is a result of many years of financial soul-searching by a sophisticated modern investor. The underlying quest has been to articulate my own set of principles to prosper from financial markets.

    If you think of investing as a battle, you need to prepare for it thoroughly. Get in proper shape. Learn your moves, acquire your armor, your shield, your helmet and your battle horse. A magic formula (or magic weapon in this context) will be wasted if you get killed by the market’s first arrow. But with proper training and equipment, this weapon may give you a devastating advantage.

    This book prepares you to use one specific kind of magic:

    the sword of necessity.

    It is a consistent intellectual approach to finding trades which work in the broadest range of economic scenarios. Every chapter in this book represents a step towards building this approach. Taking each of those steps has its own merit. Both aspiring and experienced investors may find value in this book long before the advanced concepts, such as necessity and dominance, are introduced.

    Before speaking of specific weapons, I need to describe the battles in which I fight.

    I am an investment manager that specializes in long-horizon, discretionary global macro trading. It’s quite a mouthful. This long string of adjectives is needed to identify my sub-genre in the vast universe of trading and investing. Here’s what they mean:

    Long-horizon means that I primarily look for trades and investments that might (and often do) take years to pay off.

    Discretionary means that I, a human being, make all of the decisions. It is the opposite of automated, algorithmic trading. I sometimes do use quantitative models, which can be a useful tool. But I am not the one who develops and interprets them.

    Global means that I consider opportunities around the world. There is nothing I must trade, and nothing I may not trade. I have my preferences; for example, U.S. interest rates are my bread and butter, and I seldom trade corporate or emerging markets bonds. I trade major currencies; I like getting involved in Turkey and South America, but seldom in Eastern Europe. I monitor energy and precious metals, but know little about agricultural commodities. I invest in financial and tech stocks, which are more interesting and understandable to me than others. There are too many financial products in this world to track them all, so I choose based on my experience, investment history, and, frankly, some intangible aesthetic preferences. Still, my world of trades is large and far-reaching. I will discuss in detail the advantages of having such a wide reach.

    Macro means that I bet on directional moves of assets. It is the opposite of arbitrage , which is when you take advantage of price discrepancies among very similar, or even economically identical, assets. Typically, macro is associated with sourcing your market views from macroeconomic principles.

    Trading is a term that, in my experience, is loaded for laypeople with countless assumptions and preconceptions. For me, trading just means making money by taking positions using financial instruments. I use it almost synonymously with investing. But many people draw a distinction, using investing to mean buying assets, and trading to mean making bets, both short and long, on financial instruments. (Not all financial instruments are assets; for example, derivatives are not assets.) By that definition, I am certainly a trader. But I also think I am an investor. Most of my money is invested in a single asset: myself. The performance of this asset is defined by how well I make use of the capital.

    #

    Now that I have spelled out what I do, a question remains: Why does what I do make money? And if what I do makes huge piles of money, then why isn’t everyone doing it?

    I’ve been called a genius, a rock star, a star trader, and on occasion less flattering names, depending on how well the most recent trade went.

    Once a colleague at J.P. Morgan said, I wish we could throw out 95% of the trades we do every year and keep just the good ones!

    Most people are used to judging trades post-factum: I wish I’d bought Apple stock at $20 like I wanted to or What a genius, she got out of stocks right before the crisis or Euro vs. dollar in 2003 was a no-brainer.

    Looking back at my almost twenty years’ worth of trade ideas, whether executed or not, I wonder; was there a way to tell ex-ante, which were the good ones?

    This whole discussion would be irrelevant if I didn’t hold the conviction that profitable trades exist to begin with. One could say: Isn’t that obvious? After all, some money managers — Warren Buffett, Steve Cohen, Stan Druckenmiller and Jim Simons, to name a few — have been generating outsized returns decade after decade. Clearly they have been doing something profitable.

    Well, not so fast. Trading is often compared to poker; both involve making a move that gives you the best odds of success. But the outcome of any individual trade or poker hand is usually beyond a single player’s control. All you can hope for is being right more often than wrong.

    Is it possible that the most profitable players/investors are just the luckiest ones? Even over decades of excellent returns that seem statistically significant?

    I have a friend who is a professional poker player. He has been doing it for more than twenty years, making a steady living, year after year. Once he ran a statistical simulation: 1,000 players with a winning rate and the random fluctuation typically expected of a solid poker player, each playing 1 million random hands (yes, one million!). It turns out that, given the statistical odds, a few of them ended up losing money over the long run, despite their continuously superior play. He was baffled and discouraged. His profession seemed invalidated by the fact that whole careers in poker could be built and destroyed purely by a statistical swing.

    So how would we know that there is actually such a thing as superior poker play? This particular question has been reasonably answered. Randy Heeb, a friend from the University of Chicago, has weighed into the discussion. Both an excellent economist and an excellent poker player, he concluded — based on a study of 415 million Texas Hold’em poker hands played online¹ — that skill trumps luck. His argument on behalf of proponents of online gambling was accepted by the courts, which used it to determine that poker was not a game of pure luck and could not be restricted by laws against internet gambling.

    Poker provides an excellent statistical field to measure performance, but trading is different; and in some ways, it is more like duplicate bridge². As in duplicate bridge, everyone is dealt the same hand: the world we live in. But even duplicate players cannot get away from the luck factor. A slight variation of the bidding or playing system could be proven to be a boon or a disaster for a given card distribution. Likewise, traders can get lucky or unlucky based on a multitude of factors, many of which are, surprisingly, purely administrative: the products your boss allows you to trade or the terms of your credit lines. I know this from experience, as I’ve had my share of being in the right place at the right time, and in the wrong place at the wrong time.

    So, as the poker simulation shows, a good player can end up being a loser or, conversely, a bad player a winner over the course of million hands. How many trades does a trader make in her career? It varies widely. A long-horizon trader like myself makes fewer than a hundred crucial trades in an entire career. A day trader might execute thousands, maybe tens of thousands of trades.

    An algorithmic high-frequency trader technically engages in millions of transactions, but I wouldn’t count it that way. Each trading program is essentially one long trade; you are investing in the algorithm, not in the individual trades it is performing. And an algorithm makes money like a trending security — until it doesn’t, either because someone has come up with a better program or because the market paradigm has changed.

    So trading involves a smaller statistical sample than poker, but that isn’t the only distinction. Investment management is also prone to survivorship bias. Poker tournaments are consistently attended by both battle-scarred sharks and eager schools of young fish³. Plenty of losing players enter tournaments again and again, making it possible to analyze the difference in performance expectation between the previously successful players and the returning fish.

    In the world of finance, though, it is only possible to trace the performance of those who report their results to investors. Those who don’t perform are soon left with no investors. So the lucky survivors as a category cannot be compared with those who had a bumpy start and later became unaccounted for.

    Regardless, it is seems obvious that in the vast universe of traders any individual's past track record might greatly differ from what should be expected in the future based on their market acumen. Some star traders are born out of pure luck that allow them to score a few home runs early in their career.

    However, this reality does not, in and of itself, disprove the assumption that true trading geniuses do exist.

    Investors searching for money managers understand this issue. Thus they seek out not only a strong track record, but also an extensive explanation of a trader’s principles and strategies. Sometimes they receive the explanation and sometimes they don’t. Black boxes remain black boxes, especially in the world of algorithmic trading.

    #

    Personally, I have never been a black box. I have always expressed my ideas and opinions vocally (some might say too vocally) to my colleagues. Yet, speaking off the cuff and publishing a book for all time are very different. It has taken me time to articulate what my strategies are comprehensively.

    I have delivered multiple presentations at J.P. Morgan and promoted myself through grueling interviews and investor meetings. Typically, I would explain my investments philosophy by starting with something I believed was applicable to any trading strategy whatsoever: Dislocation equals value. Something has to be trading at the wrong price in order for someone to take advantage of the opportunity.

    So each trading style is essentially an answer to three questions:

    How do you find dislocations?

    How do you profit from those dislocations?

    How do you manage your capital and control your losses when you are wrong?

    #

    I will narrow down my investment style by the process of elimination.

    • Some traders dive into economic and statistical analysis to find dislocations. They crunch the numbers and endeavor to beat publically available economic research. I am not that.

    • Some traders, especially in stock markets, are very good at collecting unique intel and developing an in-depth understanding of underlying businesses. The notorious use of flying helicopters over corporate storehouses to validate business activity falls into this category. I am not that.

    • Some traders build and exploit superior mathematical models to value complex assets. I am not that.

    • Some traders use superior technology to engage in super-fast algorithmic trading. I am not that.

    • Some traders study technical charts or market flows and use their experience to understand market positioning and momentum. I am not that.

    • Some traders possess great discipline and developed market intuition. Whatever position there are in, they are quick to sense the shifting dynamics and escape without incurring major losses. I am not that.

    The common thread of those observations is that I am not somebody, who (through meticulous research, acute observation skills or superior technology), obtains information not easily available to other market players.

    There is another way to put it:

    the thrust of my investment strategy is not limited to analyzing forces that drive markets.

    The Next Perfect Trade focuses on one of my personal advantages:

    Understanding the forces that drive successful trades.

    The book is structured around ridding your portfolio of inferior trades and isolating the superior ones. The book is divided into three parts which build off each other and progress from least to most complex:

    • Part I provides a framework for developing a positive risk / reward by using the market tides and avoiding the common mistake of stacking the odds against yourself.

    • Part II teaches how to minimize the trades and portfolios, which have potential to lose money, even when the underlying view is correct.

    • Part III provides the system for identifying dominant trades and achieving a portfolio which is profitable, even when the underlying view is wrong.

    #

    I invite you on a journey through the labyrinth of intellectual and psychological fallacies that plague the investment process. In the spring of 2002, after five years on Wall Street, I had reached the heart of that labyrinth to discover

    the magic of concurrent necessity.

    I found what I think of as the greatest opportunity in the history of markets — a perfect trade. This revelation shaped my entire career. Ever since 2002, I have been seeking out strategies based on the same pure concept.

    I will share the path of this thinking in accessible terms, incorporating charts and real-world examples with which readers at any level can engage.

    I will also demonstrate how a failure to recognize the principles outlined in this book led seasoned traders to miss a similarly perfect trade opportunity that coalesced in 2014 — and, worse, to enter what has proven to be the worst trade ever.

    I challenge you, reader, to use the book’s principles and ideas to better prepare yourself for battle.

    Whether you aggressively consume the book’s content and adopt its principles, or simply pick out specific areas that help refine your own philosophy, if you improve your performance based on my ideas, I will be very proud. I look forward to reading about your investment success!

    Part I Swim with the tide

    The direction of the tide is the answer to questions like, All else being equal, where are the things going? or Where are the things going in the long run?

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