CAVIAR CYCLE // TRADING FRAMEWORK

Trading Rules

A desk reference organized for fast review across mindset, market behavior, risk, execution, volatility, position management, and research.

01 — MINDSET & DISCIPLINE

Resilience, objectivity, loss response, consensus and emotional control

  • Perseverance and emotional resilience to keep coming back, b/c as a trader you get beaten up horribly.
  • Always objectively evaluate your own progress and process, write down mistake to improve.
  • Create a "mind like water" approach to trading
  • Risk control is critical. Rigorous risk control not only keeps losses small, it impacts profit potential. You must be in a position to seize opportunity. The only way to do that is w/ a clear mind. Don't expend mental energy by managing poor trades. Cut those that are not working.
  • When markets become volatile...consensus and crowded trades get hurt
  • How will you response to a target loss? 1/2 target? Get out? Grip chair? Envision the scenario and ensure you incorporate into your thinking
  • You have the option to keep a percent of your PNL this year...you want to serial option to do that every year, so you can't be blowing up.
  • It's not about being right - it's about making money. Taking losses is part of the process, so don't dwell on losing trades. Think about your next trade. Trading is a business. Treat it like one, keep records of your trades and journal your experience
  • Never stay in a losing trade b/c you think it will come back. Minimize the loss. Accept it and walk away. The worst thing any trader can do is freeze. You need to know how you will respond in any situation.
  • Don't follolw the herd or you will also be a sheep
  • Hope is a four letter word for a trader
  • Never become a billionaire as a range trader. Press trades and ride winner. Tudor Jones
  • Surest way to guarantee emotions will impact trading decisions is by trading beyond ones comfort level.
  • Know what you can lose.
  • Need to know what the consensus view is because you really do make the most money when consensus shifts.
  • If you are wrong, you are probably not the only one in shock, so you better be the first to sell.
02 — MARKET BEHAVIOR

Bubbles, trend strength, correlated markets and crowd behavior

  • You can ride bubbles, but do so in liquid positions, which you can cut fast when the market turns.
  • Bubbles last a long time and there is money to be made out of bubbles. But you need to be early...worst thing is to be stubborn and late to convert.
  • You know a bubble is over when it starts unwinding. But post-bubble dead car bounces can be vicious. Don't think you will find people who made the majority of their money shorting bubbles.
  • A bubble is easier to trade from the long-side since the inflation is smooth, while bubble bursts tend to be highly erratic
  • Never sell the strongest markets until they fail.
  • Failure of a market to respond as expected to a price move in a correlated market can reveal inherent strength or weakness
03 — RISK & POSITION DISCIPLINE

Desired risk, ego, sizing, review, euphoria and implementation

  • You have to take risk to make money, but you are supposed to take risk you want, not risk you don't want unless there are costs to not taking that risk. Have the risk you want, don't want risk you have.
  • Never cost trade
  • Don't trade with ego or become to invested in your own positions.
  • Position review: would I enter this trade today at this price?
  • Losing money is what kills you...not the actual loss..the psychology. You lose bullets in your gun. You want to be there when the great trade comes along. 80 percent of profits come from 20 percent of trades.
  • Trading around positions creates excess profits in choppy markets and keeps you in trades longer (ex JGBs, TIPs....take partial profits).
  • Don't looking for outside guidance in positions. Have to formulate your own opinion and not rely on experts
  • Beware of trades born of euphoria. If you are on the right side of euphoria or hysteria, lighten-up
  • VAR tells you how volatile your current portfolio was in the past. If you expect higher vol, run lower VAR
  • How a trade is implemented is as important as the trade itself
  • George Soros has the least regret of anyone he ever met. No emotional attachment to an idea. When a trade is wrong, cut it, and move on to something else.
04 — THESIS & TIMING

Conviction, homework, position aging and macro direction

  • If you believe something big might happen, but aren't sure what: play in limited downside
  • Don't trade unless you have done all the work and really have a view (7s10s vs 7s30s JGB)
  • Timing and aging positions...you might have a great idea, but market might not be playing ball.
  • 3 things needed to make money: 1) good fundamental story, 2) a good trend that looks like it will carry on, 3) market handling news the way it should (bull markets ignore bad news and any good news is a reason to rally)
  • 2 biggest mistakes: 1) traders who don't do enough homework, 2) too casual about risk
  • When economy stops getting worse, people can be optimistic again. Never underestimate the potential for people to be optimistic and believe everything is going to be ok. What is important is not whether growth is good or bad, but getting better or worse.
05 — STRUCTURE & TRADE MECHANICS

Rates, transaction costs, asymmetry, diversification, correlations and stops

  • buying payers:
    • Fighting against rate carry, not likely to pay out on a terminal basis
    • If 1x1 payer spread, not long that much vol due to higher vol and vega on the short leg due to skew
    • In a big sell off to the short strike, vol explodes and call skew depressed, so lose on the skew component.
  • churning trades is costly...transactions costs are small, but certain (law of large numbers)
  • don't pay to get in/out of trades for low probability events which you don't disagree with the market unless transaction costs are low or risk-management is important over gap event. figure out whether it's important to the risk of the book (correlation, size)
  • buying back wings prevents stupid stopout delta hedging from short vol trades
  • Implement trades asymmetrically
  • reviewing positions frequently prevents mistakes
  • Mike Platt 2 truths: Diversification works & markets trend
  • Value is irrelevant in times of market stress..its all about positions. Markets will trade against positions.
  • Spread trades can be riskier than outright when correlations shift
  • Set stops based on when prices are inconsistent with hypothesis, not your pain threshold, which the market doesn't care about. Start by deciding where the market would have to go for you to be wrong and place stop there. Then decide how much you are willing to lose on the idea. Stop losses should not be pain thresholds (different for short-term ideas). Make sure entry/exit strategy in sync with why you like the trade. Long term ideas shouldn't have short-term stops. Don't get stopped out at a time you think your trade idea is still correct
06 — VOLATILITY & STRESS

Market stress, vol, leverage, complexity, liquidity and portfolio correlation

  • In bull markets, bad news counts for nothing. But if there is a break that reminds people what it is like to lose money, suddenly the buying is not longer mindless..,people start looking at fundamentals.
  • Markets tend to overdiscount uncertainty related to identified risks and vice-versa with risks that have not been expressly identified (ex - CPAC)
  • Look for cheap vol on smoothly trending markets
  • if a market can only move one direction the vol needs to come down, or else sell options against the direction it can't move
  • Favor trades and structures with less leverage (ie 2s10s better than 2s5s )
  • If a vol purchase (sale), how does the vol look? (Implied vs. realized, etc)
  • The more complex the product, the higher the hurdle due to bid/offer, illiquidity/less flexibility.
  • Exotics can provide attractive risk management characteristics (high leverage, limited downside way to short vol)
  • Worth paying exotics vig when: 1) fits a view 2) structure is cheap and/or 3) surely risk mitigating
  • Don’t confuse temporary dislocations with revaluation and repricing that will persist or is not yet complete.
  • Don’t get caught into beta 1 / deleveraging profile.
  • For illiquid trades, stress scenarios need to be higher.
  • Can take more risk in long vol strategies vs short vol strategies.
  • Can take more idiosyncratic risk in scenarios where the book makes money
  • What is the correlation to portfolio? If positive, is the trade a better way to express the view?
07 — EDGE & POSITION MANAGEMENT

Catalysts, expression, profit-taking, convexity and PNL discipline

  • Where is the edge in the trade? Is the structure the optimal expression of the view. Break the structure into it’s component risks.
  • What caused the move and what is the catalyst for repricing?
  • Buying a laggard as a proxy for a leader is a bad idea. Sell the weakest, but the strongest.
  • What change in information set (either market pricing, framework, or time) would lead to change in the position size for either risk management or shift in trade thesis? Doing this thesis in advance will lead to better identification of risks, testing of trade thesis, and trade management.
  • Take profits as trades become less attractive
  • Don't short convexity when taking large duration/delta risks
  • PNL is the biggest risk management tool…if you are going to panic, panic early
  • When you really need risk management is when history does not repeat itself.
  • You must play big when you have high conviction, most often got into trouble with low conviction positions
  • What matter is how much you make when you are right vs how much you lose when you are wrong.
08 — RESEARCH & DISAGREEMENT

Primary research and deliberate challenge of the prevailing view

  • Touradji says he prospers because he does more research than most hedge fund investors, a practice he learned from Robertson. Touradji analysts log thousands of miles a year. Andreas Hommert, a metals analyst, has traveled to China to gauge demand for air-conditioning equipment. Analyst Austin Brown has been to Zambia to look at its copper mines.
  • "When two intelligent parties disagree, that's when the potential for learning and moving ahead begins," Mr. Dalio told me last week. "The most powerful thing that [an investor] can do to be effective is to find people you respect who have opposite, different points of view [from yours]—and have an open-minded exchange with them about what's true and what to do about it."
  • Only by deliberately seeking out thoughtful disagreement, says Mr. Dalio, can you counteract the false confidence conferred by a rising market. Investors "could really improve their probabilities of being right by 30% or 40% simply by saying, openmindedly, 'Who disagrees with me in an intelligent way? And let me understand that disagreement,'" he says. "I think everybody can do that. They just have to make a deal with the people around them to be that way."
Disclaimer
This framework is provided for educational and hypothetical purposes only. It does not constitute financial advice or a recommendation to buy or sell any security. Trading and investing involve risk.