Earlier this year, Interactive Brokers suggested that BCMstrategy, Inc. start a blog series on "how to trade the news." The blog series has done well, so we are now planning a webinar with Interactive Brokers and an e-book. We are happy to re-post the Rules (one per day) to our blog followers starting now!
Background: Markets have long sought to generate alpha from policy developments. The 24/7 media cycle, turbo-charged by social media and algorithmic high frequency trading, accelerates execution cycles and generates information overload which complicates strategy formation. This blog series articulates 12 rules for designing news-related trading strategies. They apply across all asset classes and financial instruments. Posts include examples and concrete data.
Rule 1: Be Objective
This is harder to implement than it sounds. But being objective is a crucial condition of success when designing and executing market strategies related to policy developments.
Why Being Objective is Hard
An investment thesis requires conviction and evidence. It includes often embedded assumptions regarding the regulatory, economic, and political context in which execution will occur. Markets demand directional conviction. Consequently, traders can fall in love with the investment thesis. This blinds the trader to contrary evidence, which is why risk limits exist. The same is true in risk management. From trade approvals to periodic scenario analysis and stress testing, risk managers test portfolios and positions against expected adverse developments.
When dealing with the policy cycle, the risk of blindness increases exponentially for three reasons.
Emotions –Denial and Disbelief: If one disagrees normatively or ideologically with the policy choice, much time is wasted by fighting the outcome conceptually. Time is money, particularly if the policy choice has a material adverse impact on the economics of the position over the investment horizon.
Surprise -- Justification: If the policy choice was unanticipated, time is wasted trying to prove that the outcome could not have been predicted. The reality is that inflection points usually are missed because the policy monitoring process was flawed or nonexistent. Machine learning and artificial intelligence may minimize the scope of error, but those processes are still hostage to the programming provided by individuals potentially biased by preferred economic policy or ideology priorities.
The Lemming Effect: It is true that the most alpha gains accrue to early adopters. But it is also true that there is safety in numbers. Taking a position contrary to prevailing wisdom can generate significant resistance from risk committees. A trading strategy consistent with what “everyone” believes to be true generates less risk of adverse personal consequences for the trader if “everyone” turns out to be wrong.
Why Being Objective Is Important
The job of a money manager is either capital preservation or alpha generation, not policy formation. When traders or risk managers focus on whether a policy trajectory is normatively “good” or “bad,” they miss a valuable opportunity to spot and profit from inflection points that challenge their world view.
Case Study – Brexit: Prevailing opinion holds that exiting the European Union will adversely impact on the UK economy. This perspective drives denial and disbelief regarding Brexit policy trajectories. Consequently, many missed the February inflection point when EU and UK leaders began making technical preparations for a no-deal outcome.
As the chart below illustrates, policymakers pivoted towards implementing a no-deal outcome between February 6 and February 9, 2019.
While most people were following the anti-Brexit gossip that dominated the headlines in this period, the smart money was positioning itself to prepare for a no-deal Brexit in reaction to concrete action taken by policymakers on both sides of the English Channel. More in-depth analysis of this inflection point is available HERE.
How to Implement Rule 1
Adjust to policy developments just like you would adjust to momentum in the Dow or the VIX, guided by objective facts and data. Clarify assumptions. Does a long-dated position overlap with a pending rule change in the industry? Does an options expiration date straddle a key summit, leaving you exposed to policy risk?
Distinguish between policy (what elected and appointed officials are saying and doing) and politics (public sentiment, polling data, vote counts).
Accept that policymakers and voters can – and do – make choices that contravene the “laws” of economics in furtherance of preferred priorities or values. Rather than fret that the “laws” of economics are being trampled, identify which specific laws and regulations are in play.
Prioritize facts over opinion. Whenever a trader or a risk manager says “I cannot believe they did -- or will do -- this,” push back. Is the outcome illegal or otherwise proscribed by treaty, law or regulation? If not, then the outcome is possible. Determine whether the possible outcome is (i) likely and (ii) how it would impact the position if it were to occur. If the evidence supporting a position relies on someone else’s opinion (“this prominent person says….”), know that you are looking at a lemming and dig deeper. If the evidence supporting a position relies on a policymaker’s statement or actions, know you are looking at cold, hard facts and are on the right track.