Easy Money: Mistakes of Paul Tudor Jones by Stephen Duneier
I have a confession to make. I like the easy trades, the obvious stuff. My trades are structured to provide a wide range of profitability and an extended period of time to be right. It’s very rare for me to ride a move all the way to the very end. Instead, I prefer to play the meaty part, and then move on. Many times, after presenting a new trade to colleagues in an investment committee meeting, I’ve heard, “Well thats not rocket science,” in response. That’s when I know I’m on to something. To be honest, it’s always baffled me why it is that so many professional investors constantly try to thread the needle, both on the way in, and out. You see, my ego isn’t tied up in being perceived as the smartest guy in the room. It’s more concerned with the returns generated. I don’t get attached to trades, regardless of how compelling they might be. Instead, it’s the investment process itself that is paramount to me.
“Make the hard trade, not the easy trade.” Paul Tudor Jones
Case in point, now that USD/JPY has reached the original targets identified in JPY1 back at the end of January (101.20 spot, -2.5 risk reversal), quite a few have asked what I think about the currency pair. The simple answer is, not much. Opportunity exists at the extremes, not in the middle. All of the factors that made it a compelling trade at the end of January have been resolved. Spot was at the top of the range. Now it’s in the middle. Risk reversals (skew) were very low relative to the norm, especially given where spot was trading. They are back up now. Implied vols were also trading near the lows, but not anymore. It was the combination of heavily skewed expectations based on what I believed to be a flawed analysis of the macro picture, particularly as it related to the US vs Japan, along with market prices that underweighted the possibility that the prevailing view could be wrong, which created the opportunity. In other words, the fact that so few thought USD/JPY lower was even a remote possibility, was reflected in the price. Given that I believed a big move lower in USD/JPY was a high probability, the trade was attractive. None of what made it attractive to me back then is in play today.
Here’s the thing about big contrarian calls like this one. People tend to become attached to them. For many, it’s difficult to simply walk away, to stop talking and thinking about it, for it is the narrative to which they become attached. Narratives can morph if they aren’t pre-scripted, making it difficult to know when they end. However, if you treat it as simply another expression of a view, one with gradually diminishing risk/reward attractiveness, with specific and finite expectations, it is easy to leave it behind when they are triggered.
“No trade can be entered unless the risk/reward ratio is greater than 4-to-1.” Paul Tudor Jones
Positive Expectancy I’ve been very vocal about my oil view. I believe it would take a tremendous spike in demand for it to stay above $50 for any length of time, and given how every country in the world has been struggling to stimulate demand of any kind for years now, I just don’t see that happening anytime soon. Some will read that and draw the conclusion that I think oil is going down. That’s how our brains work. We tend to think in terms of binary outcomes. Yes or no. Black or white. Up or down. Spike or collapse. Truth is, we spend far more time talking about the extremes, all while muddling through gray maybes right in the middle.
One of my clients shares my oil view, but for weeks was having trouble putting on a trade to express it. In considering different possibilities, he would inevitably begin with a put on oil and then explore different ways to offset, or at least reduce, the cost. He kept coming to the conclusion that implied volatility was too high.
If his approach sounded rational, it’s because that’s how we are programmed to think about markets and positioning. I mean, when was the last time you heard an analyst come to your office or a talking head on TV say, “I think Company XYZ will just sit right here.” Maybe once, because they’d never be invited back. Consider a probability distribution. You’d be hard pressed to find one that isn’t heavily weighted toward the center, anticipating no change. Yet, because of the way information is presented to us and because most investment instruments require movement in order to generate returns, our first instinct is to position for a directional shift. Even in the case where his view was that oil would not go higher, his first thought was to position for it to go lower. They are not synonymous. It was a mistake, but not the only one.
Given that he believed implied vols were too high, spot was trading at $50 and he thought it unlikely that it could stay above there for very long, the best expression of his view would involve selling volatility and betting that it wouldn’t go much above $50 for any length of time. The simplest expression of that would be the sale of a european digital call. To review, a european digital call option involves a fixed payout of 100% of the notional amount if spot is above the strike price at expiration. The seller would receive a proportion of the notional amount up front as a premium. If spot finishes below the strike, they keep that premium and the option expires worthless. Typically, the premium is roughly equivalent to the delta of a plain vanilla option with the same strike. If he were to sell a european digital call option struck at $50, it would likely be priced around 50% of payout, reflecting the 50/50 odds of it being above vs below $50 at expiration. However, selling that wouldn’t take advantage of what he believed to be high implied vols. To do that, he could either look to sell a 35 delta strike, or a simple call spread, say selling a $50 call versus buying a $55 call. Both trades have pre-defined, limited downside, are short volatility and profit if spot doesn’t rise above $50 for an extended period of time. There’s one problem with both of them though. They don’t adhere to the misguided, yet generally accepted principle regarding risk/reward, similar to that proposed by Paul Tudor Jones (see quote above). My client immediately rejected the idea to sell the 35 delta equivalent european digital call (struck at 55). Why? Well, it would mean risking 65% in the hope of making just 35% and who in their right mind would do that? Not many investors, but why not? Knowing the payoff is only part of the equation. If it were all that mattered, we should just have Powerball tickets in the portfolio. It’s not all that matters though. In order to judge whether or not it’s a good investment, we need to know the investor’s expectations. In other words, the probabilities he assigns to the different outcomes. In this case, he believed there was just a 25% chance that oil would rise above $55 and an even lower probability it would remain there until expiration. The expected return on the trade is therefore (.75 x 35) + (.25 x -65) = 10. Given his expectations, that’s a trade that should be done.
About the Author For nearly thirty years, Stephen Duneier has applied cognitive science to investment and business management. The result has been the turnaround of numerous institutional trading businesses, career best returns for experienced portfolio managers who have adopted his methods, the development of a $1.25 billion dollar hedge fund and 20.3% average annualized returns as a global macro portfolio manager.
Mr. Duneier teaches graduate courses on Decision Analysis and Behavioral Investing in the College of Engineering at the University of California.
Through Bija Advisors' coaching, workshops and publications, he helps the world's most successful and experienced investment managers improve performance by applying proven, proprietary decision-making methods to their own processes.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America, Managing Director in charge of Emerging Markets at AIG International and founding partner of award winning hedge funds, Grant Capital Partners and Bija Capital Management. As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.
His artwork has been featured in international publications and on television programs around the world, is represented by the renowned gallery, Sullivan Goss and earned him more than 50,000 followers across social media. As Commissioner of the League of Professional Educators, Duneier is using cognitive science to alter the landscape of American K-12 education. He received his master's degree in finance and economics from New York University's Stern School of Business.
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