Colm O’Shea: Know When Its Raining
The common outlook of a successful global macro manager is a trader who is capable of forecasting major trends in world markets through skilful research and understanding. O’Shea underlines that his edge is recognizing what has happened and not forecasting what will happen.
He believes that trying to pick a major turning point is extremely difficult and trying to do so is a losing strategy. Instead, he waits till events occur to confirm a trading belief. For example, he felt that unreasonable risk-taking from 2005 to 2007 had magnified various markets beyond practical levels and left the financial markets susceptible to a major selloff. However, instead of forecasting turning points, he was trading according to the widespread market facts and had bullish positions. He did not shift to a bearish position until an event confirmed that the markets were about to roll over. The event was that the liquidity in the money market was fading away in August 2007. There was no need to forecast anything, but to recognize the implication of an event that was ignored by many.
O’Shea believes that trade implementation is more important than the trade idea. He strives to execute a trade in such a way that it generates the best return-to-risk and limits losses when the trade is wrong.
Flexibility is an important quality to successful trading. It is essential for a trader not to get attached to a notion and should always be ready to get out of a trade if the price action is conflicting with the trading belief.
In April 2009, O’Shea was very negative about the financial prospect. However, the market price action was inconsistent with his bearish belief. Thus, he developed a completely different theory that seemed to fit the situation- the markets marked the beginning of an Asia-led economic recovery.
Both equity and commodity markets ventured on a multiyear rally and his original market expectation would have been disastrous. He was flexible enough to realise his mistake and act upon it allowing him to generate profits.
O’Shea believes that the best way to trade a market bubble is to take part on the long side to earn from the excessive euphoria. To try to pick a top is almost impossible and prone to large losses. It is easier to trade from the long side because the uptrend in a bubble is often steady, while the downtrend can be highly volatile due to bubble burst.
There are two important components to trade the long side of a bubble successfully. First, it is important to launch a trade early in the bubble stage. Second, the long position should be structured to limit the loss because bubbles are subject to sharp and abrupt downside reversals.
For this reason, instead of being outright long in a bubble market, O’Shea would take positions like long call, in which maximum risk is the option premium paid.
Macro trades are generally based on a fundamental view. However, it is not necessary to always have a reason for the trade. Sometimes when the fundamental reason is not evident, the market price action indicates something important going on.
Long Term Capital Markets (LTCM- a hedge fund) demise had strongly impacted the markets. O’Shea adjusted his positions because he inferred that the market action magnitude was indicating an important fundamental development. He recalled the concept of investing first and investigating later.
O’Shea also emphasised the importance of discipline while managing money. He explains that money management discipline could also be ineffective if it is not compatible with the trade analysis.
Many traders set stops at painful price levels instead of setting them at levels that disapprove of the original assumption. Despite getting stopped, they believe that their original presumption was correct and tempt to again get into a trade, only to mounting losses.
O’Shea’s advice is to first decide where you are wrong and then set a stop. If the stop indicates an uncomfortable loss, then keep the position size smaller accordingly.
One common principle that underlies almost all the trades is that they are structured to be right-skewed. This means, the maximum loss is limited, but the upside is unlimited. Long options, long Credit Default Swaps (CDS) & long TED spreads (difference between the three-month Treasury bill and the three-month LIBOR based in U.S. dollars) are all examples of trades where the maximum loss is restricted.