Biases in Trading: The Neuropsychological Contest of Emotion and Logic

The following piece is quite formal. Before I start sharing trades and analysis on this blog I wanted to provide an insight into my interpretation of behavioural macro trading. In which case I won’t have to unnecessarily elaborate when I work through my process in later posts. Apologies if this is TL;DR.


“Once we realize that imperfect understanding is the human condition there is no shame in being wrong, only in failing to correct our mistakes.” – George Soros

1) Logic, Emotion and their Biologies
2) Dual Process Reasoning
3) Shortcuts to Fallibility
4) Anatomy of the Gold Bug
5) Emotion Drives Cycles in Trading
6) In Closing
7) Further Reading

Logic, Emotion and their Biologies

“Reason is, and ought only to be the slave of the passions” – David Hume

Our brains are in constant disharmony, a contest between two conflicting forces. The first force is emotion. Emotion, can be both wondrous and destructive. Primarily because it is a characteristically primal, subjective and intrinsically hard-wired system that operates on an intuitive autopilot. The second force, logic, is less primal in nature due to its extrinsic abstract qualities and typically requires purposeful effort in order to reason objectively.

These two forces are asynchronous and so, remain in perpetual disunity, with one often contradicting the other,  e.g. the platitude “my head says one thing, my heart another”.

Even when we attempt to reason as objectively as possible, emotion interferes in the process, resulting in an outcome intertwined with our instinctive emotional biases. Hence, this inherent predisposition to faulty reasoning – to be a slave to our passions – our fallibility; was regarded as the manipulative function by George Soros. Nb. Not only do we manipulate reality, but also our understanding of it.

Neurologically speaking, the Neocortex, the part of the brain considered responsible for objective decision making; cannot reason without being influenced by the Amygdala, considered responsible for subjective emotional function.

The Amygdala is given priority in the brain over the Neocortex. As a result, one’s opinion tends to feel in an ill-reasoned, preconceived manner that was likely subsconsciously, and then consciously; constructed long before it was considered rationally. A curious function from an evolutionary biology perspective of our lizard brain attempting to keep us out of danger.

As information comes in, our subjective emotion is constantly undermining and contaminating our process of reason. This reflexive propensity influences all people differently.

Yet, this is only the beginning of how we fail to logically reason.

Nb. I’ve left out the discussion on hormonal effects on cognition and behaviour as it’s worth its own post entirely. Check out John Coates book linked below in Further Reading to jump start on the topic.

Dual Process Reasoning

In Thinking Fast and Slow, the eminent psychologist Daniel Kahneman separates how we process information into two systems. We have an instantaneous, intuitive and instinctive System 1, and a deliberate cognitive system, which is (hopefully) logical and rational, System 2.

System 1 is automatic, stereotypic and subconscious. It is no surprise then that it’s function is most closely associated with the Amygdala.

System 2 is the one we call upon for problem solving and strategic thinking, it requires a lot of energy via concentration. Depending on one’s familiarity with the problem at hand, System 2 takes a conscious effort to recruit, thus straining our finite capacity for logical effort.

Due to the effortful nature of System 2 and a finite capacity for abstract logic, we tend to take shortcuts. It’s hypothesised this is due to our reasoning faculties being a more recent evolutionary adaptation. Nevertheless, what we do know is the shortcuts we take. By being aware of these shortcuts and giving them a taxonomy, perhaps we can (hopefully) better recognise them in others, and, even better, give ourselves the tools to introspectively critique our own reasoning.

Shortcuts to Fallibility

Now we’ve covered the neuropsychological conditions which make us prone to failures in our reasoning, let’s look at some of the tendencies which result in the human brain drawing incorrect conclusions.

Cognitive biases are patterns in perceptual distortion that are replicable and responsible for misjudgement and illogical observation. There’s a vast array of examples for these spanning both human interaction (social biases) and judgement (memory and decision making biases). Cognitive biases arise when emotion, coupled with the rapid-fire nature of the lizard brain; result in heuristics applied outside the bounds of reason. Biases in professional trading and investing have been well documented since Keynes’ beauty contest and they are worthy of an entire tome themselves, so I only gloss over some key ones in this piece with the below examples.

Cognitive Biases
Source:  Royal Society of Account Planning

Logical fallacies are errors in logic, they can be formal violations of propositional logic or informal fallacies whose content or argument requires a leap in logic, leaving a disconnect between one’s premise and resulting conclusion. Most commonly these are inappropriate generalisations. Another great graphic with some examples below.


Reasoning by association, substitution or analogy, is an example of an inappropriate generalisation, a mistake humans often employ to shortcut the effortful process of recruiting System 2. When we find a false equivalency, we rather conveniently do not have to distill a problem to its first principles and reason out from there. Instead we are trusting the logic of the analogy; something that works well in our memory, which is typically associative, but less so in logical propositions.

An axiom is a starting point for a logical proposition, generally so evident that it is presumed true without skeptical inquiry. Axiomatic thinking is valuable when one has successfully identified a first principle, but disastrous when patently false. e.g. The Fed’s monetary policy will lead to inflation. In this false axiom, there’s a substitution between a bias about a contingent event, with an objective first principle; invariably perceiving it as given. i.e. Given A then B.

It is no surprise then, that this was likely undertaken in an attempt to reason quicker and probably done emotively and subconciously before being rationally considered by System 2. A curious commonality in these types of misjudgements is that they generally stem from an ideology, be it political, economic or religious; all are likely to incite and galvanize emotion.

“At the time, I was politically right wing and that fit with being an inflation-alarmist. The theory that the evil government was constantly debasing the currency provided for the perfect perspective for trading the inflationary markets of the mid-1970s.” – Michael Marcus, Market Wizards

Michael Marcus’ quote above is a pertinent example of one’s political ideology impacting their decision making. In investing and trading this can be both help and hindrance.

I’ve included a small survey out of curiosity to see if Michael Marcus’ observation held true in recent beliefs about the outcome of Quantitative Easing (QE). The hypothesis being: is the right more prone to an inflationist belief because of a political ideology espousing smaller government? Please check the box which best describes you. I’m Australian so forgive me if this seems a little politically insensitive.

In this way, we can ascribe a typology to ideas held by market participants and treat these ideal type generalisations as hypotheses when making investment decisions of our own. By considering sentiment and psychology and working out which story, or ideal type is the most powerful in the contest between bulls and bears, as traders we are better equipped to handle the pendular swing of sentiment and positioning in markets, such that we may have a better chance to predict and profit from the dynamic price movements and volatility in financial markets.

Giving these hypotheses the treatment of scientific falsification, we prevent ourselves from making the mistake of getting wedded to false axioms.

Anatomy of the Gold Bug

“Gold is the only commodity where the amount of supply is literally about 100 times as much as the amount physically used in any year. That is not true of any other commodity, such as wheat or copper, where total supply and annual consumption are much closer in balance, and true shortages can develop. There is never any shortage of gold. So gold’s value is entirely dependent on psychology or those fundamentals that drive psychology. Many years ago, when I was a commodity research director, I would totally ignore gold production and consumption in analyzing the market. I would base any price expectation entirely on such factors as inflation and the value of the dollar because those are the factors that drive psychology.” – Jack Schwager, Hedge Fund Market Wizards

The anatomy of the gold bug is the home-ground for behavioural macro analysis. As noted by Jack Schwager, given that gold is the only commodity whose supply is completely unrelated to the amount physically used there is no rational economically derived fundamental logic to explain the price movements in the commodity, it is simply a function of what people are willing to pay and that is determined by their expectations, which are likely biased by their political and economic ideology and emotion.

The antidote is to consider gold mechanistically; in terms of the market’s positioning, and behaviourally; in terms of sentiment, story and expectations. Sadly, this is not what happens in practice. Logic is suspended as participants are influenced by their axiomatic beliefs. The right wing guy with the house in the country who owns guns and gold and is fearful of big government and inflation, as an extension of the Michael Marcus archetype; takes it as a given that inflation will be created by the profligate government without questioning the fundamental logic of that axiom. Instead, he’s thinking about something which is contingent as though it is a given and not distilling the observation to first principles… because it was easier to skip that part.

Emotion Drives Cycles in Trading

“Faced with the choice between changing one’s mind and proving that there is no need to do so, almost everybody gets busy on the proof.” – John Kenneth Galbraith

You will come across many professional traders who will point out the disparity between paper trading and the real thing, this is because when paper trading you haven’t had the market test your nerve. That’s before accounting for the emotional difficulty one may face when it comes to changing one’s mind.

Consider the generic chart for gold below. This chart represents one of the greatest displays of emotions in trading. Indeed anyone who trades derivatives or understands the Greeks knows that it’s more complex than simply buyers and sellers. However, resistance and support keep occurring in the same ranges outlined in red for a reason, as Mark Dow smartly put it: “the behaviour behind resistance, of course, is the old I’ll-sell-it-when-it-gets-back-to-where-I-bought-it”, or vice versa.


Indeed, we can see how emotion is driving this process. For example, imagine your bias is to be bearish – you are more confident that you are correct when reality, read price, accords with your thesis, and conversely, less confident when it looks to be challenging resistance and doesn’t confirm your thesis. If you try to short gold when it makes a new low and it fails to break down, you stop out of your position as your fear response kicks in and the Amygdala or System 1, overrules the logic that justified your trade. Thus, there’s an upward force on price and the continuum of reflexive feedback between price and conviction continues.

Similarly, the bulls begin to develop confidence when the price appears to be breaking higher, and when it fails, their System 1 interferes and they hit their stops, and the process repeats. This occurs across various macro horizons. Above we can see it occurring in the course of months, but it also transpires in every timeframe, from intraday moves to the course of years. For example, take gold’s long slow march from its early 2000’s base, to its eventual sharp acceleration and blow off top. In longer term cycles, the pendular swing might be slower, and the bulls might have had the power for longer, but the process is still the same. Once the self-reinforcing positive feedback between price and participants behaviour is extinguished by the bubble bursting, the virtuous circularity becomes vicious.

GC1 lt

“Religion is a function of repetition and a passage of many many years. 10 years is effectively sufficient to create a cult, a cult of belief, in capital markets.” – Hugh Hendry

Ultimately, we can see the neuropsychological contest of emotion and logic not only occurs internally for market participants, but is also represented collectively through price action in markets, where we observe a contest of ideas represented by the participants willingness to risk capital on those ideas, reflective of their strength of conviction. The more people are convinced, the greater the emotional conviction, the stronger the idea and the more likely it is a meaningful move, or potentially, a bubble will develop. Most notably, it is often these illogical cult-like axiomatic beliefs which empower people to risk the most capital with the greatest conviction. Numerous newsletter writers on the internet, charging a $20p/m fee are incentivised to cater that, to paraphrase Kahneman: “A reliable way of making people believe in falsehoods is frequent repetition, because familiarity is not easily distinguished from truth”.

In Closing

Feedback allows us to update System 1, allowing us to develop skills, so that we are less prone to letting the Amygdala mislead us. This requires time, the effortful recruitment of System 2; and the ability to be introspective so that one is not allowing emotion to cloud their ability to remain objective. Dalio has tried to instill this within his culture at Bridgewater:

“I’ve learned that everyone makes mistakes and has weaknesses, and that one of the most important things that differentiates people is their approach to handling them. I learned that there is an incredible beauty to mistakes, because each mistake was probably a reflection of something that I was doing wrong, so if I could figure out what that was, I could learn how to be more successful.” – Ray Dalio

Ultimately, embracing mistakes and critical thinking (ex-ante and ex-post) are the only tonic to assist us with rationality. Nevertheless, it’s easier said than done, particularly in markets. Let’s see how you behave when you have your money on the line!


Further reading:
The Hour Between Dog and Wolf by John Coates
Thinking Fast & Slow by Daniel Kahneman
Behavioural Investing: A Practitioners Guide to Applying Behavioural Finance by James Montier


A Recommended Reading List for Trading, Investing & General Knowledge

After spending far too long attempting to add the most relevant books to my Goodreads widget for this site I gave up. Nevertheless, this encouraged me to sit down and pen a post on the most valuable books I have read to date, as well as some of the ones I intend to read – in part, a Talebian “anti-library” if you will.

“The writer Umberto Eco belongs to that small class of scholars who are encyclopedic, insightful, and nondull. He is the owner of a large personal library (containing thirty thousand books), and separates visitors into two categories: those who react with “Wow! Signore professore dottore Eco, what a library you have! How many of these books have you read?” and the others — a very small minority — who get the point that a private library is not an ego-boosting appendage but a research tool. Read books are far less valuable than unread ones. The library should contain as much of what you do not know as your financial means, mortgage rates, and the currently tight real-estate market allows you to put there. You will accumulate more knowledge and more books as you grow older, and the growing number of unread books on the shelves will look at you menacingly. Indeed, the more you know, the larger the rows of unread books. Let us call this collection of unread books an antilibrary.” – Nassim Taleb

I’ve had the fortune of a lot of freedom to read and think, the two are not mutually exclusive, as in my opinion the most progress is made when you read deeply, reflect and interact with your library every time you encounter a problem that reminds you of a passage or concept you might have encountered previously, or one you intend to encounter. For this reason, Taleb’s quote above is one which serves to illuminate how I go about educating myself.

I have constructed the below list with two further quotes in mind as inspiration.

“You’ve got to have models in your head. And you’ve got to array your experience – both vicarious and direct – on this latticework of models… The first rule is that you’ve got to have multiple models – because if you just have one or two that you’re using, the nature of human psychology is such that you’ll torture reality so that it fits your models, or at least you’ll think it does… And the models have to come from multiple disciplines – because all the wisdom of the world is not to be found in one little academic department.”   – Charlie Munger

I’ve always aspired to a cross-disciplinary approach, in fact I always wanted to be able to design my own college/university degree, in order to pick and choose courses I wished to study. In my opinion, the journey towards erudition is man’s greatest imperative. Munger certainly characterises this ethic regarding the acquisition of wisdom with his description of a “latticework of models”. When reading this list, think of the headings as your latticework.

“One bit of advice: it is important to view knowledge as sort of a semantic tree — make sure you understand the fundamental principles, ie the trunk and big branches, before you get into the leaves/details or there is nothing for them to hang on to.” – Elon Musk

Musk, another extraordinary erudite, delivers a similar message, also relaying a spatial structure to convey his message; that one should understand the fundamental principles of a discipline before working down to the nuances. I’ve tried to do so in the way I’ve ordered the books under each heading.

For those of you who are time poor and don’t have the luxury of spending an inordinate amount of time reading as I do, and you’re simply curious about the financial markets, the first three books I recommend are all by Michael Lewis. Lewis has a remarkable ability to educate the reader about key institutions, their interconnectedness – the plumbing; the securities, the players and ultimately the challenging lexicon (full of acronyms) which characterises modern finance. Read these three, preferably in order.

Now comes the juicy stuff!

First off, here’s a tome recommended by Michael Mauboussin on cross-disciplinary thinking:

Discretionary Macro:

  1. Reminisces of a Stock Operator by Edwin Lefèvre
  2. Global Macro Trading by Greg Gliner
  3. Diary of a Professional Commodity Trader by Peter L Brandt
  4. Market Wizards by Jack Schwager
  5. Hedge Fund Market Wizards by Jack Schwager
  6. Inside the House of Money by Stephen Drobny
  7. Invisible Hands by Steven Drobny
  8. The New House of Money by Steven Drobny
  9. Alchemy of Finance by George Soros
  10. Soros on Soros by George Soros
  11. Rational Macro by John Butters
  12. Expected Returns by Antti Imanen
  13. Handbook of Exchange Rates by Jessica James
  14. Dynamic Hedging by Nassim Nicholas Taleb

Behavioural Macro/Econs/Psychology:

  1. Thinking Fast and Slow by Daniel Kahneman
  2. More Than You Know: Finding Financial Wisdom in Unconventional Places by Michael Mauboussin
  3. Think Twice by Michael Mauboussin
  4. Structured Analytic Techniques for Intelligence Analysis by Rechards J. Heuer Jr.
  5. Predictably Irrational by Daniel Ariely
  6. Animal Spirits by Shiller & Akerlof
  7. Irrational Exuberance by Robert Shiller
  8. The Bounds of Reason: Game Theory and the Unification of the Behavioral Sciences by Herbert Gintis
  9. Behavioral Game Theory by Colin F Camerer
  10. Behavioural Investing: A Practitioners Guide to Applying Behavioural Finance by James Montier
  11. The Little Book of Behavioral Investing by James Montier
  12. Judgement Under Uncertainty: Heuristics and Biases by Daniel Kahneman
  13. The Hour Between Dog and Wolf: How Risk Taking Transforms Us, Body and Mind by John Coates

Thinking & Logic:

  1. Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger by Charles T. Munger
  2. Seeking Wisdom from Darwin to Munger by Peter Bevelin
  3. Intuition Pumps and Other Tools for Thinking by Daniel C. Dennett
  4. A Rulebook for Arguments by Anthony Weston
  5. Being Logical: A Guide to Good Thinking by D. Q. McInerny
  6. Think Like an Engineer by Mushtak Al-Atabi
  7. Thinking in Systems: A Primer by Donella H. Meadows

Political Economy, International Relations, Foreign Policy and Geopolitics:

  1. Social Theory of International Politics by Alexander Wendt
  2. Constructing the World Polity by John Ruggie
  3. Foreign Policy: Theories, Actors, Cases by Steve Smith
  4. The Political Economy of International Relations by Robert Gilpin
  5. Expert Political Judgement by Philip Tetlock
  6. Geopolitics: The Geography of International Relations by Saul Bernard Cohen
  7. Perception and Misperception in International Politics by Robert Jervis
  8. The Grand Chessboard: American Primacy and Its Geostrategic Imperatives by Zbigniew Brzezinski
  9. The Trial of Henry Kissinger by Christopher Hitchens
  10. Diplomacy by Henry Kissinger

Probability & Decision Theory:

  1. Rational Decisions by Ken Binmore
  2. Philosophical Theories of Probability by Donald GIllies
  3. A Treatise on Probability by John Maynard Keynes

Risk Management: Statistics, Position Sizing & Mathematics:

  1. Fortunes Formula by William Poundstone
  2. Beat the Market by Edward O. Thorp
  3. The Kelly Capital Growth Investment Criterion: Theory and Practice by Leonard MacLean
  4. Fooled by Randomness by Nassim Nicholas Taleb
  5. The Black Swan by Nassim Nicholas Taleb
  6. The Misbehavior of Markets: A Fractal View of Financial Turbulence
  7. Against the Gods by Peter L Bernstein
  8. The Definitive Guide to Position Sizing by Van Tharp


  1. Manias, Panics and Crashes: A History of Financial Crises by Charles P. Kindleberger
  2. Extraordinary Popular Delusions and the Madness of Crowds by Charles MacKay
  3. Devil Take the Hindmost: A History of Financial Speculation by Edward Chancellor
  4. The Ascent of Money: A Financial History of the World by Niall Ferguson
  5. Virtual History: Alternatives and Counterfactuals by Niall Ferguson
  6. The Rotten Heart of Europe by Bernard Connolly


  1. Essays in Persuasion by John Maynard Keynes
  2. The Collected Works of F. A. Hayek
  3. Imperfect Knowledge Economics by Roman Frydman
  4. Can Capitalism Survive? Creative Destruction and the Future of the Global Economy by Joseph A. Schumpeter
  5. Stabilizing an Unstable Economy by Hyman P. Minsky


  1. Economy and Society: An Outline of Interpretive Sociology by Max Weber

Philosophy of Science:

  1. The Logic of Scientific Discovery by Karl Popper


  1. Letters from a Stoic by Lucius Annaeus Seneca
  2. Meditations by Marcus Aurelius

Biology, Cosmology & Physics: 

  1. Richard Feynman’s Lectures by Richard Feynman
  2. Sapiens: A Brief History of Humankind by Yuval Noah Harari
  3. Darwin’s Dangerous Idea: Evolution and the Meanings of Life by Daniel Dennett
  4. The Greatest Show on Earth: The Evidence for Evolution by Richard Dawkins
  5. The Grand Design by Stephen Hawking
  6. A Universe From Nothing by Lawrence M. Krauss
  7. Cosmos by Carl Sagan
  8. Death By Black Hole by Neil deGrasse Tyson

Value Investing:

  1. Security Analysis by Benjamin Graham
  2. Value Investing: Tools and Techniques for Intelligent Investment by James Montier
  3. The Essays of Warren Buffett by Warren Buffett
  4. You Can be a Stock Market Genius by Joel Greenblatt
  5. Fooling Some of the People All of the Time by David Einhorn
  6. Margin of Safety by Seth Klarman

Short Selling & Cooking the Books:

  1. The Art of Short Selling by Kathryn Staley
  2. Financial Shenanigans by Howard Schilit
  3. Quality of Earnings by Thornton O’Glove
  4. Unaccountable Accounting: Games Accountants Play by Abraham Briloff

Technical Analysis:

  1. Technical Analysis and Stock Market Profits by Richard W Schabacker
  2. Evidence Based Technical Analysis by David Aronson
  3. Technical Analysis of Stock Trends by Robert Edwards & John Magee
  4. Technical Analysis of the Financial Markets by John Murphy

Quantitative Finance, Systematic Trading, Programming & Coding:

  1. The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed it by Scott Patterson
  2. Quantitative Trading with R: Understanding Mathematical and Computational Tools from a Quant’s Perspective by Harry Georgakopolous
  3. My Life as a Quant: Reflections on Physics and Finance by Emanuel Derman
  4. Statistically Sound Machine Learning for Algorithmic Trading of Financial Markets by David Aronson
  5. Algorithmic Trading by Ernie Chan


  1. Elon Musk: Tesla, SpaceX and the Quest for a Fantastic Future by Ashlee Vance
  2. The King of Oil by Daniel Ammann
  3. Losing My Virginity: How I Survived, Had Fun, and Made a Fortune Doing Business My Way by Richard Branson
  4. Steve Jobs by Walter Isaacson
  5. Arnold: The Education of a Bodybuilder by Arnold Schwarzenegger
  6. The Greatest Minds of All Time by Will Durant

Business & Entrepreneurship:

  1. Zero to One: Notes on Startups, or How to Build the Future by Peter Thiel
  2. Bold: How to Go Big, Create Wealth and Impact the World by Peter H. Diamandis

Personal Development:

  1. How to Get Rich: One of the World’s Greatest Entrepreneurs Shares His Secrets by Felix Dennis
  2. Think and Grow Rich by Napoleon Hill
  3. How to Win Friends and Influence People by Dale Carnegie
  4. Awaken the Giant Within by Tony Robbins
  5. The 7 Habits of Highly Effective People by Stephen R. Covey
  6. Influence: The Psychology of Persuasion by Robert B. Cialdini
  7. The 48 Laws of Power by Robert Greene
  8. The 4-Hour Workweek by Tim Ferriss
  9. The Alchemist by Paolo Coelho
  10. The Four Agreements by Don Miguel Ruiz
  11. Outliers by Malcolm Gladwell

I left out a lot of books that were close to making this list, but for the sake of deconstructing it to a (semi) realistic number of recommendations and selecting the top percentiles within each topic, some great books were culled. I’ve still got a lot more to read and learn, which means that this list as well as the breadth of topics will probably grow. Albeit, I certainly wish someone had shared this list with me when I first caught the bug – it would have saved me plenty of time!

I’ve found I can optimise the time it takes me to read using audio, particularly for the non-technical tomes. For example, Liars Poker on iTunes is three hours, The Big Short is nine hours and Boomerang is seven hours, hence, there’s no reason you can’t do all three inside a week. I’m a little particular about my books and like to have them in audio, soft copy (pdf) and print. If you’re working to a budget and have a tablet, you’ll find some of these books as pdf’s on the web.


Get reading people and actualise your potential!

Nb. Please note, I’m an amazon affiliate, so if you buy through this site I’ll receive a referral fee.

Reflexive Macro Blog: A Re-introduction

I’ve been trading for roughly seven years, the last three of which have been working with a long volatility biased relative value arbitrage fund – a mouthful I know! My role was global macro strategist, however my responsibilities covered the whole spectrum of the trading process from idea generation, to expression, to position sizing, to execution and trading (as well as lots of delta re-balancing).

Learning about volatility and derivatives from this perspective has (I think) greatly enhanced my abilities in macro. Maybe that means I’m no longer just a directional discretionary cowboy.

Ever since I began to take an interest in markets, “macro” has, at least to me, felt like the most natural approach. Starting out I found it hard not to ask the big questions, deciding that if one chooses a strategy that does not include top-down decisions and as a result defaults into one’s own currency for example, invariably one has made a decision. I’m fond of these existential questions, it’s no wonder then that I call myself a behaviouralist. Nb. The Queen’s English only on this blog!

Presently I’m running a global macro fund and consulting business. I have been consulting since 2011, essentially the business involves sharing my highest conviction trades with institutional clients (HF’s and family offices). Now that I’m flying solo, I’ve finally got around to getting the website set up. It’s currently under construction, however the link is My objective now the business is formalised is to share my highest conviction ideas on an ad-hoc basis (between 6-12 high quality ideas per annum). Please feel free to reach out and I’ll share some of my work.

I have refined my process through which I filter my ideas over a number of years and if they don’t stand the test of scrutiny, which ultimately boils down to expected value and an implied expectations gap; then I won’t pull the trigger. I will outline my behavioural framework in essay form in a later post.

Being an autodidact I’m very much still learning, so if you have a divergent opinion or any dis-confirming evidence regarding my process or any of my ideas/hypotheses, please share, I will appreciate it.

Einstein’s observation in a letter to his son is one that resonates well with how I got to this point in my career:

“Mainly play the things on the piano which please you, even if the teacher does not assign those. That is the way to learn the most, that when you are doing something with such enjoyment that you don’t notice that the time passes.” – Albert Einstein

I’m in this business because I enjoy it, the freedom to read, study and think as I please is my greatest passion, so be prepared for a broad spectrum of ideas and observations on this blog.

I’m not sure how, although I have come to be fairly active on twitter, you’ll find me @PrometheusAM.


China, Iron Ore and a Future Bust

“The numerous misfortunes, which attend all conditions forbids us to grow insolent upon our present enjoyments… For the uncertain future is yet to come, with every possible variety of fortune.” 

– Solon’s Warning


I am one of the very few Aussies who is concerned about the future of an industry, iron ore exports; which represent a large portion of Australia’s GDP. From a fundamental top-down perspective I concur with the Hugh Hendry/Jim Chanos observation that China is amidst a credit bubble and is running an unsustainable economic model. The Chinese steel sector would be unprofitable in 2012 based on Chanos’ forecasts, yet they continue to add more and more capacity to a decentralised steel sector which is directed by local municipal government employees so they can meet their GDP targets.

From Barrons (emboldened emphasis mine):

“China has an investment-driven model where they simply want to produce GDP growth. They can continue showing GDP growth, as long as there is credit to support that investment. The problem is that most of these investments, at this point, do not generate an economic return and haven’t for a while. So you have the dichotomy of a country growing its GDP but destroying wealth. I view it as a stock that’s rapidly growing, but whose earnings are below its cost of capital. Any finance professor would tell you that’s a company that is liquidating and going to run into the wall. That’s what China is doing. But it can go on for a while.”

Essentially, China responded to the financial crisis with a massive stimulus via credit expansion in 2009.  From a historical standpoint, this was the single largest monetary expansion as a percentage of GDP ever undertaken.


China M1


China M2

With the CCP’s politburo aggressively directing the economy from on high and trying to stimulate growth via incentivising construction, massive overcapacity was inevitable.  Most notable examples: construction (property developers, cement makers), steelmakers (steel companies, iron ore miners, coking coal miners), shipping (ship builders) – all suitable industries to be short when the timing is right. This view is my fundamental bias, albeit I am agnostic to timing.

Below are a couple of videos on the Chinese real estate over-construction/overcapacity problem, the first which aired on Dateline in 2011 gives some insight into the idle-capacity which represents the liabilities side of China’s balance sheet, the second by Stratfor gives a more recent look at the policy implications and the difficulty the CCP are having in maintaining growth, whilst increasing the standard of living and attempting to convert from a investment-led growth model to a consumption-led one.

In order to monitor the fundamentals on the ground in China there are two main considerations, 1) policy (which I will be monitoring going forwards) and; 2) Shanghai rebar (short for reinforcing steel) is essentially the secondary market of iron ore and is the best proxy to Chinese domestic demand.


Shanghai Rebar Inventory


Shanghai Rebar Price


Iron Ore

Today, iron ore prices are reflecting the positively bullish assessment of global growth (read Chinese) demonstrated by equity markets. Early last year I spoke with World Steel Dynamics, who reinforced my bearish bias with a view based on their brilliant research that Iron Ore would sell off by July and they were very nearly correct with timing and their target price level. So I will look to discuss with them again in the near future what their views are for 2013.

From the information we do have however, we can see that Iron Ore is leading rebar, this divergence would (normally) encourage me to look for an entry to be short once rebar falls over, however, 93 mines have been shut down in India due judicial activism which may have contributed to short-term supply constraints.

Shanghair rebar and Iron Ore

CORRELATION – Iron Ore & Shanghai Rebar:

Iron ore and Shanghai rebar are usually fairly tightly correlated as we can see below, yet they have diverged to the 99.59th percentile over the last 12 months’ spread – perhaps this is due to a disparity between on the ground demand in China and iron ore prices reacting to a supply squeeze out of India?

Shanghai Rebar Iron Ore Correlation

All things being equal, I anticipate a continued short-term global economic rally, however, one thing we can be certain of is that the underlying reality will again rear its ugly head and demonstrate that Iron Ore demand is not as significant as many companies have bet. The largest bet by an Iron Ore producer on this demand is that of FMG with a total debt to equity ratio for FY2012 of 2.26x.

FMG’s expansion plans have eclipsed targets of 95Mtpa for FY2013, with an annualised Dec12 run rate forecasting a possible 100Mtpa, with an ultimate target of 155Mtpa.


FMG and Iron Ore are very tightly correlated at the moment, given FMG’s highly levered bet on the price of Iron Ore, its fate is invariably sealed to the price staying above $90/t for the next 2 years (I will get to this in my next post) – making the future of FMG very binary.

Correlation Iron Ore FMG


FMG is in a long term down trend since it hit a post financial crisis high in January 2011, the key resistance line since that time is drawn in below and FMG has continued to sell off on approach to this trend line. However, given Iron Ore prices are nearing $150/t and FMG is running a potential 100Mtpa, one must assume FMG’s equity price will advance on Iron Ore prices at this level and break out through this trend line.

FMG trendline

FMG is testing some very important price levels at $5.04 which is a key resistance level, I suspect it will roll over slightly from here and bounce off support at $4.67 to rally and break out through the resistance at $5.04. Thereafter, $5.50 and $6 are the key resistance levels. Between these price levels I anticipate FMG’s price action to encounter resistance, at which point I will look to pull the trigger on my bearish positions: short the equity and long OTM puts at previous key price levels of $3.50 and $4. 

FMG resistance breakout


Implied volatility, which is the market’s best estimation of future price volatility and hence an input into option price models; often falls during rallies, which provides an opportunity to take an option position with an increased probability of making a profit. Nb. the longer the timeframe the higher the likelihood volatility will mean revert. In this case I will look to pull the trigger on the put positions with different tenors (I hope to outline for you in the future) as well as a buy a long-dated strangle, to express a view on FMGs binary future, as well as to take advantage of the flaws in normal distributions – an inability to accurately gauge the probability of future price trends that are deemed improbable by the pricing model.

Implied volatility is a key caveat when I enter options positions, if implied vol is high (which I like to think of as a price) it means I am paying more for my options, and less likely to expire in the money from a probabilistic standpoint. Typically I like to buy volatility in the quantiles, near long-term lows – areas where I am comfortable the Implied is near a floor. If we look at implied volatility below, we can see it is heading towards April 2012’s lows in the low 30’s – remember, low volatility is the single best predictor of higher future volatility.

Implied Vol

Implied Skew Steepness


A normal distribution, the mathematical basis for options pricing models imply future prices are more likely to be near the current level, while probabilities decrease significantly for prices further OTM from current levels.


However, I think the reality for FMG is a fairly bimodal distribution, something more like this:


If this is the case, regardless of my bearish view on FMG’s future, we can de-risk our directional view, expend a small amount of premium and buy a long-dated strangle – this position could have some potentially large upside when FMG’s price moves to acknowledge that Forrest/Power have either succeeded or failed… We will find out in the next 9-18 months.
In the meantime lets keep our fingers crossed FMG’s Implied Volatility falls and it rallies to $6, so we can make the bet!

Enjoy your weekend,