The Anatomy of a Short Vol Trade | Exploiting Geopolitical Shocks

Given markets are prone to different regimes, which often last long enough to put proponents of methods antithetical to the environment out of business — or in a psychiatric ward — it is then necessary to have a number of different approaches or frameworks to remain adaptable enough to exploit variant regimes.

What is ‘Short Vol’:
Short vol is a strategy wherein a derivatives trader sells short a put and a call option at typically equidistant strikes out-of-the-money, with the same expiries. This contract works like an insurance contract, hedging the counterparty for moves in the underlying instrument beyond the strikes (plus the premium received), up until the expiry of the options. Once a trade of this strategy is undertaken, the options seller has a short gamma profile, whilst being positively exposed to theta – the rate of decline in the price of an option through time. As time goes by, the probability a given option will move into the money decreases, and so the theoretical liability of the seller decreases accordingly.

My Experience Adapting:
Having come from a background in a long vol fund, malleability has been essential for me to revise my beliefs around shorting vol. Principally, being a reader of Taleb, I am still rather reluctant to having permanent tail-risk and so, I look to hedge such outcomes when structuring a trade to limit worst-case drawdowns to something pre-defined. Additionally, I am reluctant to enter the short vol side without having a view on future implied volatilities. To satisfy these preferences, shorting vol after a meaningful expansion in implied vols is when I feel most comfortable… Perhaps because of that elevated premium!

In 2017, this worked favourably in a couple of instances, both were geopolitical in nature, where political catalysts caused outsized realised vol due to markets overreacting — and implied followed accordingly.

The Anatomy of Geopolitical (Over)Reactions – A Behavioural Model:
Distinguishing between genuine geopolitical events where there is a digital repricing and those which are simply a liquidation or de-risking event — with a later re-risking — is no hard science. In either case though, realised vols have already expanded and implieds naturally chase in response. Thus, selling a strangle is of worthy consideration, especially in the liquid foreign exchange markets where double digit moves only tend to occur when somebody abandons a fixed currency regime (cough… SNB).

Polemic Paine (@polemicpaine) one of finance twitter’s resident gentlemen and one of its more generous contributors, pointed out a brilliant model in his post Markets. Where Physics Meets Psychology which fairly accurately depicts the mental model one must apply for such events. It is called the damped harmonic oscillation. With time, the amplitude of the oscillation decreases, just like the pitch of investor sentiment as market participants calibrate to the shock.

IMAGE 1: The Damped Harmonic Oscillation

Evidently, it seems in the examples I shall outline below, this framework held true. Behaviourally speaking, this is because the shock value decreases with each newer instalment of the same story — much like how “Grexit” was seemingly of much greater dramatic magnitude after the first Greek default, than the later n reincarnations of the same disaster.

Additionally, there’s a mechanistic reason for this process too, in that, after all the leveraged weak hands are washed out, all the positioning left is in it for the long haul. Accordingly, these less fragile participants, with longer temporal horizons inadvertently reduce the probability of high realised volatility from stop runs and news events.

Case Study 1: MXN on Trump’s Election

As a function of Trump’s rhetoric regarding the border wall, the potential renegotiation of NAFTA and other fairly protectionist views within the Donald’s policy platform; the Mexican Peso traded like a real-time referendum of speculators expectations of the election. Polling was shown to be rather inaccurate, perhaps because of the social stigma associated with admitting to being a Trump voter. This was further compounded by betting markets which had priced in a Clinton win, in a curious one-mimics-other information feedback loop. Thus, the November 8th election of Trump corresponded to an almost eleven sigma rate of change for a singular daily observation in the Mexican peso, as evidenced below.

CHART 1: USDMXN Daily Rate of Change with linear regression std dev +4 (red) +2 (red), -2 (green), -4 (green).

Further, the 30 day realised volatility of the currency leapt to a near 3 sigma deviation to historical vols.

CHART 2: USDMXN (white bars) vs USDMXN 30d realised volatility (blue) with linear regression std dev (+3, -1)

Interestingly, whilst the move was so digital in nature, implieds remained elevated whilst realised volatility managed to fall to below it’s 5 year mean (the green line above), bottoming near 11 before the end of 2016.

Suppose one had waded into the chaos and sold a 1m strangle to exploit the elevated risk premium attributed to the Mexican peso because of Trump’s election, it’d have been a rather nice period of positive theta to see out the end of the calendar year… Whilst some less than experienced commentators panic sold all of their equity holdings!

Whilst I didn’t have the vision to partake in the normalisation of the Peso after the Trump-shock, it did reinforce my earlier experience from 2016’s other major supposed political shock…

Case Study 2: GBP on Brexit

On the 23rd of June 2016 the people of Britain voted against remaining in the European Union. Meanwhile, polling — as it did later in the Trump polling debacle — suggested the Remain camp had it. Presumably, the bookies were watching this polling and thus they were completely discounting the outcome of Brexit. While the market was watching these two derivatives, instead of options pricing to gauge the likely outcome… Arguably, a less reliable process than having a pint at a pub with the locals anywhere outside of west London!

This all amounted to a rather significant political ‘shock’ with a 14 sigma daily rate of change in the cable (below) and an 11 sigma move in EURGBP.

CHART 3:  GBPUSD Daily Rate of Change with linear regression

Whilst I didn’t take action on the short vol side after Brexit, I did attempt to buy an early dip and was stopped out. Arguably, I was applying the wrong framework. I did think Brexit was a coin toss of a chance, but had misunderstood the asymmetry it represented – a worthy topic for a later essay. As we can see below, it wouldn’t have been an unreasonable approach to short vol once the July low was in place, as it was over a quarter of sideways action before the eventual re-test and break of the low.

CHART 4: GBPUSD (white bars) vs GBPUSD 30d realised volatility (blue)

Presumably, these observations are what later encouraged the framework to ‘click’ as I later wrote in my February 2017 piece The Common Law Premium – Buying the Pound Sterling:

These implied volatility levels are invariably elevated as a function of the grey swan-like impact of Brexit. Arguably, they price a measure of recency bias given the likelihood of another ~14 sigma daily move is low, which fits with my unpretentious observation that markets ascribe a greater risk premium to political uncertainty than to its antithesis.

This view justifies the perspective that both implied volatility and realised volatility will revert toward the mean as markets re-calibrate to a more certain political reality, in a market where the weak hands have been shaken out due to such high realised volatility.

Simply put, less fragile positions reduce the probability of high realised volatility. However, this is not to suggest exposure to unlimited loss structures is ever prudent. Instead, loss-limited structures, such as short put spreads; enable the ability to collect this elevated risk premium with a pre-defined and limited loss. Similarly, for those who trade esoteric structures, selling one-touch puts provides a similar return profile to put spreads as they are loss-limited, non-recourse structures.

In the piece, I was referring to GBPUSD 1m implied volatility still being in the 89th percentile of its historical distribution.

CHART 5: GBPUSD 1m Implied Vol as at February 2nd 2017

At various times this year I exploited this elevated premium, originally short puts and on a couple of occasions later, short strangles. Nevertheless, specifics aside, this gave me the experience to quickly identify another opportunity later in the year.

Case Study 3: EWZ on the Temer Revelations

On the 18th of May 2017, EWZ gapped down nearly 20% on news of recordings of Brasil’s President Michel Temer supposedly making bribes. Presumably, the angry crowds on the street and congress members demanding his impeachment contributed to a slightly over 8 sigma move in the rate of change of the EWZ index.

CHART 6: EWZ Rate of Change with linear regression

To the best of my recollection, having mulled on it over the weekend, I thought there was some counter-intuitive logic that, even if Brasil impeached its second President in a row, after Dilma Rouseff, it signaled an unwavering dedication to enforcing the rule of law and upholding the people’s will… A bullish sign!

As a result, I shorted some June and July expiry structures which contributed a collective 420bps to the portfolio over that period.

Short Vol Alert Model:

Going forward, I have developed a couple of models in TradingView which will alert statistical outlier moves in realised vol in particular markets to encourage one to assess whether they fit the framework… Indeed, deciding whether to follow a signal and the appropriate method of expression requires a lot of consideration. Nevertheless, these alerts going forward will presumably allow one to hopefully exploit the dynamic outlined herein and share these trades with the Prometheus Macro Premo Social members.

CHART 7: Statistical Short Vol Model 1

CHART 8: Statistical Short Vol Model 2


Whilst it’s difficult to know for certain if this approach is superior to continually selling vol, it strikes me as shifting the already attractive win/loss ratio of short vol a touch into one’s favour for the reasons outlined above… Further, it seemingly would reduce the probability of a black swan type event marking implied vols against you in a manner which is terminal for one’s portfolio. Meanwhile — extending the biological analogy further — it largely removes the eventual malignancy of exposure to unlimited loss from constantly shorting vol in an infinite time series.

With that said, I welcome any feedback from you all via the AMA or the comments section below.


Carl Hodson-Thomas

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Podcast | “Do What Works” | Prometheus in Discussion With Anthony Crudele

“That’s the fundamental algorithm of life, repeat what works!” – Charlie Munger

Dear readers,

A fortnight ago Anthony Crudele of the Futures Radio show was kind enough to invite me on to discuss my ideas about macro. In the podcast I try to introduce a few of the ideas which I discuss in my upcoming book Reflexive Macro: A Behavioural Approach to Global Macro Trading.

The audio is a little fuzzy from time to time, apologies, it’s likely due to the dodgy Australian internet. If I can find the time, or source somebody on Upwork to tap out the transcript, I shall post it here on the blog.

Topics include:

  1. Doxastic Openness — referring to one’s ability to revise their beliefs based upon new evidence;
  2. Evolutionary Decision Theory — on being less Lexicographic in decision making and building a comprehensive argument for action.
  3. Seeking reliable trading epistemologies — doing what works;
  4. Reflexive reasoning — how some technicals can be self-reinforcing;
  5. Position sizing — the philosophical schools of probability.

Please enjoy the podcast embedded below and feel free to hit me up in the AMA section if you have any questions or feedback.



P.S. Apologies for the close up of my head below!

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Trade Idea | A Compelling Contingent Trade

Elevator pitch: What if I told you there was a trade that would hedge your whole book to a Chinese correction AND had the idiosyncratic risks that suggests it probably may just make 7x anyway… Would that be something you’re interested in!?! 

Introduction: Forgive me for doing the Hugh Hendry to kick off, but I get a buzz out of this idea. The following piece is on FMG AU, the Western Australian miner who’s HQ I live adjacent to in Perth, Western Australia. Previously, I wrote a post on FMG here in 2012, I had been bearish iron ore for a while and the strategy worked out well. If the success of that early trade is anything to go by, then this could be a cracker. Forgive the mediocre quality of analysis, at the time I was very green and still working out my process.
I am an extremely average salesperson, but I think my grasp of logic and reason make up for it… So now that I’ve given you the sales pitch, let me indulge you with the analysis!

Hypothesis: Due to the comprehensively low volatility environment we find ourselves in, idiosyncratic opportunities are significantly mispriced. To invert the old adage, the receding tide runs all boats aground!

First Principle: Our first principle, or presupposition if you will, is that iron ore is the first derivative of China’s economy. Thus, following this logic, the companies most levered to iron ore will be the best expressions of the thesis. So the logic goes like this… If China’s economy rolls over, then iron ore will fall and FMG AU will be impacted most adversely.

Fundamental Macro Context: Presently, market participants and geopolitical analysts are parsing the words of President Xi’s speech at the 19th National Congress of the Communist Party of China, looking for hints of what the future holds for China. Some seem to think that now Xi is so well entrenched that he may be confident enough to take the risk to delever the economy. I am completely agnostic, as I have no predicitive function in that analysis. In fact I am ambivalent to the growth prospects of China.

What do concern me are the probabilities, and in the following analytical framework I hope to lay out the reasons for my conclusions as to what the risk reward proposition is, the probabilities and why this is a positive expected value trade.

Fundamental Equity Context: It’s simple, FMG is the most financially and operationally levered stock to the iron ore price. Principally, because the quality of their ore is not 62%Fe and thus, they likely have to pay penalties over and above.

As you can see in the below chart, FMG is the most financially levered to an iron ore price drop with a cost of production of USD ~ $57/t, whilst they are also the most operationally levered with a cumulative seaborne iron ore production somewhere close to 1300mt.

CHART 1: Iron Ore Miners Cost of Production & Cumulative Production

Commodity Context: Iron ore is still within the grips of a long term bear market, one which I was able to correctly anticipate back in 2010. Relief since the late 2105 bottom has been a function of Chinese stimulus, which seemed to directly flow into commodity prices by way of construction and thus steel production. Indeed, it’s only reasonable to expect the causality to flow the other way.

CHART 2: Iron Ore Weekly Price Chart

Equity Context: Since that bottom, FMG has meaningfully outpaced iron ore, as a function of its leverage.

CHART 3: FMG (blue) vs Iron Ore (orange) Normalised as at Jan 2016

Intermarket Analysis: Similarly, FMG has also outpaced its Australian peers with much lower cost profiles RIO & BHP. Both have only managed to outperform the commodity marginally.

CHART 4: FMG (blue), Iron Ore (orange), RIO (light orange), BHP (yellow) Normalised as at Jan 2016

Technical Analysis: FMG is forming a top-like pattern with $4.50 looming as the support. Classical pattern traders might call it a head and shoulders with a sloping neckline, but typically, what is the most obvious is best. Presumably, the reasoning for such a level being meaningful is that new longs will likely look to cover as new lows set in and a new trend takes force. Whilst technicals would logically seem to have unreliable claims upon reason, the other reliable method of understanding reality — experience — suggests otherwise. Thus, I hypothesise that objective and intersubjective technical methods work because humans are prone to patternicity and other type 2 errors, and so they become self-fulfilling. With respect to the below chart, support is indicated by the red horizontal range, if breached, the propensity for sustained selling is likely.

CHART 5: FMG Technical Support

Historical Mean: Further, as we look back at a monthly price chart, we can see that $4.50 is roughly the mean of the volume at price historical distribution on the left axis.

CHART 6: FMG Monthly

Bimodal Distribution: Zooming in once more to the fortnightly price chart, we can see the bimodal nature of historical prices on the left axis, which should arguably suggest that FMG is unlikely to have normally distributed price action in the future. Thus, an option seller using a model which prices options off a normal probability distribution will more than likely be misled, if the future looks anything like the past.

CHART 7: FMG Fortnightly

Implied Volatility: Which leads us to FMG’s implied volatility. Yesterday, when I clipped this chart, FMG’s implied vol was in the 6th percentile over 10 years at 30.46. Albeit, that percentile data might be slightly skewed given the single low data point in 2009 of 13.92 is wrong. Further, over the last 5 years, FMG’s implied vol is in the 3rd percentile of observations.

CHART 8: A Decade of Implied Volatility Data

Realised Volatility: Arguably, this is anomalous, and doesn’t comport with the facts presented here. But why has it happened? This opportunity exists for two different kinds of reflexive reasons: behavioural and mechanistic. Behaviourally, implied volatility tends to follow realised due to recency bias, which is the tendency to overweight recent data. Mechnistically, implied volatility tends to follow realised volatility, this is because options buyers delta hedge according to daily or weekly moves and are unwilling to buy and bid up implieds if there’s no volatility to realise. Together, they can form a self-reinforcing virtuous cycle that otherwise is referred to as reflexivity. With this in mind, it is unsurprising then, that FMG’s realised vol is particularly low, around 1 standard deviation below the mean of historical vols.

CHART 9: Realised Volatility:

Key: -1σ (green line), mean (green dotted line), 1σ 2σ 3σ (red dashed line)

Implied vs Realised: Looking at the last 40 months of data in interactive brokers, we can see that at 29.6% implied is presently significantly below the 200 day realised vol of 41.3%… Which had been as high as 67.8% in May 2016!

CHART 10: Implied (white), 30d Realised (orange), 200d Realised (purple)

Skew:  Volatility skew shows the difference between implied volatilities of options against their moneyness – how in or out of the money they are.

It can suggest a few things:

  1. Volatility Smile – shows that out-of-the-money volatility is higher than in-the-money volatility.
  2. Volatility Skew – shows that puts are cheaper than calls or vice-versa, and thus, suggests where the options market is hedging directionally.

For the December skew below, we can see that calls are priced relatively cheap vis a vis puts, which may allude to the options market’s estimate of directional risk.

CHART 11: December Skew

Volatility Timing  Model:

I made a volatility timing model to signal alerts when certain conditions are met and it is a favourable environment to get long vol. It is difficult to test its empirical reliability due to lack of options data, because I don’t yet know how to layer it onto bloomberg data… Nevertheless, it’s was what alerted me to this trade recently, so its job is done!

CHART 12: Long Vol Statistical Timing Model

Expressions: There are various ways to express this trade, here are some…

  1. Short the stock outright and keep an eye on iron ore as one’s guide.
    Sizing: I wouldn’t size much more than 250bps of one’s book.
    Stop: $5.49.
    Target: $1.50.
    Risk/Reward: ~5x.
  2. Buy 3m FMG strangle @ 105% & 95% moneyness and roll quarterly.
    Delta hedging: it’s path dependent, so hedge accordingly.
    Backtest: With a 50% win/loss ratio and a positive equity curve (without hedging), it’s arguably safe to assume that entering at these vols will suggest a higher probability of gains

  3. Buy June expiry $4 puts for $0.27
    Originally, I priced this up as a $4/$2 put spread, but cheapening it with the put leg at 2c is almost pointless… I’d rather buy it for 2c! The r/r of the put spread was up to 7x, to give some idea.

    Return Profile:

  4. Buy 9m OTM $2 puts
    Theoretically, they cost 2c!?!

And that’s my two cents!

If you made it this far, thank you for reading.

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Disclaimer: Please read the disclaimer on this site.

The Common Law Premium | Buying the Pound Sterling

Dear readers, below is a piece that went out to members and friends of Prometheus Macro Research on the 12th of February. We hope you find it informative. Note that although the trade’s horizon is multi-year, we take into account some shorter-term considerations such as positioning and sentiment, for the purposes of developing a compelling argument for action, as well as to attempt to gain an additional edge from timing.

Universally, markets tend to ascribe a greater risk premium to political uncertainty than they will to its antithesis. So, perhaps there is a subtle irony that I would develop a compelling argument for action on the long side, coincident to the announcement that the British Parliament has authorised Prime Minister May to begin the process of invoking Article 50 of the Lisbon Treaty. A consequence of the vote to leave the European Union succeeding in the referendum on the 23rd of June 2016. A vote which left the freshly minted portmanteau ‘Brexit’, indelibly imprinted upon the popular lexicon.


I’ve written before about the implications of ideology in speculative and investment decision making in Biases in Trading, where I made the case that through an evolutionary tendency toward emotional reasoning and various other fallacies and biases, people are predisposed to mistakes when making trading decisions according to their underlying political ideology. Indeed, perhaps this is why I didn’t fully exploit the fall in the Sterling whilst I was confident the ‘leave’ vote would prevail. A lesson which reminds me to focus on expected value and the potential asymmetries of political outcomes.

Politically, I leant toward Brexit, yet I didn’t appreciate that the outcome of its triumph would be so significant in the Pound over the short-term. Nevertheless, with new information and the iconoclastic tendency to question ideas that to others might be sacrosanct; I am inclined to face the other way. As the politics of Britain leaving the European Union has unravelled, it has appeared to me the emotional fervour has been distinctly in the Remain camp. Thus, I contend it is rational to diverge from the crowd amidst this cynical frenzy, and instead embrace an opportunity.


Let us consider, that to the many people around the world living in countries with a less well-entrenched rule of law – if at all – that presently the Pound represents an opportunity to buy a share in the common-law system at a steep discount. The assurance of the common law system, as well as the land rights and other liberties which come with it, is a significant factor in the robustness of the world’s most successful commercial economies. Similarly, as opposed to its counterparts in customary and religious law, common law underpins the geopolitical position of the countries who employ it, by attracting capital.


It is no surprise then, that the 16% drop in the ‘cable’ since ‘Brexit’, puts the currency in value territory against the dollar on a Purchasing Power Parity (PPP) basis; as evidenced in the chart below provided by one of our members at The Macro Trader.

CHART 1: GBPUSD PPP Valuation with 20% Bands


Given our behavioural, statistical and technical reasoning, then temporally speaking the British Pound is likely to be near a multi-year cyclical bottom.


The British Pound trade-weighted index is approximately in the 3rd percentile of observations over the past 17 years as evidenced below.


Whilst, the BOE Calculated Effective Exchange Rates UK Broad Index is presently in approximately the 4th percentile of observations since 1990.


Given these compelling statistical inferences, one must then consider the relative fundamental and technical characteristics of the Pound against various currencies.


Technically speaking, the pound looks attractive on numerous fronts. The classicists are focusing on what many regard as a potential “double-bottom” pattern, indicated in red below, although a channel may be the more likely interpretation.

CHART 4: GBPUSD Daily with 200MA in Blue

Further, on the weekly chart the cable is resting and potentially bouncing-off long-term trend support. From an elementary statistical standpoint, it is not unreasonable to anticipate a move toward the mean of the histogram on the left axis, which is why statistical extremes with support, such as these, are appealing. Particularly, considering it is currently within the 2nd percentile of observations since 1993.

CHART 5: GBP Weekly

Of course, currencies are priced relatively, thus other crosses need to be considered beyond simply the technical attractiveness vis-a-vis the dollar.


Similarly, on a daily basis, the euro-sterling appears to be a more compelling short, with a confluence of technical events occurring. Firstly, a seven-month head and shoulders pattern has the classical traders talking about a move which they measure down to the 74 handle. Further, the neckline of this chart happens to converge with both the 200-day moving average and an uptrend line that has held on the pair since it bottomed in late 2015.

CHART 6: EURGBP Daily with 200MA in Blue

Turning to the weekly, the cross doesn’t yield too much in terms of a constructive technical insight. Although, fundamentally speaking the euro seems like an ideal candidate to express this trade as the political uncertainty baton has now been passed from the United Kingdom to the European Union, whose fragility is far greater without the Brits as a member state. Indeed, this is heightened by the risks posed by the various European elections this year.



The short term chart appears to have potentially bottomed and reversed trend, given the price looks to have almost cleared the 200 day moving average. Albeit, there is little else technically compelling about the cross in the short-term charts.

CHART 8: GBPJPY Daily with 200MA in Blue

However, one constructive observation is the long term support against the Yen which has held since the mid-nineties. Perhaps one’s view of whether Abenomics will devalue the Yen would be the dominant factor in deciding the Sterling-Yen cross is the best expression.


Indeed, further consideration must be given to the regime of a given market and whether it fits with one’s strategy. In the case of sterling-yen, it is traditionally a great cross to trend follow as evidenced overleaf.

Our weekly trend-following model recently signalled a buy on the cross. As mentioned, historically this strategy works favourably, going back to the beginning of our data in mid-1975. Certainly, it is a somewhat cherry-picked, lowbrow observation and whilst it is important to avoid over-fitting to the past, one must also consider the particular characteristics of a given market.

CHART 10: GBPJPY Weekly Trend Following Model

Whilst we don’t follow this systematically, it does provide meaningful insight into the probabilities of the approach one might take on the sterling-yen cross.

CHART 11: GBPJPY Weekly Trend Following Model Performance Summary



Positioning data for spot foreign exchange transactions is not available (hopefully one day), however we can look at the futures non-commercial positioning in the Sterling as a proxy. Notably, it is presently at relatively extreme levels vis-a-vis history.­­ In fact, the levels are nearing the extremes set in 2013 when speculators and hedge funds were almost unanimously bearish, and wrong.

CHART 12: GBPUSD Weekly & COT Net Non-Commercials Speculative Positioning

As a behaviourist, one must consider that positioning is a real-time referenda on financial speculators’ sentiment, which evidenced by short positioning reaching the same extreme levels as 2013, is extremely bearish. Hence, we are inclined to take the other side.

CHART 13: GBPUSD Weekly & COT Non-Commercial Shorts Positioning

­One of our members brought to our attention that these numbers must be adjusted for Open Interest, which he has done and ranked by percentiles on his site Presently, hedge fund positioning is in the 17th percentile, having recently increased from the lowest decile.

CHART 14: GBPUSD & COT Positioning Adjusted for Open Interest


The GBPUSD volatility surface indicates market makers are more willing to write calls than puts presently. Rephrased and inverted, that means there is more demand to hedge via puts than calls. Suggesting that the market’s intersubjective probability assessment – or collective agreement of the Sterling’s future pricing – is fairly bearish. Consistent with our inferences from positioning data regarding the market’s sentiment.

CHART 15:  GBPUSD Volatility Surface

Further, this skew indicates selling downside structures to the hedgers may be of interest, so we shall turn our attention to implied volatility overleaf.


GBPUSD one month implied volatility is presently quoted in approximately the 89th percentile of the last 5 years’ data, as evidenced by the chart below.


CHART 16:  GBPUSD Implied Volatility

These implied volatility levels are invariably elevated as a function of the grey swan-like impact of Brexit. Arguably, they price a measure of recency bias given the likelihood of another ~14 sigma daily move is low, which fits with my unpretentious observation that markets ascribe a greater risk premium to political uncertainty than to its antithesis.

This view justifies the perspective that both implied volatility and realised volatility will revert toward the mean as markets re-calibrate to a more certain political reality, in a market where the weak hands have been shaken out due to such high realised volatility.

Simply put, less fragile positions reduce the probability of high realised volatility. However, this is not to suggest exposure to unlimited loss structures is ever prudent. Instead, loss-limited structures, such as short put spreads; enable the ability to collect this elevated risk premium with a pre-defined and limited loss. Similarly, for those who trade esoteric structures, selling one-touch puts provides a similar return profile to put spreads as they are loss-limited, non-recourse structures.


Long: GBPUSD & GBPJPY (trend following)


Derivatives: short gamma GBPUSD can add carry to the position

Rates: cheapen VaR by receiving LZ17

Equities: we shall follow up with our equity views when the timing is right

Given we have a multi-year time horizon on the Sterling and a fundamentally bearish bias over a similar temporal horizon on the euro, a strategic long with no stop is our chosen methodology. With the sterling-yen, trend following is our chosen strategy given its historical efficacy.

Further, whilst we don’t take unlimited-loss short gamma positions, selling the downside on GBPUSD remains an attractive proposition, particularly taking into consideration the skew and richness of the implied volatility, as well as providing the opportunity to add carry to the position.


Typically our position sizing process is one shamelessly adopted from James Leitner of Falcon Management Corporation who was kind enough to share his Kelly Criterion or optimal leverage sizing process with some of the Drobny Global Advisors members along with the presentation The Evolution of a Macro Portfolio. However, given we haven’t yet expanded upon this methodology and our variant of its application – looking at frequentist and intersubjective probabilities, and the expectations gap between them – for the purposes of keeping this piece as concise as possible we will leave this to a later date. Further, given a 100% allocation to a single currency exposure ­is everyone’s default position, sizing strategic long-term currency positions requires a somewhat different process to the one we would otherwise undertake for other asset classes. Of the various approaches one might employ, a risk-targeted approach is what we shall adopt. Accordingly, it is necessary for those who implement this trade to size according to their own risk tolerance. We shall follow up with an explanation of our sizing methodology and an introduction to our macro tracking portfolio in the coming days.

Carl Hodson-Thomas

Nb. For those of you interested in learning more about receiving our research, please visit

“Tha Squeeze” – A Gold Vol Trade Idea

If you read my last piece, you’ll be aware that gold is my favourite battleground for numerous reasons. As a disclaimer I’m already short and I also own some GCZ5P 1150 strike puts. As the title suggests, the trade outlined herein is to trade vol outright.

Last July I went to the Drobny Macro Summer School Conference in NYC. My favourite trade at the time, one that I suggested at the conference, was to buy precious metals vol below 12 vol points and it preceded to trade up throughout the rest of 2014.

2014 vol

The trade was predicated on essentially the very same reasons I outline below. This post may provide some good insight into my process. Eventually these posts will become much less thorough as I don’t need to flesh out the fundamental narratives and there becomes less need to elucidate on my thinking.

Type – Contingent: potential breakdown, potential vol expansion, potential catalyst in rates.

Fundamental Context – Gold is a story in decline, its failure to break higher has continued to impair expectations of the “believers” in a positive outlook. Meanwhile, despite the drama over the Drachma, gold has failed to stage a rally. All whilst the Fed looks ever closer to raising rates, with 6.71 months until the first rate hike indicated by markets.


A good friend tells me that “these are still doomsday prices”, expecting the mean reversion has much further to run. Further, the financialisation of commmodities markets as a result of the internet allowing every man and his dog to trade anything from home, means a huge build-up in positioning transpired through the zeroes. Coinciding with the meme that inflation was coming due to the Fed’s QE program. Gold was bid to outrageous levels and has since sold-off in similar fashion to historical bubble analogues. For further reading on the fundamentals, see Mark Dow’s blog.

Hypothesis – Gold looks set to break down and given that vol is compressed, we have the opportunity to play a mean reversion in the absolute level of vol. with the added benefit, that if the Fed raises rates during our trade horizon, it may be a catalyst for gold to collapse.

Timeframe – 4-5 months.

Trade – Buy a four month straddle on GCZ5.

LT Trend – Strongly negative
Intermediate Trend – Negative
ST Trend – Negative

GCQ5 Trends

Price Levels:
I think of price as the outcome of a contest of ideas in markets and reflective of the strength of conviction to which traders believe in a given story. With this interpretation in mind, the charts tell the story.

GC1 Price Levels

1165, 1140 and 1130 are the key support levels, yet as we can see in the below chart, the range of support may be quite wide.

Gold Price Chart

Gold is sitting right in the middle of its regression channel which has been in play since the April 2013 selloff that occurred right after gold failed to stage a meaningful rally during the events of the Cyprus bailout in March 2013. I remember thinking at the time this essentially invalidated its supposed purpose as a financial hedge.


Selling on overbought conditions proved quite fruitful since, as gold continually made lower highs. This is a strategy worth following until this regime breaks in one direction or the other. As evidenced by the below (very basic and obviously cherry-picked) backtest.


Nevertheless, even this mean reverting price behaviour has been sufficient to see large spikes in gold vol, but a breakdown of the magnitude of 2013, perhaps on the Fed raising rates, could see a significant vol spike.

Implied Vol:

“The single best predictor of future increases of volatility is low historical volatility.” – Jamie Mai, HFMW

If we think of price as the function of a contest of ideas, then the inverse of volatility is the measure of participants’ confidence in those ideas. For this reason it is a particularly valuable insight into a given market for a behaviouralist.

The low in implied vol in 2008 is obviously some bad data which skews the statistics somewhat, but even at the 9th percentile, we can be confident we are buying vol cheap.


Looking at the XAUUSD vol for confirmation, we can see that over the last 10 years only 319 observations have been below the current level.


Bollinger Band Width:
As a technical proxy for vol, we can also see that Bollinger Band Width is particularly narrow. In the same vein as the Jamie Mai quote above, as a technical indicator, BBWidth is often used for a situation called “Tha Squeeze” whereby it often tends to contract before periods of high volatility.

BBand Width

As we can see in the below skew, risk is to the downside.


To gauge whether history is on our side, let’s look at vol seasonally. Most notable is the fact that August & September have the greatest average monthly positive changes.

Gold Vol Seasonality

Certainly if the 5 year average is anything to go by, July isn’t bad timing for entry.

Seasonality 5 yr average


Directionally speaking, as mentioned, my bias is to be short gold. If your strategy is to sell breakdowns, there may well be some interesting entries in the next few days. In terms of playing vol, we can either do it via delta-hedging an option or with an option structure.

Here is an indicative structure.


Obviously it’s path dependent, but presuming there are some good moves before expiry,  delta hedging may well pay for the trade as implied vol here is only indicating a daily volatility of 0.95%. Below is the payoff chart if you hold til expiry without hedging along the way.

Straddle Payoff


Due to the length of this piece I’m leaving out my expected value and position sizing process for a later post. Don’t do a trade like this if you don’t know how to size or manage it. I’ll likely hedge moves to the topside more aggressively given my directional bias is that gold goes lower.

Gold looks like it could break down tonight, so let’s see how this trade goes.

Please read the disclaimer.


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,