Trade Idea Generation. the process of writing and thinking..LETS DO IT

[DcifrThs]

Ok guys, it's been a while since the last one of these but as i do it, i think it makes sense to have everybody chime in.

my motivation now is to write about a 3-5 page economic overview of the world and then parse out and precisely define some trade ideas as a result.

a friend of my father owns a 1bil global macro fund around where i live and he says he isn't hiring researchers now due to lack of senior people capacity to give attention to new researchers. i would like to show him that i don't need that much attention and simply give him something, whether he wants to consider me or not, that shows my abilities.

the first step to writing a SUCCINT, CLEAR, and IMPRESSIVE outlook/trade idea summary is brainstorming and picking the best ideas.

what follows is the brainstorm i had yesterday mad late at night and this morning before a recruiter interview in the city.

i also wrote some of this on the train from where i live to grand central and back.

it is VERY short hand but you can get the idea of what the brainstorming session is like.

please comment on ANYTHING you want and feel free to add whatever you want. we will all learn a TON from this i hope.

outline:

- bullet point trade ideas.
- economic overview.
- tying economic overview to trade ideas
- dealing with likely correlations/portfolio construction aspects of each idea.

ideally i'd like to walk away from this with 3-5 great ideas and about 10 decent ones (maybe more).

here are my thoughts brainstorm thoughts in shorthand:

- Short TIPS long 10yr??. bet that BEI will fall. Inflation is right now expected to be higher than in a long time due to low and falling dollar, economic weakness and the fed’s most recent 50bp cut. Impact of lower foreign demand for US10yr (rate rise). Perhaps long TIPS short 10yr? bet that inflation will be higher than priced in.

- Look at jpy/usd. Jpy/aud; jpy/nzd; jpy/eur. Carry trade unsustainable. China less likely to fall than US in terms of economic growth. Affect on Japanese CA? exports to china still strong while exports to US fall due to falling consumer demand? Counter point that jpy is so low vs. these four currencies that much lower would drive up fundamental flows into the yen. Further, interest rate diffs are responsible for 46% (Bernstein decomposition) of returns on currencies. Japanese rates can’t get much lower whereas US/AU/NZ/EUR have much room to fall if economy does poorly so very good bet here. These four are likely highly correlated though so treat possibly as 1.5 bets etc.

- Maltese lira (new place for investment, large demand, large exports) vs. euro as joining EU comes closer (jan 08). Long lira short euro? How will this play out as time of joining draws nearer? How much of this is priced in?

- Eurro vs. pound. UK and euro so tightly tied. UK far more likely to have housing affect consumer spending. Flow through to EUR though. How much? Enough for a long EUR/GBP bet?

- Overall USD. Dual deficit country. Interest rate diffs w/ rest of world? How much more likely to fall than, say japan. In addition to JPY/USD bet JGB vs. US10yr. long 10yr short jgb.

- Industrial production data/cap.util. consumer spending/corporate profits (mean reverting) growth data in US vs. euro vs. UK vs. china vs. japan

- Commodities, dependence on china/US. Ethanol craze too high? True greenery of ethanol vs. govt subsidies.
o Bet on uranium vs. oil. How has spread done historically. Uranium vs. natural gas…especially in Europe where Ukraine is at the hands of Russian demands. New pipeline in via sea? How would that affect demand for uranium vs. natural gas?
o What about oil overall. Not much room for increased supply and china growth even if it falls to 8% is still a huge demand factor. Copper may still rise despite US slowdown as china is biggest factor there and new production coming online won’t be likely to surpass growth rate of demand for the metal.
o Platiunum/palladium vs. gold spread. Probably blown out as gold has increased a ton and I don’t know what has happened with platinum palladium. How close are these historically (PPvs. G). is it now wide? (many demand factors for gold vs. platinum) has it gotten too wide? Short gold long platinum if it has.

- Diversification of SWFs away from US$ and US10yrs (look at last foreign purchases of us securities and how it is has changed over past year? What is likely future change?). what happens here with commodities if prices fall for oil exporters.not likely though given overall global demand.

- Interest rate diffs: US/UK, US/China

- Chinese bond market, possible implications: inflation since sterilization in china has been issuing of govt bonds to reduce inflationary impact of FX reserves. Would this increase likely inflation (reduce spectre for Chinese growth long term) or reduce inflation (and thus allow more comfortable growth w/o overheating)

- Corporate spreads. for individual companies within the same industry, a diff trade between those w/ very high int’l exposure and those with high degree of domestic exposure. Long CDS of domestic short CDS of foreirn (bet that insurance cost of 10mil of debt of foreign will fall vs. domestic insurance cost)

- Corporate spreads in general. Profits at 40 year high, possible decrease in consumer spending. Debt markets functioning poorly…what to expect in terms of corporate profits. How well do corporate profits track performance of debt? Financing costs of banking sector may cut still into profits of citigroup and the like. Is there a trade here?

- 3mo euribor/libor vs. short rates. Bet that they return to normal. Long 3mo euribor/libor short 1 mo euribor/libor. Where to get data to show as chart? (time vs. spread or time vs. 3mo euribor/libor US/UK/EUR denomination vs. 1mo same)

- emerging market debt. Peru's free trade agreement (FTA) with the US could add 1% to growth already at 8%. this could also give security to investors in peru. there is also a prospect for columbia and panama FTAs with panama much more likely than columbia but less likely than peru. so what do the current columbian, panamanian, and peruvian debt spreads over UStreasuries look like?
o approval in peru/panama could divert trade from columbia. so possible diff bet long peru/panama debt short columbia debt
o EAFIT study if both approved (peru/panama) could take 2.2% off GDP in columbia and lose 400k jobs

- candian bonds vs. US. commdity based economy trades highly w/ USA. outlook for loonie possibly stronger so long as CA improves as a result of similar commodity prices and overall stable global outlook

- australian wheat prices took .75% points off AUS growth in 06-07. BIIIIIIIIIIG draught going on there. worst in a century. contributing to high wheath prices globally.






ok so that is where i stand now.

over the next week i'll filter and compile these into a tight memo of 3-5 pages.

i'd also love to get some data so i know what is going on out there.

hope we can all learn a ton from this.

Barron

[quant_trader]

Barron,

I know that you are writing the memo as for general propose, but it might be worth while to find out exactly the types of trades that they do, before you write this, so you can target their interest better. So for example, most of your idea looks really interesting, but they are all over the map. just my 2cents.

[DcifrThs]

[ QUOTE ]
Barron,

I know that you are writing the memo as for general propose, but it might be worth while to find out exactly the types of trades that they do, before you write this, so you can target their interest better. So for example, most of your idea looks really interesting, but they are all over the map. just my 2cents.

[/ QUOTE ]

i'm doing it for me as much as them.

it's a brainstorm so it is supposed to be all over the map [img]/images/graemlins/smile.gif[/img]. my post above concentrates on US/ china. i'll go country by country and then market by market in a more organized manner than the brainstorm obviously.

but the fund is a global macro hedge fund so i'd like to come up w/ 3-5 solid ideas that are uncorrelated and possibly 10 or more that are worth digging into . they can be everywhere in any market all over the globe.

that is the beauty of global macro [img]/images/graemlins/smile.gif[/img]

thanks for your cents though!

Barron

[kimchi]

I'm afraid I don't have anything to add as don't tend to consider the fundamentals when looking for trades.

I'm just wondering how this fits into your ideas of efficient markets. I don't understand how you can find trades if the markets are efficient.

I'm also interested in how you manage these positions if you were to take them. I know you're interested in the research/analysis side of things, but if you were given trade ideas to execute, how would you manage your risk and positions?

[DcifrThs]

[ QUOTE ]
I'm afraid I don't have anything to add as don't tend to consider the fundamentals when looking for trades.

I'm just wondering how this fits into your ideas of efficient markets. I don't understand how you can find trades if the markets are efficient.

I'm also interested in how you manage these positions if you were to take them. I know you're interested in the research/analysis side of things, but if you were given trade ideas to execute, how would you manage your risk and positions?

[/ QUOTE ]

first point: i don't think markets are sufficiently efficient and i've divered my attention from my discussion w/ phonebooth to this. when ig et more time i'll go back and continue that discussion.

second point: i take one thing at a time. lets say i condense all that down into 3 trades:

1) maltese lira vs. euro
2) short US 2yr long US10yr (yield curve flattens)
3) long JPY/USD

i'd imagine that my entire portfolio was allocated to these 3 positions and plug in some vol & correlation #s. i'd expect 1 to be uncorrelated with 2 and 3 but i'd think that there may be some correlation between the yen strengthening and the yield curve flattening. namely, if the US 2yr yield falls (long the 2 yr), then the Yen should strengthen so if i get that leg of the trade right, the yen should strengthen vs. the dollar since interest rate diffs accound for the plurality of currency returns. so i'd be conservative and plug in a 50% correlation.

then i'd look at the volatility of these positions over time (or simlar positions in the case of maltese lira vs. euro). currently i don't have the data to dig into this but i'm just taking you through how i'd go about it.

from there i'd assign a maximum % of the portfolio that each bet could take on assuming it has a 100% absolute value signal. that takes into account correlations and volatilities. this is done so that i can hit a target dollar volatility very easily relatively speaking by adjusting the overall capital in the portfolio.

then i'd look at my signal. how confident am i in each of these bets. if 1=50%, 2=20%, 3=80% i'd want to allocate my portfolio accordingly.

then you simply divide the capital according to the max allocation and multiply by the signal you have. so if i had $100 and if each bet was at a max signal it would be:

1) takes up 40%
2) takes up 30%
3) takes up 30%

and my signals were:

1) 50%
2) 20%
3) 80%

then my capital allocated to each position would be:

1) $20
2) $6
3) $24

in reality that is much trickier because for each bet you have to know exactly what you're taking on...and there are costs to taking on these bets... and some are more costly than others, AND most annoyingly, the market doesn't give you a $6 jpy/usd futures contract lol.

further, the short 2yr/long 10yr bet can't just be put on as 1 unit short the 2yr 1 unit short the 10yr. you have to adjust for duration. if the 2yr has about a 1.5 year duration and 10yr has a 7.5 year duration then your position must be long 7.5/1.5 units of the 2yr for every 1 short unit of the 10yr you take on. otherwise, you'd have an odd bet that doesn't match what you want to take on in terms of yield curve exposure. if you just did 1 unit short 2 yr 1 unit long 10yr, the bet would be weighted 7.5/1.5 times more towards the 10yr than the 2yr since the 10yr has that many more times the duration.

similarly, you have to match the volatilities for the diffbets of anything you do (i.e. if you had a diff bet short JGBs vs. long Gilts...japanese rates rise relative to UK rates...then you have to adjust the bet size so that you end up with a balanced position...the JGB is far more volatile than the Gilt). i used 2 simple examples (1and 3) and one semi complex example (2) to show that a lot goes into managing these bets.

anyways, i hope this answers your questions.

i also hope i haven't made any silly mistakes, though taht is possible since my brain is fried at the moment.

using matlab can be a pain in the freaking ass when you have nested loops of crap and you forget a semicolon and the program blows up [img]/images/graemlins/frown.gif[/img]

Barron

[ahnuld]

Id stay away from the ukranian oil trade you were talking about. Putin freaks me out and id try to stay away from that entire region right now as russia is really not a good place to be investing. It will get worse when Putin's term ends and he reveals how he plans to stay in power.

[DcifrThs]

ok well hows this: lets start with America and CHina.

right now, the latest figures from china have had higher than expected inflation (mostly from food though) coupled with blistering growth > 11% in the second quarter.

China imports goods from south east asian nations (SEANs) and exports them to the US/EUR/UK/Japan. further, china imports a good amount from Japan. where can i get data on these? world bank? IMF? chinese current account broken down by goods/services/remittances by country?

china also imports a ton of commodities and will likely continue to grow at a very fast pace of at least 8% for the next few years.

a few things that are negatives in china:

1) stock market bubble: share prices up by 400% in over 2 years and average p/e ratios backward looking at 50. this isn't a huge problem though because even if it does fall, the total value of tradable shares (not held by govt) is only 35% of gdp vs. 180% of gdp in america. further 80% ofchina's urban households own their own home. so debt isn't a big part of the chinese culture

2) some data i could find show that china's exports to the US increased by 14% vs. 40% to the EU. it is estimated by the owrld bank that if US consujmption falls by 1% of GDP, that oculd knock off .2-.5 percentage points off china's GDP. but even if us consumption falls by more, the chinese economy NEEDS to slow down. further, that might help to reduce their trade surplus and alleviate some political pressue from the US>

3) unit labor costs were possibly under threat as average wages rose by 15% ina year in china. the good news here though is that productivity rose even faster so there are still declining unit labor costs in china that could help fuel demand for china's cheap exports.

further, china's banks are in better shape now than they have been previously (non perfomring loans down to 7% from 30% in 2001).

investment in china is HUUGE (45% of GDP and growing by 25%...thoguh this includes land purchases as investments which really aren't)...but corporate profits are still growing meaning that the artificially low cost of capital hasn't sparked overinvestment yet. (we'd expect to see falling profits if investments wree growing too fast).

china is also protected from crisis by the massive FX reserves.
___________________________

now onto the US:

this last week showed some good and not so great data.

- strong employment report (relative to losing 4k jobs) of 110k vs. 115k expected jobs added. increase in m/m wages of .4% vs. .3% expected.

- expanding manufacturing (ISM manufacturing and non manufacturing surveys were good. former below slightly at 52.00 and the latter above expectations at 54.8)

- consumer credit expanded by over 12.5billion vs. about 9billion expected

- motor vehicle sales came in at expectations 12.4m

- for both july and august, personal income and consumer expenditures came in at or above expectations

- construction spending came in at .5% growth vs. -.2% expected fall in august. but overall this area seems weak in terms of the US economy.

- consumer sentiment came in at 83.4 vs. 84.3 so slightly below. but overall given the turbulence in august, this is promising. september's number is obviously important as well.

- corporate profits are still very very high (4.3% latest growth rate). near 40 year highs in real terms.

- durable goods orders fell in august by 1%point more than expected but that follows a very large gain in july of 5.9% vs. 1.0% expected.

- inflation is within the fed's range (even urban CPI) though pressures remain given the weak dollar (larger import prices...but that is balanced by fewer imports) high capacity utilization (82.2%) strong production growth (.2% vs. .3% expected)and a very tight labor market which might loosen up slightly given the layoffs expected in the near future. highly unlikly though that wage pressures will ease any time soon.

- current account was at -190billion last reading, better slightly than the 195 and 200 in the previous 2 quarters.

- business inventories continued to rise by .5% / month in september

- nonfarm productivity rose by 2.6% while unit labor costs still rose by 1.4%

so overall, we still have a fairly strong economy given the occurrances of the recent past.

however, it is important to note that the new data coming out this week and this month/next month will be hugely important interms of determining where we are likely to go.

it might be the case now that 2 year yields at 4.15% are a bit too low in the short term. this bond reflects expectations of interest rates in 2years. if growth comes in strong w/o easing inflation pressure, this could move up to 4.25-4.4%.

similarly, the 10 year yield is right now at 4.65% or so and may be underestimated given the amount of possible inflation in the next 10 years (higher BEI than we've seen in a while, but as i mentioned int he first bullet in the first post, that could be either too high or still too low depending).





ok folks, so there are some more data and thoughts, feel free to chime in [img]/images/graemlins/smile.gif[/img]

thanks,
Barron

[DcifrThs]

this process has been going verrrrrry slowly for a few reasons, the main one is the pain in the ass getting even monthly data.

despite the problems, i've accumulated some very good data from 1960 and now have built a respectable (nonupdated unfortunately) database fromw hich to make pretty pictures to go along w/ my anaylsis.

be that as it may, i wanted to throw out the main positions i'm looking at now and hoepfully get some feedback.

1) long EM credit default swaps. these have fallen (i.e. spreads jumped) recently as more negative news from the US comes in. i think this is overdone since many of the major EM countries in the index depend far more on china/euro area than the US

2) long ~10yr BEI. this one is one of my highest conviction and most thought out trades. it is long 10yr TIPS short 10yr nominal bonds (duration adjusted obviously). the rational is as follows: right now, we are in a precarious economic position. growth is at risk and capacity pressures/still relatively tight (but easing slightly) labor market, high commodity prices, and a weak (and likely weakening) dollar are all contributing to an inflationary environment. the break even inflation rate though hasn't adjusted significantly. it should and it isn't. it apparantly seems to adjust more in retrospect and thus appears to be not a great predictor of future (or expected) inflation. i.e. during the last 3 years, the BEI rate adjusted more in retrospect and didn't even predict the moderate inflation we saw until it already happened.

a rate cut now will only stoke inflationary fires and thus push the 10yr nominal yield even higher and increase demand for inflation protected securities.

further, the fed has shown a high bias for low rates and is likely to cut even when not 100% necessary to hold up growth since inflation expectations appear to be anchored (i.e. the 50bp cut in sept. and the previously low rate era etc.). this is a risk as the faith in the fed's ability/will to control inflation will be tested when the economy slows AND inflation pressures persist.

add to that the liquidity premium (not liquid TIPS vs. very liquid 10yr) which perenially depresses TIPS yields and this position looks highly attractive. this is a longer term position though since, as noted, the BEI rate won't likely adjust immediately.

3) long 2yr, short 10yr. right now, as stated above, a rate cut is likely to push up yields for the 10yr (more inflationary expectations) while obviously pushing down yields for the 2yr. this isn't priced in sufficiently at this point.

4) short USD vs. JPY, Yuan, and asian emerging markets. this is a fairly straightforward trade. despite global imbalances starting to correct themselves, the falling off of demand for US treasuries by these countries combined with their ever growing CA surpluses and US interest rate direction spell tough times for the dollar vs. these countries (while the dollar might even be overpriced vs. the EURO at this piont)

5) on a similar note, the pound now looks expensive vs. the Yen and Yuan.

6) this one i'd wait until the short rates adjust after the coming likely fed cut (as noted the fed apparantly likes lower rates). i'd bet that after the coming rate cut, UK rates and US rates will converge. the UK economy is showing weakening signs and the housign bubble there will likely eventually put some downward pressure on growth as well (though not as much as in the US). so i'd go long UK short rates and short US short rates (1-2yrs) and use that diff bet to capture the narrowing of the interest rate diff. this could also be a signal for going long the USD/GBP as that might be a bit expensive after the coming fed cut.

7) finally, i think that the gumming up of the credit markets is likely to come to a halt in 3-6 months. but i think it will improve in the coming weeks/month so i'd start putting on a euribor spread narrowing bet. i'd go long 3mo euribor futures 1mo out and short 1mo euribor futures 1 mo out.

i'd love to hear some feedback or questions on these 7 bets that i'm writing up right now so let's hear it.

thanks,
Barron

[CrushinFelt]

[ QUOTE ]

3) long 2yr, short 10yr. right now, as stated above, a rate cut is likely to push up yields for the 10yr (more inflationary expectations) while obviously pushing down yields for the 2yr. this isn't priced in sufficiently at this point.


[/ QUOTE ]

You're already missed some HUGE movement in the 2 yr. Though, I do like anything that deals with the steepening of the yield curve.

[ QUOTE ]

4) short USD vs. JPY, Yuan, and asian emerging markets. this is a fairly straightforward trade. despite global imbalances starting to correct themselves, the falling off of demand for US treasuries by these countries combined with their ever growing CA surpluses and US interest rate direction spell tough times for the dollar vs. these countries (while the dollar might even be overpriced vs. the EURO at this piont)

5) on a similar note, the pound now looks expensive vs. the Yen and Yuan.


[/ QUOTE ]

Agree with both. See John Kane's Leverage thread.

I'd like to comment on #2 but I'm not familiar with those products.

I feel like this is an awesome time to be investing and really envy John for putting some $ to use and you (assuming you go through with some of these ;p). I don't have the capital yet to do anything other than feed my Roth and make a few option and/or bond plays.

[spider]

Well, I really have no opinion in terms of pro/con, you are getting into some pretty hairy stuff. But I would mention a couple of things to keep in mind wrt the Fed:

1) Bernanke establishing reputation as inflation fighter -- You always hear that the new guy at the Fed needs to prove to the markets that he is serious about inflation early on so he'll be credible down the road. To the extent this is true, the Fed might exhibit a short term bias for a higher fed funds rate than otherwise. I think this is pretty plausible although I'm not sure if there is any real evidence of this. Also, Bernanke came into the job w/ a strong reputation as an inflation fighter so he probably has less need to establish the reputation than, say, Greenspan when he first took over.

2) Liquidity -- I don't really know what is going on wrt to these SIVs, CDOs, etc. Which is not surprising or significant. But I'm also not sure ANYONE knows what is going on here and that is a little scary. Wrt the Fed, it makes it harder to predict how they will act in the future since they might be considering a lot more than the usual inflation/growth tradeoff. For example, some have said the Fed needs to cut not so much to stimulate growth, but to increase liquidity.


Bottom line: Good chance to kill or be killed if making financial bets in the near term.