How do you beat the zero sum game?  You can’t change the fact that trading is a negative sum game with transactions costs.  The expected value of the overall global game is always going to be zero, relative to the benchmark.  But can you create a situation where the expected value of your local trading is positive?  The answer is “yes” – in several ways.  

When people trade, they are fixated on looking for that big “up” or “down” trade.  That really only happens a few times a year, if they are lucky.  And they may need to get lucky again to be on the right side of those trades.  What they should spend a little more time looking at is how they are going to make money the 80+% of the time when the markets are “doing nothing” or when they don’t have a strong view.  That’s where consistent profitability comes from.  Strangely, very few people discuss it.

Consider the following extreme example.  Remember when we looked at trading equities, I said the benchmark of that game was not zero (as it is with futures trading), but the performance of the market as a whole?  Say historically equities are up 8% a year and you expect that to continue.  If your entire futures book was made up of S&P futures, your local baseline performance would be the return on the S&P and not zero (as it would be for futures trading under normal circumstances).  In this example, you just went from a baseline zero percent expected return to a baseline 8% expected return.  You turned the zero sum game into a positive game.  I am certainly not advocating buying S&P futures – as that may be a terrible trade.  But I just wanted to highlight the importance of having positive “carry” in your book.  The carry of an asset is the return obtained from just holding it.  

Having a book of smart carry carry trades makes sense.  What do I mean by “smart carry”?  Perhaps this is best explained by an example of a “not-so-smart carry” trade.  With STIR futures, there is no “carry” per se.  What we look at is “roll” – where the trade would be if “nothing” happened for three months.  Say you buy EDZ6 @ 99.00 because if it keeps rolling down the curve to where EDU6 is (say 99.15), in three months you would make 15 basis points.  15bps in 3 months sounds pretty good!  Except if we sell off, you could lose even more.  I’m not saying to just go do trades just for the sake of carry.  What I am saying is to look for smart ways to have a positive carry component to your portfolio.  
[to be continued]