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]
