The Macro Trading Floor transcript – 13 December 2024

Alf (00:00.96)

Buon giorno everyone. Welcome back to The Macro Trading Floor. Alf speaking, my good friend Brent with me. How’s life?

Brent (00:07.512)

Hey Alfonso, it’s beginning to look a lot like Christmas around here, so things are pretty good.

Alf (00:13.066)

Well, for people who can’t watch me, I’m wearing a t-shirt that says, “no prob-llama”. If you are on YouTube instead, you might have a laugh out of it. I was reflecting with Brent before clicking record that people in this industry, they take themselves very seriously, I would say. And I hope Brent and I do actually the opposite.

Brent (00:31.95)

Actually, you know what, speaking of comedy in financial markets, there’s an amazing article in FT, I’ll put it in the show notes, one of the funniest articles I’ve read in finance in a long time about the year-end outlooks and how there’s just like literally hundreds of these year-end outlooks and the lack of information content. It’s a great article anyways, I’ll put it in.

Alf (00:53.932)

So there was an investor that asked me what about my investment outlook for 2025. So he allocates into the hedge fund and I said, what do you mean with outlook of 2025? I mean, we have Trump with the tweet, he can change anything next week. So I’m not gonna give you any outlook for 2025. And he said, great, that was a trick question. Excellent. So anybody that gives you an outlook of 2025, probably you can ignore, I would say.

Brent (01:19.276)

Yeah, it’s more marketing, I guess, than functional. And that’s a good segue actually into what we’re probably going to talk about today because it’s getting very interesting as we get closer to January 20th. And we still don’t really know what the policies are going to look like. We know the outlines of a plan or whatever, what are you thinking now for, let’s say, the outlook for the first two months of the year? Let’s be more realistic.

Alf (01:45.068)

You’re trying to pin me down now. So I would say that when it comes to the US, I had a fun conversation with two clients this week and they both came with two different angles, both of them completely valid narratives. So I’m to put them through for a second and then I’ll tell you what I think. Curious to hear your thoughts as well.

So the first was nobody remembers the first six months of the presidency. And therefore Trump will sacrifice growth and it will come in hard and it will pressure Europe and Canada and China and everyone. And because his ultimate game is to also pressure Powell to lower rates. So by weakening the economy, then Powell will have to say, crap, I need to cut rates. And then Bessent comes in and refinances debt at cheaper rates. I mean, all seems to kinda make sense. And then at some point Trump can claim a win.

And then he can basically soften the stance and the economy will recover because of lower rates. And so this was case A. And in option A, then the trades there would be that you have to buy the dollar because Trump comes in very aggressive on tariffs and that the Fed is going to cut rates. And maybe you have to sell some stocks as well, because this combination isn’t great, really. Tariffs, low growth. So you know, this was the first.

And then another client said, no, no, no, what are you talking about? I mean, Trump is pro-growth, he’s never gonna sacrifice growth. He wants stonks to the moon. And so it’s gonna be all deregulation. And the way he’s gonna convince Powell of cutting rates is via disinflation. So there’s gonna be a lot of policies about capping oil prices and not be very harsh on tariffs.

And first get Powell to cut rates gently, stonks to the moon, refinancing done of the Treasury 7 trillion maturities. And after that, he will kick in with tariffs. And so the trade is just the opposite: buy equities, sell the dollar. So, okay, that’s case A, case B, both completely valid. Question to you now, what do you prefer?

Brent (03:44.374)

So I guess that kind of does reveal the binary nature of this whole thing, but I think those two views both overestimate the power of the president of the US to control all the markets. It sounds a little bit more like Xi than the United States to me. So I’m much more with number one.

I think that Trump’s regret on doing Obamacare and other kind of useless things that didn’t really work out in 2017 is reflected in his picks, right? I mean, he’s picked the most hawkish, aggressive people. And so to me, I like scenario one a lot better, which is come in, and I think just slapping on the 60 % tariff on China or 25 on Canada and Mexico on day one seems very unrealistic. Like think there’s enough voice of reason, say from Bessent and from Musk saying, can’t just do that and expect the economy to function.

So I think… more realistic would be some kind of smaller tariff on day one, say 10 % across the board, and with the threat to increase them. And then three months later or six months later when it’s set to go to cataclysmic levels, magically some kind of agreement will be made and Trudeau will say, we’re adding 10,000 border guards and we’re gonna you know, look at the flights that are bringing terrorists across the border or all that kind of whatever, whatever they end up deciding. And then Trump can slowly pull back and things kind of stabilized.

So to me, I think there’s going to be a lot of angst in Q1, dollar much higher and probably stocks lower, honestly. Like I know that’s like a stupid thing to say when stocks go up every single day, but the reality is they don’t obviously, right? I mean, it’s maybe 60 or 70 % of quarters stocks go up. They don’t go up every single quarter. So I would be betting on, and I am betting on a stronger dollar. And the really interesting thing about it is that I feel like it’s one or the other. Like wherever Eurodollar or Dollar Canada is now, it’s just not gonna be here in February or March.

It’s either gonna be, know, DollarCAD is gonna be 300 points lower or 500 points higher. Or it’s going to go up and then they cancel the tariffs as it goes down. either way, the way the volatility and spot are priced right now, I feel like we’re in this sort of, it’s a disequilibrium essentially. Like it’s a binary disequilibrium where either the tariffs happen or they don’t. But because they’re kind of partially priced in, you’re going to see a big reaction from markets either way.

Alf (06:30.476)

For me, the most innocent part of your comment was that you put Musk and voice of reason into the same sentence. And I know it’s very early over there in the US, but that was interesting. Just kidding, just kidding.

So, okay, let’s try to analyze a bit your perspective here. So, I mean, one thing I have to agree on is that if you look at the volatility that has been priced in certain FX markets, it’s really, really low. On Canada, we talked already a while ago and regardless of these threats coming closer, potential threats coming closer, it doesn’t seem like FX trades are very scared of potential jumps in there. And that’s something that like if you work for a hedge fund or you have a mandate in options, I think in FX there is quite a lot of interesting things to do.

For example, the vol is much more priced and appreciated in bond markets, for instance, than it is in FX. And when it comes to the equity market, I mean, the case, so if you go around and you say you wanna buy some puts or be a bit more bearish, people are gonna laugh you out of the room, which is a good setup. I like when people want to laugh people out of the room because it means the consensus is very, very strong. I think there are a couple of charts going around on stocks, Brent, that show that the confidence that investors have that stocks are gonna go up next year is very high.

Now you said something right, stocks do go up most of the time. So it makes sense to expect that they go up or in statistical terms, if you want to sound fancy, you can say the distribution of returns has a positive drift. You can save this for your manager, know, go there next week. It’s going to work. But the interesting thing is if you look at downside protection in equity markets and you try to compare put prices and to do that you have to find environments where the volatility was more or less the same in terms of realized, you have to find levels where interest rates were the same so all the components that go into option pricing were more or less the same as today. Because that’s the only way to standardize really the cost of options over time.

If you do that you will see there are a couple of episodes when this was the case for example 2006 and 2007 realized vol was very low, interest rates were roughly where they are today. So you can compare and will see that the cost of downside protection is pretty much as low as it was in early 2007. Now, caveat, last caveat, low cost of protection doesn’t mean you will make money by buying ports, it just means that from an expected value perspective, you could think about buying some protection.

Brent (09:08.398)

Yeah, you know what’s interesting is today’s Friday the 13th, so I was obsessing over the number 13 for some reason. And I was looking at, so a lot of times when people look at the VIX, they’ll see it at 12 or 13 and be like, this is unsustainable, Minsky moment, stability breeds instability and all that. And actually the VIX, the most common handle for the VIX to close on is 13. So like 9 % of all days since 1990 the VIX is closed on a 13 handle. And 82 % of all days the VIX has been below 25. So normally like low kind of stable vol is the standard and then everything else is an aberration.

But to your point, just something that popped into my head about drift, I think that’s the central reason why commodities are just always a way more difficult trade than stocks. Because innovation and technology are bullish for stocks and bearish for commodities. The extraction of commodities becomes more and more efficient with shale, for example, being an important technology. And so there’s a negative drift to me in commodities, which is why Malthus and all those people that bet on higher commodities in the long run have always been wrong.

So I think that’s an interesting aspect of the commodities thing because people always look at like stocks versus commodities and go like wow this thing this thing’s been going down for a zillion years. Well, the reason it’s going down is because stocks have positive drift and commodities have negative drift.

Alf (10:43.436)

Yeah, and let’s specify why. I mean, it’s not like an axiom. It’s like an undeniable truth. But there are reasons why that is the case. I mean, stocks have a positive drift because believe it or not, stocks go up over the long run, reflecting earnings growth. So, wow, companies make money and therefore stocks go up. And I know that in a certain year, 90 % of the vol of or the upside performance of stock markets can be valuation adjustments or buybacks or whatever you want. But over the long run, stocks have positive drift because they have earnings growth behind them, right?

And for commodities, you can say the opposite, right? Because basically we produce new commodities basically every year. So every year we increase the supply of these commodities. They don’t have cash flows behind them. They are commodities, right? And so actually they tend to have a negative drift.

Now, the interesting thing is that when you look at the expected value of a trade, the mean or the drift of the distribution is not the only thing that matters. You have to look at the entire distribution. So commodities tend to have a positive right tail. So in periods of inflation, tend to perform really well, for example, right? Great portfolio diversification properties as well. Stocks have the exact same problem. They have a deep negative tail from time to time. You’ll go down 30, 40 and 50%. So that’s the nature of…

Brent (11:56.824)

That’s super interesting. So you’re actually being compensated in commodities because you have positive convexity on supply shocks, I guess. Yeah. Yeah.

Alf (12:04.564)

And inflation. So when you look at like portfolio allocation, right, you will have some… why stocks are the cornerstone of portfolio allocation is because they have positive drift, right? And so people like to have certain expectations of positive returns over time. Problem is that you also buy negative tails through stocks, right? I mean, if you were in the 60s or in the 40s, you went down like 40%, 50% on stocks, right? And so you don’t want that you want diversification. And commodities will give you negative drift, but they will give you that inflation hedge in case inflation picks up and they act as a portfolio diversifier.

There is no right or wrong when you look at assets. There is just expected value in that specific moment. Like when you buy commodities, you need to expect that there is going to be an inflation surprise and pretty anytime soon or otherwise you’re bound to lose money. That’s the nature of it. With stocks, it’s the opposite Brent. You can go years with not much happening and stocks love not much happening. That’s perfect because macro is, you know, not volatile and you keep making money. They’re just two different assets.

Brent (13:03.564)

Right. And I guess good commodities traders identify supply shocks or things like in uranium, for example. You know, that trade worked well because there wasn’t enough supply. So maybe that’s going to happen in other commodities. But anyways, that was a whole non sequitur. That was interesting. We weren’t even planning on talking about that.

But one thing going back to the complacency on the dollar is there should be, in my opinion, a big premium on options that trade after inauguration. Because the tweets obviously are moving markets to some extent, but they’re still kind of like subject to any change. They’re not policy, they’re just tweets. And sure they may be bargaining chips and they give you some insight into what the policy will be. But ultimately January 20th is when you know there’s a binary kind of switch from like bullshit to actual policy being executed.

And some of the policies can be executed on day one, for example, tariffs. So there should be a premium on options that expire after January 20th in FX, and there really isn’t. Like, if you look at one month, which expires before, and three month, there’s barely even a spread compared to what’s normal. So I bring that up not to tell people to sell one month and buy three month, but just to indicate that there’s really not very much priced in for some kind of chaotic moment in January or February of 2025.

I mean, honestly, I think there should be a lot priced in because either the dollar is going to rip or it’s going to sell off like crazy. In 2017, the dollar had rallied similar to now and then Trump didn’t do anything in 2017. So the dollar cratered because expectations weren’t met. either the expectations are going to be met or they’re not. And either way, there’s going to be a big move.

Alf (14:58.592)

Yep. So in general, optionality is not something you pay a lot for. And as an old sage once said, it’s better to buy an umbrella when the sun is shining, not when it’s raining. That would be a bit too late. Talking about optionality and interesting things going on, we have our friend from Switzerland and Europe that seem to be going back to their old days. And Switzerland specifically, because they’re slashing rates so fast that the zero lower bound, well, lower bound, it’s never been a lower bound for Switzerland, but the zero interest rate environment is very close to happening again.

And Europe also, they’re planning to slash rates by another 100 basis points over the next four meetings. That’s gonna bring interest rates below 2%. It’s not zero, but it’s going fast back to what used to be a low rate environment in the European continent. So any comments, Brent? We can just go back and try to, once I was asked to measure how many 50 euro bills, could be stored in a vault to avoid…

Brent (16:00.36)

I remember that. Yeah, yeah. When rates were negative, people were like, well, I’ll just put a billion dollars in a higher bunch of security guards and the security guards will cost less than the interest that I’m receiving by whatever. Anyways, negative rates are insane. But yeah, it’s really interesting with Switzerland because they’re starting to fall back into that thing that Japan was in for a long time where you have very low inflation or deflation. You have very low rates, and you have a strong currency. And no credible defense or no credible weapons really to break that cycle.

That’s the problem that Switzerland has. It’s just mind blowing that the carry on Swiss right now. if you buy Dollar Swiss and it goes down 300 points over one year, you actually break even because of the carry. Like it’s, and Dollar Swiss doesn’t move that much. So the carry is amazing, but the problem is there’s just that sucking sound of like the SNB has no credibility, right? They intervened in Euro Swiss starting from 1.49 and we’re at 0.93 now.

And so in the end, like for the yen, what broke it was Abenomics and that was a completely different set of policies. So the Swiss thing is super interesting. I think there’s a lot of interesting trades to do on the carry side, but I’m not like all that excited about being short Swiss simply because of the carry. Because a lot of times it’s been, mean, Swiss has been a trap for what, since, I remember 2009 was when they were intervening, you know, so whatever that is, 15 years they’ve been intervening and it’s been going up. So you need something to break that. I’m not sure what it is.

Alf (17:46.218)

Some war stories on Switzerland. I have a friend who lives in Poland. And Poland, whether you know it or not, they looked at this Switzerland thing and they said, what? They have rates at zero rates and negative? Now we’re to do something cool. Polish banks are going to offer to Polish citizens mortgages in Swiss francs.

Now try to figure this out. So you’re in Poland, a country which is growing really fast, like 7-8 % nominal growth. You’re used to have nominal rates at like 5-6 % in Poland. All of a sudden somebody comes and says, hey buddy, do you want to buy a house in Warsaw and I’m going to give you a mortgage in Swiss Franc at like 1.5 %? You’re like, sure, mine.

And so what happened is that there were quite some mortgages issued in Swiss Franc and a few years later, the Swiss franc had rallied aggressively against the Polish zloty despite the carry, despite the interest rate differential Brent. It’s basically like you said, right? I mean, these guys keep having a strengthening currency, the Swiss franc, and they can’t stop it. There is no way that they can stop it. It’s just like a sucking sound.

So what happened is that all these households figured out that the mortgages they had at 2 % actually were not that good after accounting for the fact that the Swiss franc was appreciating like 10% a year versus the Polish zloty. And it actually caused quite an imbalance in the economy and central banks and policymakers had to intervene.

So there is quite something that, know, betting against Switzerland and only looking at carry is quite difficult. They accumulated one trillion dollars of reserves over time. I mean, they just keep buying all they can, euro assets, dollar assets. They own Nasdaq. They buy everything they can and they sell Swiss francs for it, of course. They still can’t weaken the currency.

Brent (19:33.08)

Yeah, and those structural short positions are interesting. Like for a long time, emerging markets were always short dollars. I mean, they still are obviously. But there used to be times when was so short dollars that if some kind of shit hit the fan, the dollar just absolutely exploded against every currency because they were all structurally short via debt. And those things can be, same with the yen carry trade, those things can be monstrous.

And then, the interesting thing too is so like your ECB terminal, think is like what terminal pricing or implied pricing is 1.7 or something like that, I think. Or even RBA is starting to get sound a little bit more dovish. And then you look at that in contrast to what’s going on with the Fed. And I think a few times we’ve been here where like Fed pricing is kind of slowed down and I think it was April or May of 2024. I think there were people were talking about maybe Fed might hike and stuff. And those trades have always been a fade.

But I’m starting to wonder now with inflation so sticky on a lot of measures like on core, especially all the core measures and wages and everything are still around 3, 4%, whether we might get, and I know this is a scenario you’ve talked about for ages… a repeat of 1995 where you got three cuts in ‘95 and then on hold for all of ‘96. I think it should be on the bingo card that Fed does nothing in 2025, but do you think that’s possible or do you think there’s still definitely gonna be cuts?

Alf (21:10.614)

So as I try to mumble something that makes sense, I’m gonna try as well to open my probability pricer thing because I’ll…

Brent (21:20.486)

Oh yeah, I wanted to know what the probability of that is actually. The CME Fedwatch thing does like a rough calculation, but I don’t even know what they’re using for that honestly.

Alf (21:23.372)

Let’s take a look. Yes. Let me fire it up. So, OK, let’s see. What do you want to know that the Fed’s going to be on hold in 2025?

Brent (21:35.854)

So I want to bet, bet on hold, what’s my payout, I guess would be my question.

Alf (21:45.13)

Hope that I don’t blow up the computer by doing that. So, okay, there you go. So Fed on hold, it means that they cut in December though, right? So they have to go back, they will have to go to like, was it 4% if they cut in December or 4.25? I think it’s four, I think it’s four.

Yeah, okay, so next year, odds that they’re gonna be on hold is, whoa, that’s actually not that low. Whoa, it’s like something around 35%, as we speak. So that’s not that low.

I mean, to consider this a one out of three scenario is not an aberration, would say, Brent, right? I mean, it’s totally fine to assume that there is a 33 % chance that they don’t do anything. At the end of the day, if you look at the absolute number of cuts on the screen, right, not at distribution, but just at the cuts themselves, then for next year, you have something like probably I think two, two and a half cuts as the modal outcome. Let’s see. You have about, wow, 50 basis point only mate, like two cuts. That’s all you have. So that’s like the mean of the distribution. So it makes sense that zero cuts is like 30 % or something. Yeah.

Brent (23:03.31)

Yeah, that sounds right. Okay. So the interesting thing is if you contrast that to what people actually think, I don’t think you would find that many people that think Fed’s on hold all year. But maybe it’s just because we’re used to the Fed moving a lot. I mean, obviously there’s been many years where they were on hold. So looking at inflation and looking at GDP, mean, even the jobs data, like it just all to me just looks like it’s back to ‘17 ’18.

And then I guess then the question just becomes where is neutral? You’re laughing.

Alf (23:38.828)

Good luck.

Brent (23:40.301)

Like, yeah, the thing with neutral is that I think essentially the real way, like you can look at all the models and all that and put 500 PhDs on it and you’ll get a bunch of different answers, which they do have. But I think the real way that the Fed identifies neutral is they compare where policy is to financial conditions over time. And as financial conditions remain loose with higher interest rates, then they raise their estimate of neutral.

So like, if you spend a year where financial conditions are loose and rates are here, well you go, well, shit, I guess neutral’s not two then. You know, like, I mean, it might be three and a half, but it’s not two, or it’s not two and a half. So I think that’s what’s happening now is if you look at what Bowman and other people at the Fed are saying, they’re like, eh, maybe neutral’s a little bit higher.

And it’s kind of a little bit of a circular situation because by the time they actually reprice neutral and you know, the long-term dot moves up, that’s probably the time where at that point you’ve actually waited so long that Fed funds actually is restrictive and then things crap out and then your estimate of neutral goes lower because it’s pro cyclical.

So I think the question is with so much uncertainty on neutral and then financial conditions still being very loose and the private sector being very strong in the US, how much can you really cut when you don’t know where neutral is?

Alf (25:07.402)

Yeah, I think I agree with you. The problem is that unfortunately, Brent, there is no skew in this trade anymore because once you price only two cuts for next year, I mean, sure, it can go to one cut because it’s hardly going to go to zero, simply because people are going to be willing to pay some premium, right, for cuts next year in case there is a worsening in the economy. So it can go to one cut, but that’s it, man. I mean, like, a lot of it is priced already.

The market thinks by looking at the shape of the curve as well, that the neutral in the US is around three and a half percent. And what I mean with the shape of the curve is that you can look at the steepness of the curve and basically understand where the market thinks neutral is. Because if the market brings rates pricing below this understanding of neutral, then the curve after that point is going to be steeper.

So the idea is, say neutral is three and a half. If the Fed cuts to 3.25, the curve then is going to steepen up after that in the assumption that cutting below neutral strengthens growth and inflation down the road. And right now that point seems to be around three and a half percent on the U.S. curve. And so the Fed dot, for long, how is it called, like long run potential, whatever they call it, neutral rate, basically, it’s still below three.

So one of the things I think they will do at the next meeting, Brent, is pump that up, I think above 3%. Now that basically means for the Federal Reserve that to come back to a neutral stance, they really have to cut a few times and that’s it. And they can take their sweet time. But again, we’re basically just repeating a narrative which is already prized. So that’s like, we sound like talking heads on CNBC, buddy. So we should maybe do something else.

Brent (26:41.944)

Well, the problem with neutral too is that I think it’s highly contingent on the distribution of liabilities in the economy. if the government is the primary liability holder, who cares? I mean, they can put Fed funds… say everyone’s refinanced at zero and the government has all the debt, like to the extreme, if Fed funds goes to 10%, the economy is not really gonna care. I think neutral is a lot more about where the liabilities are financed.

And so that’s why I think the US and Canada, for example, are so different because there was this massive deleveraging in the US in 07, 08, and now consumer balance sheets are great, whereas that deleveraging never happened in Canada. I mean, it never happened in a lot of countries. So I think that probably means that neutral is completely different in Canada than it is in the US, not just because it’s a different economy, but because people have massive debt there and they don’t in the US.

Alf (27:38.54)

Yes, looking at the shape of the curve in Canada, for example, I have it in front of me right now. So neutral in Canada is now assumed to be below 2 % Brent, which is wildly different to 3.5 % in the US. And I think it reflects fundamentals. You’re perfectly right. I mean, the US is living in a phase where effectively the government is taking on the baton of levering up the economy through their own balance sheet, right? Deficits and debt all over the place.

But the US private sector is allowed to de-leverage, which is really solid, right? I mean when you have less mortgages, less corporate refinancing, you have less pressure on the private sector, then does it make sense that neutral rates are higher? Yes, it does, right? The economy can sustain a bit higher yields in that case. Just circulated a piece this week that looks at all this balance of leverage in different economies and who’s using that generating the highest return on GDP, who can afford higher rates and who can’t.

In general, guys, if you’re listening to the podcast, you just can ping Brent or I on Bloomberg. If you have questions about whatever, something for Brent, something for me, just ping us. We don’t hold secrets. We’re going to talk to you. We don’t bite. I mean, at best, some Italian accent from my side your way, but that’s it. That’s how much I can harm you.

Brent (28:52.63)

And you know, one thing I was thinking about this with the leverage in Canada and the other countries and then the US sort of seems immune… is one thing I wonder is how much leverage there is though in financial markets in the US. Like if you look at the ratio of levered long ETFs versus levered short, it’s never been higher. You know, every single sentiment thing says everyone’s bullish.

So that makes me think that there’s a possibility of a correction in Q1 as well, just as like to take a little bit of the leverage out of the system. As opposed to the U.S. economy tanking, I could see equities correcting even in a world where the U.S. economy ends up being okay, just simply because it does feel like there’s a lot of leverage in the financial system, in crypto, in equities, in the US, that’s how it feels to me, as opposed to even though there’s no leverage in the actual real economy.

Alf (29:47.902)

Yeah, I think you’re perfectly right. There are some of these indicators of leverage in markets. But even if you look at things that are implicit leverage. So, for example, if you look at credit spreads, credit spreads are at the tightest level in 25 years, 25 years, but not only in the US, like if you take stuff like the spread between Italian govies and German govies, it’s like a hundred basis points. Guys, a hundred basis points is the same level at the top of QE, when the ECB was buying more bonds than the governments were issuing. Okay, so that’s the point where we went to 100 basis points and that’s where we are today.

Why do I say that credit spreads are implicit leverage? It’s because you’re looking at an asset where you cannot make more than the spread itself. You can only take the coupon zone and then there is a bit of mark to market change. If spreads tighten, you can get a little bit more of P &L your way, but the loss you’re exposed to in case something goes wrong, it’s huge.

So that’s a bit of the leverage is like the negative skew you’re taking on where you can make a bit of money, but you can lose a lot of it. And there are a lot of these trades going on Brent where people are sitting on the negative skew, which is a way of getting implicit leverage if you wish. Like you’re selling a lot of volatility away and if something blows up, it blows up for good. And there are a lot of these going on.

Brent (31:04.738)

Right, and any system that’s systematically selling options or selling leverage is getting worse and worse, you know, skew wise as well. So, I mean, that’s just something to watch for. I just feel like going into Q1 priced for perfection as, you know, people don’t want to sell now because of tax and all that, but there is a lot of risk to me in Q1. So I’m going to be a lot more cautious in Q1, but that doesn’t come for another 18 days.

Alf (31:33.228)

18 days in your trading style is like two glacial eras, yes, more or less. But okay, let’s just chat for a second more about leverage. I think we should. So if you’re a trader and you do have access to leverage, so you trade futures or options or whatever you do that has implicit or explicit leverage, is there any tips that you have for people when handling leverage?

Brent (31:58.734)

So I don’t think leverage is necessarily bad in general, but it is often how people get ruined. like I would say before any other consideration, eliminating risk of ruin or getting it very, very as close to zero as reasonably possible. And honestly, you should be eliminating it. It is the most important thing.

So that is rule number one. And you know, that’s what brought down Jesse Livermore and like a lot of famous traders is… No matter how good of a trader you are, the distribution of the P &L can be horrendous if you use too much leverage. So I think leverage is often employed by professionals and even by retail and it’s completely fine. It’s just do you have a way of managing the risk in the end?

So like if, you’re sitting there and your normal position is $10 million yen, but you see a great position where you can use a tight stop and be long 100 dollar yen, I mean, that’s perfectly reasonable as long as you can stop out of it, right? So I think the issue with leverage generally is that it creates positions that are too big to get out of at a reasonable price.

So if your process is I’m gonna risk 2 % of free capital on each trade or each day or whatever, and then you use leverage and then you can’t get out and you lose 9 % of your free capital, then that’s what leverage can do for you, but it can also give you better returns. And so I don’t know, I’m not down on leverage in general. I just think it’s part of a comprehensive risk management system, essentially.

Alf (33:39.052)

Absolutely. So I have two comments on there. The first has to do with trading with leverage. I think together with applying stops to any of your leverage trades, no exception, but in general would apply stops to any of your trades, even unlevered in a trading setup. The most important thing there is liquidity gaps because you’ve got to make sure that the stops can be executed at the level you want. Because if you apply leverage in an illiquid asset, then you’re in for a ride. And that’s when the problems kick in.

At the portfolio level, think people underestimate the power of leverage in terms of enhancing diversification. I mean, if you run a portfolio and you want to have all assets like stocks and commodities and bonds and FX, and you want to have all of them contributing equally to the risk of your portfolio, then I’m sorry to break it to you, but without leverage, that’s not possible because stocks or oil are way more volatile than gold or five-year bonds.

So leverage is then a way to basically equalize the volatility contribution of each of your assets in your portfolio, something known as risk parity as well. And that can be a great help to diversification of the portfolio as long as you use it properly. So nothing bad per se about leverage, it’s more about how you use it and what’s the mentality behind it. I mean do you understand that you’re levering up and you’re magnifying your gains and your losses? Because a few people tend to forget that.

Brent (35:00.524)

Right, and actually one more point on that. So the simple way to avoid the downside obviously is to do it through options. But one trap people can fall into is looking at the leverage of an option and saying, wow, like that thing pays eight to one, let me do that. But without actually looking at the expected value of like, it only happens once every 12 times or whatever. So anyways, I think we’re getting towards the end here. Is there any other, anything else you wanna throw in?

Alf (35:25.788)

No, not really, just again, if you’re not watching on YouTube but you’re listening to this show, you should know you can also watch it on YouTube with charts and all. And remember to take yourself not too seriously, to keep learning every day, and you can read it on my shirt. No prob-llama, just relax. That was it for today, guess, Brent. We talk next week.

Brent (35:46.84)

All right, thanks. Thanks, everybody. All right, ciao.

Alf (35:48.46)

Ciao guys.