JAMIE MCDONALD: So speaking about what we were saying before, managing the amount of capital that you can lose in any given moment, right? Isn't options quite a good way of doing that as long as you're always buying options?
ROGER HIRST: Yeah. I mean, I've always thought so as in the great thing about options is that you can use them in combination with inflection points. And what's great about options is that the options market will always price an event, and they'll always overpriced an event, geopolitical or whatever, but an actual line on the chart-- which is a line on a chart and no more-- but actually everybody follows in the real world as it were. That's not normally priced by an option.
And the example I used before recently was the one on gold. And that was the one where you had the level back in 2013. Clear support. It had failed once and so I was a bit nervous about suggesting it to clients again on an outright basis just being short. But volatility was also very, very low, it was the historically lowest level of gold volatility, options volatility, that we'd seen.
So this is a combination of there's a set-up that was building technically. There was a macro story behind it. There's a little bit of reticence because I tried it a few months earlier and failed miserably. But the options market allowed us to put the position, suggest the position, put the position on, knowing that if it didn't work you knew what you were going to lose. If it did work and you get this mispricing of these big inflection points, you often get these multiple X returns on your option.
And you pay a small amount of premium and then the actual underlying commodity, in this case gold, move quite significantly. And you got many, many times a return on your premium. So it's just a good way of being able to use options. I mean, not everyone wants to use them. There's a lot of complexity in them. But they can be great when you combine technicals with a nice little macro set-up.
JAMES HELLIWELL: Yeah, particularly if you have a view on volatility as well.
ROGER HIRST: Yeah.
JAMES HELLIWELL: You have an asset class just like--
ROGER HIRST: Well volatility, I mean, volatility is key for how you sort look at your portfolio and change it based on your overall positioning based on volatility increasing and decreasing I would assume.
JAMIE MCDONALD: When I was doing the long-short equity portfolio, there was really two major risk numbers that we looked at-- GMV, so ultimately how many millions of dollars you had--
ROGER HIRST: What's that? GMV?
JAMES HELLIWELL: Is that your gross?
JAMIE MCDONALD: Gross market value.
ROGER HIRST: Right.
JAMIE MCDONALD: So basically just the amount of exposure you have to markets in general. So if you had a $200 million portfolio, you would, roughly speaking, be long $100 million worth of stocks and short $100 million worth of stocks.
JAMES HELLIWELL: Totally with shorts and longs.
JAMIE MCDONALD: Exactly, totally with shorts and longs. Exactly. And then you had your NMV which really was beta adjusted. So the first thing that would happen was you take your stocks and you have some financial stocks like an HSBC where the beta is probably less than one. It's a very slow moving stock. And some really high-octane stuff, like particularly banks that were going through recapitalization. Very, very-- they moved very aggressively with the market.
So you beta adjust those and that gave you a different number because you may have had-- you may be long $2 million worth of bank A, but if it was a high beta stock it was really more like $4 million worth of exposure. So you needed to adjust for that.
And then this is where we were talking earlier about what are the different type of risk when you put on a trade. And you've got market risk, you've got sector risk, and then you've got company risk. Well the idea from what I was doing was how can I get rid of market risk, get rid of sector risk, and only have exposure to company risk and make money there.
Well, the way to do it was have a long book and a short book that were roughly matched. And basically once you beta adjusted your longs, take away the beta adjustment of your shorts, and what your left is-- call it like $10 million long-- divide by your total exposure, which is $200 million long, and then your 5% net long. And that was--
JAMES HELLIWELL: I think I need a drink.
ROGER HIRST: In English terms. In English terms.
[interposing voices]
JAMIE MCDONALD: Well, hang on a sec. Let me finish. So what I was saying was you got 5% net long. So roughly speaking, if the market goes up 1% you-- I don't want to say it, I want to get this right myself-- so if the market goes up 1%, your portfolio will naturally go up 5% of that. So five basis points effectively.
So if you were completely matched, and your NMV was zero, ideally whatever the market did wouldn't make a difference because you were just making alpha. So that was the bet.
JAMES HELLIWELL: So your bet was purely on.
JAMIE MCDONALD: So I was trying to be like, I want to net out everything except that this company is better than this company.
JAMES HELLIWELL: Is intrinsically better than that company.
ROGER HIRST: So in your better career as a retail investor for yourself, when you see volatility pick up, do you go, I'm going to take my risk down because volatility is going up? Or are you one of the people who goes, volatility is an option-- not an option-- volatility is an opportunity for me to make money. Because when you get volatility, you get the big moves like during the pandemic or during the Ukraine war. How do you approach that sort of volatility?
JAMIE MCDONALD: Well, that kind of volatility, the way I see it is because shorting the market, it's not an easy thing to do when your retail back home and you can obviously buy puts. But the best way to be short in the market, I think, is just to be in cash and wait.
JAMES HELLIWELL: I agree, That's always my philosophy.
JAMIE MCDONALD: That's basically, that's being short. So when it comes to high volatility, always make sure you've got some ammo left. And then use it to go long when you-- because the market will take down-- as you say, the market will take, when correlation goes to one, it will take down good companies and bad companies.
Now, if you know-- or good assets. I'm trying to speak about all the asset classes. But it'll take everything down together. Now that's your opportunity to put money to work on companies or assets you think are good, because the market has taken no prisoners and that's when you can make money and get really good entry.
JAMES HELLIWELL: Cash is valuable as a position because you have optionality when something's gone wrong. And also, the more you try and hedge and do derivs, try hedge your book, the additional layers of complexity you're adding. And I just say when things get out of kilter, everything goes to one in terms of correlation and always it can go wrong.
ROGER HIRST: And you should always have some cash on hand. I mean, if you put all your money including all your liquid assets into investments, and then something goes wrong and you need cash you're screwed. You've got to sell something. Which is where the problem-- this happens so often because that's when you have these liquidity crises.
So you suddenly sit there and you go, if you're fully invested, and the markets correlate to one on the downside and you've got four different assets within your portfolio correlating together in the wrong way, you've got to sell them if you need cash to pay your bills. So you've always got to have cash on hand.
But also goes to the other one of the major things when thinking about a portfolio is that liquidity is a major factor in everything that we should do with markets in terms of it can just disappear. And there's always said, liquidity is always there on the way in and on the way up. But it's never there when you want it on the way down.
JAMIE MCDONALD: Never when you need it.
JAMES HELLIWELL: That's true.
ROGER HIRST: Never there when you need it. So you've got to be prepared for that which is-- and there's a lot of different ways that can happen. I mean, you've had times when some exchanges have closed during the Ukraine war. Russia closed. So you might have been right by being short Russian stocks. Couldn't buy them back.
JAMIE MCDONALD: Yeah.
ROGER HIRST: And we've seen it in some of the exchanges, the metals exchanges, where they closed them for a number of days and you are now running, basically, you could be potentially running exposure.
JAMIE MCDONALD: Well, and here's another example about more of a lifestyle thing. But I know this seems like a very sad or pessimistic way of looking at it, but the best time to buy something is not when someone's selling something, it's when they have to sell something.
JAMES HELLIWELL: [inaudible] in the streets.
JAMIE MCDONALD: Because then they're pricing insensitive. And so let's say there's someone who's over, who's bought this amazing place in the south of France, you and he has to sell it because he needs the money for something else. And that's a great time to be buying that asset because he has to sell. And it's the same goes with asset classes.
JAMES HELLIWELL: But you want to buy a great company during a time of crisis because you often don't get a chance to buy--
[interposing voices]
ROGER HIRST: The other side of that the guy who wants to sell, you're assuming that you can buy the cheap price, which is great. But for him or her, there might actually not be a bid out there because the market might be closed. Now in property, there's no closed market. But if you are a listed asset--
JAMIE MCDONALD: What you're saying is actually, physically cannot get it.
[interposing voices]
Right. Right. Right.
ROGER HIRST: So at the moment I think there's only really things like Bitcoin, which is a sort of 24/7 market. Even most currencies have a quiet patch over weekends. The S&P is basically 24 hours a day with a few minutes off Monday, Tuesday, Wednesday, Thursday, Friday and then a little bit of the weekend. But there's very few continuous markets. [inaudible]
JAMIE MCDONALD: Is it the same options? Do they trade?
ROGER HIRST: Yeah. Options, now options are even worse. Options generally are very much listed products. In fact, they all are. You can do OTC, but they're going to have their listing.
JAMIE MCDONALD: Oh, yeah. Yeah.
ROGER HIRST: So you need a listed exchange, so you have to basically be beholden to that. And if something goes wrong, and your long or your short, and it closes and it's gone the wrong way, and what happens then is that you're long something, it goes a limit down. And that means you can't get out.
[interposing voices]
Limit goes down the next day, which means it's gone the maximum it can go down. So everyone has to factor these in and know that if something, part of your portfolio, went limit down, limit down, to zero, can you still walk away from it. It's Going to happen so rarely, but you have to factor that in.
JAMES HELLIWELL: [inaudible] commodities. The market can be limited up it seems.
ROGER HIRST: Was nickel went from $15,000 to $100,000 and they canceled it.
JAMES HELLIWELL: Yeah.
JAMIE MCDONALD: Yeah.
JAMES HELLIWELL: Exactly. That was incredible. And I'll see your point around options, risk and options, and raise it with the question of counterparty risk as well. If it's an over-the-counter option, say an FX option, for example, rather than an equity option, which tends to be listed, then you've got counterparty risk. And we saw what happened with that during the financial crisis.
ROGER HIRST: Yeah. Counterparties just disappeared and suddenly you're the person who you're supposed to collect from didn't exist. And there's another one which is similar to that which is more for derivatives but there's margin risk, which is the obvious one. Which is have a position on in futures or options.
JAMIE MCDONALD: Yeah.
ROGER HIRST: You pay the upfront margin, which is initial margin. That's your security for it. It's a bit like a deposit. But you also pay variation margin. So if it goes against you. you have to have the cash on hand to pay that.
But more importantly, in many cases, is that if volatility picks up, your initial margin, which was your security, could triple overnight. So suddenly you've got to find three times more just to hold the position, otherwise you're forced to close it down. So there's all these risks that people have to be aware of. It's a bit scaremongering.
JAMIE MCDONALD: Yeah.
ROGER HIRST: But you just have to know that.
JAMES HELLIWELL: But it's very real.
[interposing voices]
It's very real. Just, Jamie, just look at some of the funds and the other high-profile people that've run into difficulty when there's been redemptions in their fund. So in other words, investors have asked them for cash so they need to exit some positions because they haven't maintained sufficient liquidity or cash reserves to meet those redemptions. And then they suddenly find, and their investors suddenly find, that they're not able to sell any of the positions that they thought they could raise cash with. And before you know it, the market catches on. It's distress selling.
ROGER HIRST: Yeah.
JAMIE MCDONALD: This is a big problem with hedge funds because let's say they have quarterly performance reviews and the option for investors to pull money out on a quarterly basis. It's unfortunately correlated against them because if you have two quarters of bad performance, that's when you see withdrawals. And for a hedge fund manager, that's exactly when you don't want withdrawals, because you're actually going to have to basically crystallize losses in those positions.
ROGER HIRST: So these are sort of the portfolio risks that people need to be aware of. There's liquidity risk. There's market failure risk. Markets stop. Market stop trading sometimes. We always expect them to reopen, but when they reopen they could reopen at a price which is significantly off side for you. And what if your whole portfolio correlated to one in that period on the downside?
JAMES HELLIWELL: That's when you don't want a lot of leverage, that's for sure. You want to ensure that your leverage is in.
ROGER HIRST: It's all about--
JAMIE MCDONALD: Here's another one which is a little bit more of a boring one, I think maybe. But I was just thinking the options market is people who may buy and sell options to get out of positions, be aware of bid offer spreads because they can be very wide. And people, you can get lured in by certain platforms saying, oh, we'll charge $1 a trade.
Well, that's all very well. But if the bid offer spread is 10% wide, then you could buy at one and sell it a minute later and be 10% down in your position so.
JAMES HELLIWELL: And in some cases, I've seen retail investor platforms completely cease trading or stop offering trading.
ROGER HIRST: Well was it thing with Robinhood, wasn't it?
- Oh, yeah. Yeah. Exactly.
ROGER HIRST: Was it GameStop? Was--
[interposing voices]
But it was one of those stocks where they went, oh, actually we're not going to trade anymore. And no one was quite sure who was behind it. LME with nickel, which is owned by a Hong Kong Exchange.
- Right
ROGER HIRST: Chinese investor who was massively short. They closed it down. So the thing is that there is vested interest but we shouldn't scare people off with this. These are minor examples that happen that people just need to be aware of, because small liquidity crises happen quite regularly. These sorts of financial disasters do not. But you've got to make sure that your portfolio is stress tested for what is the worst-case scenario of high correlation to the downside in a long portfolio with maybe a couple of exchanges closing?
JAMIE MCDONALD: Yeah.
JAMES HELLIWELL: That's it. That's the way of thinking you're always thinking what's the worst case, what ifs, how could this play out.
ROGER HIRST: And have that cash in hand so that when these things happen and you're not in a distressed state, you're the one buying the distressed assets.
JAMES HELLIWELL: You have a framework. You have a plan. If it does go wrong then at least can react before next thing there's no bid, or you tied up with liquidity, illiquidity, and yeah.
JAMIE MCDONALD: Yeah. You never want to be forced redemptions. You never want to be forced to trade out of a position.
ROGER HIRST: And so of course, when you're looking at those liquidity issues the real amplifier for that can be leverage. When you had liquidity issues with people have used too much leverage, that's when you see not only people losing their fortune or losing their money, but also wiping themselves out and becoming bankrupt.
Because if you've leveraged a position up and your net worth is $100,000 you've got $400,000 of positions on, now they're not going to go to zero. But you know that if you've got that, if you've got that leverage, that's when it can really hurt. So liquidity and leverage is a real killer.
And so of course, one of the worst case scenarios when liquidity does dry up is that if you've got too much leverage on-- and this is what we saw with LTCM where you had a liquidity, a breakdown in liquidity, and a huge amount of leverage caused a fund of a few hundred million, which had billions of positions on, basically took itself out and nearly took the whole market out requiring pretty much every major central bank to step in and do something to try and rescue the markets from effective ruin. That was just leverage on some badly thought out bets or bets that turned out, with hindsight, to be very badly thought out.
JAMES HELLIWELL: Well it was the same with, was it Charlie Munger? There's three ways to go broke-- is it liquor, leverage, and ladies?
ROGER HIRST: Yeah.
JAMES HELLIWELL: According to him. Maybe a little bit outdated now.
ROGER HIRST: Happens a lot in all of them. So this is the thing with leverage is leverage on and liquidity, or lack of liquidity, can be an absolute killer.
JAMIE MCDONALD: Yeah.
ROGER HIRST: And most people, if you're going to use leverage, I think there's two ways you can think of leverage. One is you've got $100 grand or $10 grand and you levered up to 10 times. That's one way. Or you can use leverage through optionality by being long. Lots and lots of options which give you a very, very significant exposure but actually you still only have your premium at risk.
So someone could buy loads and loads and loads of out of the money puts on an index which gives them a massive notional, but they still they'll only lose $10 grand if it all goes wrong.
JAMIE MCDONALD: But also there's leverage from a personal point of view going back to one of the first points we were making. You may work at a big company, and have shares in that company, and have your own house, but you've got this big mortgage.
You may think, well, I've got a pretty risk-- I've got a pretty low-risk life. I mean, what can go wrong? But because your savings are in the company's shares, your job is obviously with that company and you're levered on your house. You're actually very highly leveraged so there's lots of different ways.
JAMES HELLIWELL: You don't have diversification.
ROGER HIRST: Yeah, diversification.
JAMIE MCDONALD: Right.
ROGER HIRST: Absolutely key. Diversification and having a strategy are the main themes that you need to basically nail when running your own money, running your portfolio.
JAMIE MCDONALD: One of the best advice I was ever given this guy Jimmy Haber was like basically you're trying to hit singles all the time. So--
JAMES HELLIWELL: Is this a baseball analogy?
JAMIE MCDONALD: This one's cricket.
JAMES HELLIWELL: Cricket, OK.
JAMIE MCDONALD: You try to hit singles all the time. But just the biggest chance you have of being a success is just still being at the crease. You what I mean? Don't get out. So this is what happened to a lot of hedge fund managers was they take the big bets and they may have had some great years, but then they blow themselves up and that's it. Your chances are gone. It's difficult to recover once you've had such a bad year. So just staying--
JAMES HELLIWELL: Rule number one, isn't it?
JAMIE MCDONALD: Don't get out.
JAMES HELLIWELL: You've got to still be around to trade.
ROGER HIRST: Well, it's 50% down requires 100% up.
JAMIE MCDONALD: Yeah.
JAMES HELLIWELL: You don't come back from that. Not without taking excessive risk.
ROGER HIRST: The drawdowns, the actual requirement to offset a drawdown of size, is a significant performance that doesn't come around very often. So you've got to make sure you don't have those drawdowns, which is why you need to have that strategy in place for yourself where you know what are those points where you're not going to walk away from it. So never get to those points.
JAMIE MCDONALD: I mean, so what it comes down to is how diversified are you? And that's a very personal thing. It's like, where are my exposures? What are my maximum losses in those areas? And if I am putting a trade on, the big things are entry level, am I putting everything in at this point? Or am I going to hold some back to perhaps get in at a better level?
And another big one is time horizon. I mean, you speak about this with Bitcoin which is I've got to know how long I'm in this trade for and be honest about it. And it doesn't mean you can't change it. But if you are going to change your time horizon, just be very clear about why you're changing it. But you should have one before you go into it.
ROGER HIRST: And within that, there's this sort of concept of idea horizon and trade horizon, which is that the two should match. You should put on a trade that's commensurate with the idea that you've had.
And that goes to the sort of bigger thing, which is within all of this, you are doing everything that reflects what your requirements are. As in, why are you trading? Why do you trade? Do you trade for fun? Do you trade for pension? Do you trade for your kids? And those are the reasons really behind it.
And everything you do should fall from that. Your entry, how you do your entry points. What sort of volatility you take. How much of your personal capital you put in. How much diversification you want. Do you go for correlated bets because you want a big win or do you go for concentrated bets because you want a big win? Nearly all comes down to why are you doing it.
JAMIE MCDONALD: Yeah.
ROGER HIRST: And if you set that out at the beginning, you pretty much got yourself a nice framework. Doesn't guarantee anything, but you should feel comfortable in the framework that you set for yourself and then just embellish it and develop as you go along.
JAMIE MCDONALD: Yeah.
JAMES HELLIWELL: Go on, Roger. Pop the black
JAMIE MCDONALD: Take us home.
JAMES HELLIWELL: No pressure.
- Missed it.
JAMIE MCDONALD: All right, James. Go on.