The Art of War: How to beat a strategist in the futures market?

art of war

Strategy: core directional choices that best best moves you into your desired future
Tactics: specific actions that will best implement your strategies

Without a core strategy to anchor all tactics suggestions to see which best FIT (feasible, impactful, timely) the strategy, one could randomly suggest tactics that makes the discussion chaotic. Focus on one strategy first before moving on to the next. Know that you could only implement one tactic only at the trade off of other tactics. Questions of clarification such as “Who do you think would…?”, “Why do you think that…?”,  “When do you think would…?”, or an extension of depth by “What would happen if…?” are helpful in the round robin discussion. That said, in small teams, we can tap on external resources to expand our limited, narrow, biases views. For instance, reading the views from all sell side reports allows us to be conscious of what the market have priced into assets, debts and their second order and so forth. It expands our views to encompass more possibilities.

Here, we only concern ourselves with the possibilities and among them, more plausible scenarios, and not be concerned with the probabilities of the events realising. Why? In Taleb’s book The Black Swan, he describes how one can remain defensive against negative events and stay exposed to potentially positive events, where these negative events are very unpredictable and delivers a high impact on one performance. In other words, its a binary event where the curve frowns when everyone are writing OTM options on both sides and a EVT distribution on a tail with a shortage of data is as good only as an estimate. Instead of 100% into medium risk positions, you can maximise exposure to the positive swans, say, taking 90% in extremely safe positions with positive credit carry, while remaining 10% into extremely speculative bets. Such allocation makes you indifferent to whether you know the real odds which no one really knows, and keeps you focus on clipping the incomputable downside risk. In other words, expected payoff is no different from holding a medium risk position, however, in the face of unexpected events, you will still be close to your expected payoff and not so far away due to the high impact of a black swan event. In conclusion, know the possibilities not the odds, act on what you know (not the unknown) and allocate accordingly to the expected impact or return rather than the expected odds. In the event that no black swans realise and no impact was done, then it would a year of lacklustre performance for the macro category funds from carrying credit positions.

A strategy can be rigid or flexible. A flexible strategy is able to withstand being wind-tunnel across many alternative scenarios with different stakeholders and keeps you open to opportunities. In other words, its robust to all kind of weathers and allows for adaptation. It means acknowledging that unexpected possibilities do happen and the strategy already prepares a defence against the unexpected. When an all-weather fund underperforms, it could mean 2 things: 1) it failed to account for the unexpected as a possibility such that its caught unprepared with no defence 2) it failed to revise its tactics and reposition itself on time so that it stays in course of within its strategy (i.e. its positions became illiquid and inflexible). Think of verticals. When your vertical is at the peak of in-the-money, you would realise the profit to remove bad risk and recreate good risk by rolling the strikes to the new spot price. This stresses the importance of understanding the “why” part of holding the positions initially (why verticals? what’s their payoff  structure?) so that you can adapt to a fast changing environment. When the initial thesis of entering the position is invalidated, it makes no sense to not revise the legs accordingly to reposition yourself.

3R, 2F are the key evaluation metrics to ensure strategies are robust are strategically defensive and opportunism.

  1. Robust against WCS – one can rank the performance of strategies against multiple scenarios. We can take some lessons from BCBS “Principles for sound stress
    testing practices and supervision”. 2017-12-22 14_09_38-Clipboard.pngThere is an inexhaustible list of risk factors from each asset classes that can be stressed and here is a few examples if history were to repeat. Not all hypothetically generated scenarios would be relevant as that would depend on what the core strategy is as well as the tactics or choice of asset class. 2017-12-22 14_11_32-stress testing at major financial institutions - survey results and practices.pd.pngAn example of how one can rank the strats against acenarios. In this case, Strategy 1 is the best if one’s objective is to maximise performance. Doing so ahead of time also ensures that you wont have a “knew it all along” symptom when one of your thoughts did became the actual scenario. 2017-12-22 14_17_29-scenario strategy stimulated perf - Excel (Product Activation Failed).png
  2. Resilience with “buffers to absorb inevitable disturbances” so that recovery can be swift. In trading, credit carrying positions are encouraged over debit carrying positions as it allows positions to be held on book for a longer period of time. In risk management, basel committee have required FI to hold countercyclical buffers in B 2.5
  3. Redundancy in capabilities to protect against (worst) eventualities – having more than one way to recourse to core strategy In trading, multiple overlapping legs in structures gives a choice to influence each structures separately, each with its unique goal. In risk management, basel committee have required FI to hold supplementary capital conservation in B 2.5
  4. Flexibility where positions can be scaled up or trimmed entirely without any obstacle. In trading, we should prefer shorter maturity and liquid contracts with no binding non-standard exceptional clauses or legal agreements. In terms of the complexity of the structures, majors are preferred over crosses, outrights are preferred over spread or flys? Hm, not really if there is a appropriate sequence to decomposing the legs such that flys into 2x spreads is not costly (depending on focus of strategy, volume and broker commission) and easily executable with suffice OI.
  5. Flatness of an organisation’s decision making where all views are equally important. This culture is prevalent in many great hedge funds. While entertaining many views could be daunting, perhaps, some help from decomposition into clusters of scenarios that produce the same outcomes can be leveraged on.

Since the world champion chess player have lost to a machine that could map out all possible scenarios or moves in the next k depth, is this the edge for the future? Can this be automated and hardwire into machine? If you ever played a game like this “Everyone guesses a number between 0 to 100. The winner will be the one who guesses nearest to the 2/3 of the average of all guesses” most people would only guess to the 2nd depth such that 66-100 is definitely out of possibilities (1st depth) and most would guess in the range of 44-66 (2nd depth), not knowing that their own actions would lead to the winning range of 30-44. Here, we assume players are all rational and know the rules of the game “2/3 of the average of all guesses”.

One thing is predeterminable: binary logic will not work pervasively in all cases. Along uncertainties from the interactions of multiple possible outcomes, there presents some non-straightforward exceptions where certain influence have dominance over other influences and a negate-negate binary logic cannot simply mean a true positive. This could explain why despite all the scenarios and moves fed into the memory of the machine, a human could still innovate on its feet to create new scenarios that a machine have never seen nor could it imagine, such that Kasparov managed to beat Deep Blue.

So how can we handle such exceptions arising from multiple goals which give rise to non matching outcomes? We could treat these outcomes for each goal separately, rank them, and find their sum of ranks for all goals.

Goal 1: Maximise eventual book value2017-12-22 14_49_32-scenario strategy stimulated perf - Excel (Product Activation Failed)

Goal 2: Minimise downside risk2017-12-22 14_49_38-scenario strategy stimulated perf - Excel (Product Activation Failed)

Goal 3: Maximise resilience (credit carrying) 2017-12-22 14_49_45-scenario strategy stimulated perf - Excel (Product Activation Failed)

Eventually, summing the rank across scenarios, Strategy 1 remains the lowest sum of ranks and hence the most robust strategy to achieve all 3 goals given we are indifferent among 3 goals and weight them equally. Note: this is only one of many possible methods to arrive to a final decision and may or may not be the best decision. The goals used are inexhaustible and depends on the fund. An alternative goal could be to be influenced on the downside in the narrowest sense (Bitcoin?? No part of the central bank extravagance) and broadest on the upside. The performance of each scenario is a point value from a distribution too and the worst case could happen that the expected that was simulated was not what turned out for you in reality (e.g. your other insurance, diversification, redundancies met into obstacles or unaccounted scenarios and did not kick in or act as how it should as you expected) The more legs there is, the more complex and inflexible the book becomes if one doesn’t know how to mange the legs. 2017-12-22 14_53_09-scenario strategy stimulated perf - Excel (Product Activation Failed).png

Below, I lay out a framework towards scenario planning so as to explore the range of plausible futures and possibilities and how these key issues will unfold and respond to to the external environment as well as the strategies and sequence of actions taken by stakeholders. Here, we can consider the full set of Political, Economic, Social, Technological, Ecological and Legal factors that will determine the future but they are only a part of the inexhaustible list of driving forces. While they have a wide range of possibilities, variable in their interactions and unpredictable in their outcomes, they can be explored and understood by “intuitive logics” (Jungermann and Thuring, 1987)

Paradox-Decision-Approach-Illistrated.jpgBalance between intuition (nonsensical mind) and logic (one track mind) when making decision in a paradox… encourage creativity and lateral thinking, discourage rigidity and straightjackets

  1. Whats the key focus at issue? Where is the influence most likely to be? When is the impact most likely to be delivered? What are the necessary ingredients for the hypothetical scenario to become reality? Who are the key stakeholders in this game to make it happen or conversely, be an obstacle to it happening? What factors at present do you see as potential foundations leading to the hypothetical future? Any obstacles? Looking back, how did we got here? Were the driving forces that drove us here still as strong as ever? Will we be continuing in the same direction or are we at a turning point? As existing problems resolve themselves, what new uncertainties arise? What are some important predetermined trends? (e.g. demographics, replacement ratio, election cycles) How have actors who have a stake in the future behave? How will they act to preserve their self interest? Once these storytelling is rehearse in your mind, we ought to be mindful of “who, where, when, why, how” and the environment around which we develop scenarios will be clarified. Just as if after you place bets, you will be more sensitive to news that could “trigger” scenarios to unfold and becoming reality. Such mind rehearsals enables timely contingency defense or grasp of opportunism as early events of the scenario plan unfold…. As events unfold, outcomes are 1) confirmation that strategy is still appropriate 2) confirmation that revision is needed to ensure robustness ahead 3) confirmation that previous choices are not robust and new alternative strategies are required 4) recognition that none of the options are robust ahead and contingency planning against unfavorable future is needed 5) confirmation of what ingredients are important and/or necessary precursors to the hypothetical future.
  2. What are the driving forces? Are they pushing or pulling the present towards the hypothetical future? For instance, “inflation” is not a driving force but a topic with no indication of impact on the focused issue and it prejudges a direction, excluding the possibility of stagflation or deflation. A driving force is “impact of UK economic conditions on exports to Eurozone”.
  3. Clustering the driving forces. Are these forces connected? (econometric models here e.g. 2SLS. instrumental variable, trial and errors to find confounding factors and cause-effect relations) We focus only on external cause -> internal effect rather than internal cause -> external effect which is more of a response to the former. Many key decisions made in organisations must address external factors that are not in the organisation’s grasp to influence, if any at all. Control of internal decisions without making them in adaptation to external forces does not help in the long run. Using a visual map to draw linkages of chronology and cause/effect helps. There could be some a single driving force that has no linkages to other forces.
  4. Once we got the clusters of forces, we have to debate out a vision of the cluster’s extreme outcomes that will arise over a time horizon. This is like thinking the next depth of “if this happens then…”. So far intuitive logics is a forward method that starts with policymakers and that driving forces have adequate influence over outcomes to cause the causality domino chain to fall. The scope gets narrower as we move forward from cause -> potential effect in each chain. Besides that, references can be made to history and using a backwards logics to start the chain from a problem that is to be avoided and work from effect -> potential cause. Another way of thinking is called the Fifth Discipline2017-12-22 19_47_53-Organizaţia care învaţă - Adobe Acrobat Pro.png
    7 Learning Disabilities 

    1.”I am my position.“ – When people in organizations focus only on their position, they have little sense of responsibility for the results produced when all positions interact.
    2. “The enemy out there.“ – When we focus only on our position, we do not see how our own actions extend beyond the boundary of that position. When those actions have consequences that come back to hurt us, we misperceive these new problems as externally caused.
    3. The Illusion of Taking Charge – All too often “proactiveness” is reactiveness in disguise. If we simply become more aggressive fighting the “enemy out there,” we are reacting
    4. The Fixation on Events – today, the primary threats to our survival come not from sudden events but from slow, gradual processes. Generative learning cannot be sustained in an organization if people’s thinking is dominated by short-term events.
    5. The Parable of the Boiling frog – Maladaptation to gradually building threats
    6. The Delusion of Learning from Experience – we never directly experience the consequences of many of our most important decisions
    7. The Myth of the Management Team – “skilled incompetence”—teams full of people who are incredibly proficient at keeping themselves from

    11 Laws of the Fifth Discipline
    1. Today’s problems come from yesterday’s “solutions.”
    2. The harder you push, the harder the system pushes back.
    3. Behavior grows better before it grows worse.
    4. The easy way out usually leads back in.
    5. The cure can be worse than the disease.
    6. Faster is slower.
    7. Cause and effect are not closely related in time and space.
    8. Small changes can produce big results…but the areas of highest leverage are often the least obvious.
    9. You can have your cake and eat it too —but not all at once.
    10. Dividing an elephant in half does not produce two small elephants.
    11. There is no blame.

  5.  Knowing the extreme outcomes of each cluster means we are closer to understanding the impact it generates. The only unknown is the certainty of it happening. Along time as things move in its favor, the impact remains unchanged but it moves to more certainty. The key forces we ought to have contingency plans are those with high impact, high uncertainty.uncertainty impact matrix.jpgWarren E. Walker provided a framework to determine if the scenario is indeed as certain as we thought it was. In reality, most things aren’t as certain and straightforward as we thought it is, just that we did not attempted to deliberate on the issue, seeing it as a weakness.
    walker level of uncertainties.gif
  6. As much as we plan, nothing is infallible and the expected extreme outcomes may turnout to be different from what we expected. So we do a “reality check” on the entire picture to see if there is any missing gaps in logic, scale and information. Do we need to bring in any omitted factors? Here we can do our revisions to our causality maps. Think it over and over until it cannot be more confirmed that its sane and a part of reality.
  7. We scope into the high impact, high uncertainty matrix. Say we can only focus on 2 factors A and B and 1 is the “Best Case”, 2 is the “Worst Case”. Now we have 4 internally consistent, separate but related scenarios: A1, A2, B1, B2. Why this matrix quadrant? The highest compensation is rewarded to the  one who takes the most uncertain and impactful riskRelated imageWith the best/best, best/worst, worst/best, worst/worst 4 plausible worlds, we engage in questions and devil advocate to find a set of descriptors that describes how each of these worlds would be like in the future with a justifiable foundation to what’s known (present) and unknown (future). Framing ans scoping as such don’t imply individual “prediction” but read as a group of “limits of possibility” for what might reasonably be expected to happen over time. They act as tools for making sense of complexity and ambiguity and for understanding the linkages across different areas of interest. While most descriptors do not fall in more than 1 world, they do happen in cases of ambiguity. History have not unfold with a combination of all descriptors in their best or worst, and its often the mediation of some “good” outcomes by the impact of other “bad” outcomes that broader and challenging possibilities for the future start to unfold.
  8. With the 4 plausible scenarios framed by the interaction of 2 highly uncertain and impactful factors A an B, with all the combinations from a set of descriptors, we start building our storylines to show how we might get from where we are today to these future states. A scenario timeline could be set so that we are able to track whether we are still on the right track, staying strategic.

However, reality is subjected to different interpretation by different groups depending on how we frame the facts. framing biases.gifAnd scenarios discussed in a round robin are more likely to be those which we encounter recently such as those we read in the news or social media such that they are readily available to a matching question. But these are most likely priced in so knowing it won’t be an edge itself. availability bias.png

Furthermore, the storytelling from the present to the postulated endgame would be incomplete if one ignores that policymakers also have their own interests to protect and mired in their own conflicts with other stakeholders such as the regulators, politicians, suppliers and so on. A solution to work out the likely reactions to stakeholders is to stand in the other persons’ shoes or imagine role playing his appointment and character. A well written “value-rational” question framework for phonetic inquiry by Bent Flyvbjerg focus on the interests of the society at large in relation to the future towards which a particular unfolding scenario leads.

A phronetic anthropology should stress the value-rational, and ask 4 basic questions in sequence:

  1. Where are we going?
  2. Is this development desirable?
  3. What, if anything, should we do about it?
  4. Who gains and who loses, and by which mechanisms of power?

Of course, if more stakeholders are involved and there is more polarity in winners and losers, the situation would be more complex. The struggle for power would be more undistributed with more taking things into their own hands, leading to unintended undesirable outcomes. Here, we can group the players into groups like “management” or “media”, noting that their stake at interest and level of power they have differs greatly.

Below is a power-interest matrix on BP stakeholders after the Deepwater Horizon oil spill that led to a change in stakeholders positioning. Note that where multiple stakeholders interest is involved we use a matrix to visualise and simplify our thought processes.
power interest matrix.jpgBelow is an alternative naming of stakeholder analysis matrix. In this case, disgruntled subjects could seek to form alliance with context settlers, getting context settlers interest piqued to players. Here, uncertainty remains where there is unresolved conflicts.

stakeholder analysis matrix.png

We can also interrogate our 4 plausible scenarios A/B matrix with the Flyvbjerg’s questions in sequence in relation to 2 factors A=Don’t have vs have GFC and B=Open Markets vs. Protectionism. scenario with Flyvbjerg questions.jpgSource: Scenario Thinking – Practical Approaches to the Future by George Wright & George Cairns

If you read everything that’s above, you will be ready to do your scenario planning and storytelling. Before I conclude, a mindfulness of some principles would go a long way.

Guiding principles to the development process

  1. Don’t select and exclude the rest.
  2. Doing in stages ensures the thinking process doesn’t fall into chaos
  3. While structurally in stages, guidelines are not prescriptive and can be flexibly adapted to suit specific needs. For instance, at a reality check in stage 6, more ideas can be added later to complete the picture.
  4. Challenge your own “business-as-usual” thinking. Introduce conflict and debate to develop alternative strategies or decisions, later question their assumptions and recommendations of the alternative positions on the issue. Aim to generate alternative course of actions and minimise any group based tendency towards early agreement on an idea.





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