Finding Edges: The Importance of Being a Pirate

In much of life, success results from doing what other people expect you to be doing.

You get top marks in an exam by answering the way the marker expects you to.

Rising up the corporate ladder has as much to do with “being seen to do the right thing” as it has to do with results.

I’m not judging. I played these games – and I played them well.

Unfortunately, “being good and playing by the rules” isn’t going to help you in trading.

As hedge-fund-manager-turned-vision-questing-FinTwit-celebrity Hugh Hendry is fond of saying, “You need to be a pirate”.

Lots to unpack here…

You need to zig when others are zagging.

You need to think outside of the box…

Now, I admit it’s easier to think outside the box when you’re a millionaire living in St Barts, with all the time in the world to eat mushrooms and draw Jesus and Elmo on your wall.

But the message is valid.

The price in a market is as much a function of the flow of money into the market as a precise underwriting of the theoretical payoffs of a position.

That means that trading edges come from appreciating what others believe to be true, what motivations they have, and what constraints they are under.

Rather than joining other traders, you should try to exploit what they are doing.

You need to be a Pirate.

Am I A Pirate?

  • If you find yourself attracted to things like this: “Don’t fight the trend. Buy the MACD cross-over. Risk 2% of your account on each trade.”
  • If you find yourself wanting exact rules and prescriptions to follow
  • If you find yourself following other people into trades and positions

Then no, you are not a pirate. You need some pirate training.

How To Think Like a Pirate – Football Betting Edition

As this is an article about thinking outside the box, let’s start with a non-trading example.

A well-known effect in Football (soccer) is the New Manager Effect. This is the tendency of team performance to improve under a new manager following the sacking of the old manager.

If you are not a pirate, you may take this at face value. This may excite you, and you may decide that betting on teams with a new manager is a good idea.

The pirate thinks differently. The pirate might also be excited, but not for the same reason.

The pirate’s reaction to common wisdom like this is “BULLSHIT!”

The pirate’s thought process looks like this:

  • I’ve identified some common wisdom
  • I doubt it is (entirely) valid
  • But I suspect other people think it is and over-react to it by betting on the team with the new manager
  • This demand will make the odds worse for the team with the new manager
  • So, I might be able to profitably take the other side of the bet.

The pirate refuses to accept “common wisdom”.

Motivated by the idea of an exploitable behavioural anomaly, the pirate digs into the data.

He suspects that a team’s performance does improve under a new manager – but the new manager is probably not the cause of this.

Following some simple but careful analysis (just like we teach in Trade Like a Quant Bootcamp), he finds that:

  • Performance under a new manager tends to be better than performance under the old manager before their sacking.
  • But managers tend to be sacked following extremely bad performance.
  • Extremely bad performance tends to be followed by less bad performance, regardless of whether there’s a new manager or not.

The pirate finds that the “common wisdom” is only partially right.

Teams do tend to do better under a new manager. But that’s only because managers tend to be sacked following extremely bad team performance.

The effect is entirely explained by regression to the mean in performance. The new manager has no causal effect.

Now the pirate is really excited. He knows that enough people think there’s a causal effect that it will be priced into the odds through excess demand for betting on the team with the new manager.

He runs the numbers and finds that there has historically been a small but exploitable inefficiency.

This is an opportunity to make money by exploiting the marginal effect of others acting upon “common wisdom which isn’t quite true”.

This is what pirates live for.

Say “BULLSHIT” to common wisdom. It’s a pirate superpower.

Leave a Comment