Integrated Macro Analysis, Part III: Horizontal & Vertical Exposure

5:58 pm - November 2, 2010

Note: This article is the third in a series. Also available:

IMA Part I: 3-D Structures and General Conditions
IMA Part II: The Market Tower

If one perceives the ability to craft exposure on vertical and horizontal lines, then one can see how a trading portfolio – specifically a multi-position portfolio – becomes a sort of market symphony, in which total returns rely not just on quality of analysis and initial trade selection, but on the skillful management of inter-related positions, based on a combination of clear-cut mechanical rules, logical discretionary overlays, fluid situational awareness, and the trader’s well-honed intuitive feel for points at which “adding” or “subtracting” make sense — much as the conductor brings forth diminuendos and crescendos with a masterful wave of the baton…

- old trading journal notes

Ready to travel a little further down the rabbit hole?

The final installment of the ‘Integrated Macro Analysis’ series is on what we call “Horizontal & Vertical Exposure,” or H&V for short.

Note too that, though the IMA series ends here, the journey is just beginning… over the next few months (and perhaps years), we will continue to add new layers of understanding to the ‘Mercenary Method.’

These layers will include deep-dive tutorials, instructions and examples, and even tutorial videos. If you’ll pardon our French, it’s gonna kick some serious ass.

Why do this? As good capitalists, we have selfish reasons. Primary among them is the opportunity to cultivate relentless self improvement.

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As the old saying goes, “The best way to learn something is to teach it.” In sharing our knowledge and techniques with the Mercenary community, we force ourselves to set a challengingly high clarity bar — and then we clear it, over and over again. In giving away our ‘secrets,’ we spur a natural impetus to “take it to the next level” — to keep raising the game, every month and week if not every single day.

Then too, it wouldn’t hurt to see a few new Jesse Livermores spring up in the Mercenary community. Y’all can come work for us.

Anyhow, on to the topic at hand…

Beautiful Music

For a long time, one of the mental images that has compelled us is the idea of “the market symphony” — conducting and coordinating the various elements of one’s portfolio as if they were the movements of a skilled and beautiful orchestra.

This is “the music of the markets,” writ up close and personal, in elegant and profitable form.

For the majority of traders, the perception of market success hinges on chart patterns and trading setups. This is not enough.

For the majority of investors, success is defined in terms of investment ideas only (buy and hold). This, again, is not enough. The advanced concept of interrelated portfolio management — considering all inputs in the context of an integrated whole — never really enters the picture.

For us, it is a vital part.

H&V: Defining the Terms

So let’s begin by defining our terms (which are really quite simple).

Horizontal Exposure refers to adding new positions or subtracting existing positions.

Vertical Exposure refers to increasing or decreasing position size for existing positions.

So, for example, let us say you are bullish on fertilizer names, and your thematic exposure to the ferts is concentrated in two names: Potash Corp (POT) and Mosaic (MOS).

If you were to add a third name to your roster — say, Intrepid Potash (IPI) — that would count as an increase in horizontal exposure.

If, instead, you decided to stick with POT and MOS but increase share count / total position size (i.e. pyramid one or both names), that would count as an increase in vertical exposure.

It also works in reverse. One reduces horizontal exposure by closing out positions… or reduces vertical exposure by lightening up on total size / share count… and so on.

Simple enough, right? And yet there is real magic here…

Simple, Yet Complex

The ability to masterfully control H&V (horizontal and vertical exposure) is where truly stellar trading returns come from. The great traders of the age are absolute masters of H&V.

Of course, they probably don’t call it that. (To the best of our knowledge, it’s an original term.) But they practice the discipline of H&V — which predates Jesse Livermore — by fluidly altering exposure levels in response to opportunities, risks, and prevailing market conditions.

Some examples:

When a top global macro trader spends six months trading lightly, nimbly, carefully, avoiding heavy commitments or excessive risk, and then perceives an opportune moment to take a home run cut, followed up by a period of heavy and aggressive activity that contributes to a 40% return on the year — that is H&V at work.

When a seasoned investor or trader sees an incredible opportunity to “load the boat,” and takes an outsized position appropriate to an extremely favorable reward to risk situation, that is H&V at work.

When a trader perceives a “rolling top” process, in which risk appetite dissipates and various overstretched names run out of gas one by one, allowing for incremental addition to the roster as tactical conditions confirm, that is H&V at work.

When the market presents conditions of high uncertainty, in which a big move could break out either way, and the skilled trader employs a sort of “zone” coverage that allows for hedged bets in both directions until the line of least resistance resolves itself, that is (you guessed it) H&V at work.

As you can see, the ability to “increase” or “decrease” along two axes (the “H” and the “V”) leads to an incredibly wide range of possibilities.

The dynamics of how much exposure, what kind of exposure, and most importantly when, are as critical to the end goal (outsized profits with minimized risk) as is the coordination of instruments in a well-played symphony piece.

Key point: Trading “picks,” individual setups and the like — the areas that beginning traders remain fixated on in their profit quest — are of course still an important part of the process. But they are only the beginning.

As AC/DC sang, “It’s a long way to the top if you wanna rock and roll…”

Key H&V Inputs

So how do you make decisions along the two axes? What are the inputs, broadly speaking, that influence one’s adjustment of H&V?

In essence there are three:

the state of the markets
the state of one’s portfolio
the state of one’s convictions

Making decisions based on the intertwined input of the above three is very much a “dynamic” process, in the sense that all three are constantly shifting in real time.

This is contrasted to a more “static” method of portfolio management, in which decisions are taken from a rigid (possibly computerized) list of rules, or where various aspects are left out of the decision making process entirely.

But, really, once you think about it, how can one trade wisely and responsibly without all the above kept in mind?

Markets: Sometimes market conditions are risky and dangerous. At other times the backdrop is immensely favorable. Dialing down exposure in adverse conditions is critical to survival. Dialing up exposure in favorable conditions is critical to success.

Portfolio: “Trading one’s equity curve” is simultaneously one of the oldest and wisest aphorisms in the business — see Four Lessons from Druckenmiller — and a topic worthy of separate and distinct attention. (We will address it in future in great detail.)

Conviction: From Ocean’s 11: “Why do it?” “Because the house always wins. Play long enough, the house takes you. Unless, when that perfect hand comes, you bet big. Then you take the house.”

A Few Words on Pyramiding

Pyramiding instructions appear on dollar bills. Add smaller and smaller amounts on the way up. Keep your eye open at the top.

- Ed Seykota

Again speaking to the majority — though not necessarily you! — most traders and investors are uncomfortable with pyramiding, i.e. the discipline of strategically adding to positions. H&V, then, threatens to make these folks even more uncomfortable, because H&V can be classified as an advanced treatment of pyramiding.

Except of course, this is not your run-of-the-mill pyramiding, but a discipline that exists not just on one axis, but two (re positions new and existing), and that further includes the concept of “reverse” pyramiding (i.e. tactical deleveraging as well as leveraging) as circumstances warrant.

Given that, a few words on what a successful pyramiding methodology entails:

The first requirement is conviction — a firm belief in the trade.
The second requirement is sacrifice — a willingness to risk profits.
The third requirement is tactical confirmation — a strategic entry point.

As mentioned above, a critical psychological aspect of pyramiding is a willingness to risk profits. (One assumes here, for the sake of argument, that pyramiding is done from a base of established profit, putting initial capital considerations aside for now.)

A willingness to risk profits, then, is the same as a willingness to give up accrued gains in pursuit of potentially bigger, larger gains. One earns the right to do this by building up a profit cushion in the portfolio.

This is where the dynamic aspect of portfolio management comes into H&V decisions. As stated earlier, it is truly a function of all three inputs: the state of the markets, the state of one’s portfolio, and the state of one’s convictions.

A Final Recap

Clear as mud? Let’s again revisit some old trading notes, to tie it all in once more:

Horizontal exposure is about increasing exposure via new trades.
One could call it ‘thematic pyramiding’; adding diverse new eggs to a basket.
With sufficiently large themes, different instruments respond at different times.
For instance, first industry ‘A’ goes… then ‘B’… then ‘C’, and so on.
This sort of staggered participation lends itself nicely to horizontal build-up.
Horizontal exposure also interplays nicely with “doing more of what works.”
~~~
Skillful position management is not just about leveraging, but de-leveraging.
The skilled trader does not always add to a position. Sometimes he takes off.
When to increase a position that is working? When to take partial profits?
The “vertical exposure” concept encompasses BOTH.
To increase vertical exposure is to traditionally ‘pyramid,’ i.e. add to a position.
To decrease vertical exposure is to partially cash out, i.e. book partial profits.
(One could say reducing vertical exposure to zero = closing the position entirely.)

With H&V awareness, the potential exists to cultivate virtuosity (elegant technical skill) in the real time management of positions and exposures. This virtuosity is then overlaid on top of high quality market analysis, that is to say, awareness and exploitation of ever-changing conditions.

Via this process, entirely new heights of virtuosity then become accessible in the realms of scenario building… model analysis… trade construction… probability weightings, reward to risk profiling, and so on.

The net result is a competitive endeavor with STAGGERING amounts of “virtuosity potential,” given sufficiently nuanced management of all factors involved.

See It, Live It, Learn It

And that wraps our ‘Integrated Macro Analysis’ series.

Between part one on 3-D structures, part two on the Market Tower, and now part three on H&V, you can hopefully see how it all comes together… and how becoming a great trader is astonishingly easy. Like falling off a log! Right?

Uh, no.

It only makes sense that the game would be challenging. Nobody expects to become a champion rally car racer without driving experience. Nobody expects to hold their own in a high-stakes Vegas cash game without ample hold ‘em experience. It’s only natural that trading would require the same.

That’s the bad news. But it’s not really bad news, is it, because in your heart you already knew this game was challenging. Were it a cake walk, there’d be no money in it. That’s also why the trading game is so rewarding — mentally, emotionally, and of course financially — for those who step up, and compete, and win.

Shameless request: If you enjoyed the ‘Integrated Macro Analysis’ series – or, heck, even if you hated it – don’t be shy and let us know, via comments section or email (feedback ‘at’ mercenarytrader.com).

Also, if your head is swimming right about now, fear not. There is more coming – much more – not to mention the ability to observe all these principles in action, as played out in REAL TIME via the Mercenary Live Feed.

Last but not least, thanks again for reading. Mike McD and I are having a blast here. As a Mercenary community member, hopefully you are too.

Carpe Jugulum,