One series of trades — $15 billion in profits. That’s what Wall Street Journal reporter Gregory Zuckerman dubbed The Greatest Trade Ever.
If you don’t know the reference, we’re talking about when Hedge Fund Manager John Paulson made a series of calculated bets against the subprime mortgage market starting in 2006. The bets took his hedge fund from relative obscurity to household name, earning himself and his investors windfall profits.
To put it in context, there were single days where Paulson made $1 billion in profits. Here are three tactical lessons that you can learn from Paulson’s execution of the Greatest Trade Ever.
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1. Short Weakness (Go Long Strength)
Paulson was left with a lot of options after he analyzed the housing market and decided that credit standards were too loose. He could go short any number of different quality bonds — from subprime (the lowest quality) to prime (the highest quality). At the time, there were a lot of cracks in the prime market, with individuals getting mortgages that they never should have qualified for.
However, instead of fighting that fight and waiting for defaults on higher-rated bonds, Paulson knew that the first cracks would appear in the weakest market. So he went short subprime mortgage bonds.
That is something that less experienced traders do not do. Oftentimes, novice traders will see two correlated markets — say the Nasdaq ($NQ) and the E-Mini S&P 500 ($ES) — and short the market that is down less on the day, expecting that it will catch up with the other. Instead, traders should look to short the weakest markets and go long the strongest markets.
2. Look for Asymmetric Returns
In 2006, Paulson’s fund was $6 billion in assets. Yet that year, he returned $15 billion in profits. One of his funds, the Paulson Credit Fund, returned 600%. How?
His trades were asymmetric. That means that he stood to gain a whole lot more in profits than he was risking on any one trade. For Paulson, and thanks to his use of derivatives and leverage, he was paying 1% of negative carry to make up to 100% if the bond defaulted.
We talk a lot about having a 2:1 reward-to-risk ratio. And in day trading, that’s the minimum that you would want to have. In the end, not all of your trades will work out. So you have to risk less than you are planning to make in order for you to come out on top.
Does it have to be 100:1? No. Is 2:1 or 3:1 an appropriate target? Absolutely.
3. Ride Your Winning Trades
The other key to Paulson’s success was that he stuck by his winning trades. Think about this: to make $15 billion that year, Paulson doubled the size of his fund, making $6 billion. He also tripled the size of his fund, making $12 billion. Yet after that… he still held tight and MADE ANOTHER $3 billion.
In total, Paulson’s firm bet on $25 billion of securities. In making $15 billion, Paulson saw the value of those securities decline by 60%. Most retail investors will stay in their position if their equity falls by 60%, but they would never ride it 60% higher.
For traders that want to be successful, you have to flip the script and start by riding your winning trades and letting your losing trades go.
What are you going to do to get better trading this week?