Aaron & Matt – From Prop to Global Macro Shop
In this episode, we talk with Aaron Larkin and Matt Laviolette, Co-Founders of Breakout Funds. Breakout Funds, LLC (“Breakout”) incorporates quantitative global macro thematic views with current news events to place discretionary short term concentrated trades in futures markets. Their trading approach draws on a combined 30 years of experience in the proprietary trading space where they have learned that protecting principal is the primary goal of any trading strategy. They believe that there is always an underlying theme that shapes the direction of the market, and it is their goal to adapt and implement strategies suitable for each particular market regime.
We talk about Matt and Aaron’s background as Prop traders. How they use a multi-filter approach to trading the global macro environment. They wait until all their setups line up. Take concentrated positions with very tight stop losses, coming from their days as prop traders. We also talk about unique event risks.
I hope you enjoy Aaron and Matt’s insights as much as I did…
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Have comments about the show, or ideas for things you’d like Taylor and Jason to discuss in future episodes? We’d love to hear from you at info@mutinyfund.com.
Transcript for Episode 25:
Taylor Pearson:
Hello and welcome, this is the Mutiny Investing Podcast. This podcast features long-form conversations on topics relating to investing, markets, risk, volatility and complex systems.
Disclaimer:
This podcast is provided for informational purposes only and should not be relied upon as legal, business, investment or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of Mutiny Fund, their affiliates or companies featured. Due to industry regulations, participants of this podcast are instructed to not make specific trade recommendations, nor reference past or potential profits. Listeners are reminded that managed futures, commodity trading, Forex trading, and other alternative investments are complex and carry a risk of substantial losses. As such, they’re not suitable for all investors and you should not rely on any of the information as a substitute for the exercise of your own skill and judgment in making a decision on the appropriateness of such investments. Visit mutinyfund.com/disclaimer, for more information.
Jason Buck:
This is Jason Buck I’m the CIO at Mutiny Funds, and it’s my pleasure to sit down today with the guys from Breakout Funds, which is an opportunistic, global macro fund. I have Aaron Larkin and Matt Laviolette from Breakout Funds. Guys, I wanted to maybe just start with a quick bio or even extensive bio if you want, but let’s start with Aaron, tell me a little bit about your background.
Aaron Larkin:
So I actually started off in 2003 working for a prop firm name Black Diamond Capital, which was the formal name in Chicago. And so I actually spent the first roughly 10 years of my career working in the prop space, and I spent three years with the prop firm then I ended up leaving the prop firm and managed my own book for seven years, and then eventually I end up taking over the CIO position for a small family office. So I spent my whole career working in the prop space, and then going into managing assets, and then we launched Breakout Funds in 2018, so that’s how the team came together. Matt can introduce himself and dig in, but we both started off working together and then joined back up later on in our career.
Jason Buck:
Great, Matt.
Matt Laviolette:
Sure. Thanks for having us. Pretty similar, so I started at Black Diamond as well in I believe January of 2004 just about six months behind Aaron. So I was there until 2010 and I was a partner until 2010, and left with another partner to run a macro focused book with some other guys in Chicago. And did that for about five years and had a good run and then rejoined with Aaron to run the family office, and then we eventually broke off and launched Breakout. So that’s the 20 second version of our history, I’m sure we’ll dive into specifics on how that played out.
Jason Buck:
Great. And Matt, can you give me a general overview for a prop firm for people that don’t know how it works and the startup of a prop firm.
Matt Laviolette:
That’s a good point. So prop firms people from Chicago and in the markets are very familiar with, but others are not so that’s a good point. So a prop firm would be your trading partner capital, we didn’t have any outside investors and so the general format is you have a gamut of traders, and there a lot of X amount of risk per day and if you hit that on the downside, you’re done see you later, see tomorrow. And your timeframe is very short, your leverage is very high, but because you’re in such a tight window you can live in that environment if you figure it out and know what you’re doing and evolve with the markets. So that’s the prop space. It’s very similar and very different from what we’re doing now, so I think it’s a good training ground for where we are these days, it taught us to really roll up our sleeves and be in the price discovery every single day for a lot of years. And I think that’s a skill that a lot of managers that come from analyst backgrounds at banks don’t necessarily have, and so we try and really take advantage of that skill set inside of our process.
Jason Buck:
Yeah, that’s why I wanted to highlight what a prop firm does, because it provides incredible discipline that maybe people aren’t used to. Where you have such tight stop losses and you eat what you kill, so it’s a very unique background and I think we’ll get into how that plays out to the way you guys think with Breakout Funds. Aaron also a quick question for you, you said for a while, was it seven years, you were managing your own money, why did you decide to get back into the headache of running other people’s money? Wasn’t it better off just sitting there and managing your own?
Aaron Larkin:
Yeah, kind of a good question. I think it was the challenge actually, it was the competitive nature is you want to challenge and you want to step in and do something bigger, and the strategies that I’ve developed and Matt developed were scalable. And that’s typically a challenge that prop traders have, is making that next jump because their strategies aren’t scalable, and so we saw that there was an opportunity and introduction was made, and so that’s how it worked out.
Jason Buck:
Do you also think that a lot of times prop traders their strategies are not really scalable, their capacity constraints, you have to think a little differently if you’re building to scale, is that accurate or would you disagree?
Aaron Larkin:
Yeah. No, that’s definitely accurate, it’s definitely accurate because you have a couple challenges, one is scalability and second costs, cost preventative from actually trading and executing that… At the prop firm we were members of the Chicago Mercantile Exchange, and so you benefited from execution costs that came along with that. So those are a couple inputs that go into why managing assets at a larger scale is done slightly differently than it is at a prop space.
Jason Buck:
Got it. And when I think about discretionary global macro, in my mind if I were to simplify it too much I think of it as long term leap options, right? A discretionary global macro trader has a general thesis and it may take three to five years to play out, and hopefully they have an asymmetric payoff. But you guys look at the world very I think differently, you’re using a very opportunistic model, you’re using the future space, and you may be using a shorter to medium term timeframe to express global macro trades, and you use a very systemized process of doing it, but it’s also discretionary overlay. I think we talk a lot about on this podcast and at our firm, is that the future is man plus machine, so if you guys want to start walking through the way you can look at the markets or how you take maybe a top down view and how you combine multiple ways of looking at the market to build out your global macro strategy.
Aaron Larkin:
Yeah. No, definitely. So when Matt I came together, and as I mentioned we worked together at the prop firm for three years, and then Matt and I continued our conversation all the way up until we joined back up again. And we consistently talked throughout the day on what our thoughts were, and what we were expecting, and he and I both had two different approaches. And so I was more of a levels trader and Matt was a little more of a momentum trader. And so when we came together, the idea is what we wanted to blend both of our skill sets and look at… we look at markets slightly different, even though we both traded similar markets. And we had similar ideas, but the actual execution, that was different, and the execution of that actually changes the equity curve tremendously.
Aaron Larkin:
So as we came together the idea was one, to blend our ideas and then second, is we ended up bringing another gentleman from a quantitative background and we wanted to quantify it. We wanted to really dig into our views and our strategies and really try to understand what works, what doesn’t work, and how does it work? And so we did spend a lot of time in really digging into what do we do well, what do we not do well, and where can we improve? And that’s kind of how we ended up forming into our three prong approach into how we invest in our process. And so as you mentioned, and typically in the macro space it’s looking for really long duration trade setups, and that’s the game plan. But the problem is you get a lot of waiting, you get a lot of waiting when you’re waiting for that to come up.
Aaron Larkin:
And so our time horizon is because we came from the prop space, we want instant gratification, we want to see it now, we want to see confirmation, we want to see price discovery, and so it’s really about being patient and waiting for those setups. So you’re blending this longer duration style with our background of really wanting those instant gratification setups, and those catalysts, and those price discovery. And so you start at this 30,000 foot view this, here’s your macro playbook, and this is what for us, our timeframe that we’re looking to play out is anywhere from three to six months. And the macro playbook is really, this is what we envisioned, this is what we think is going to play out, and then here is where we think the strength and weakness is on various asset classes.
Aaron Larkin:
And instead of us just putting those trades on and sitting back and waiting, coming from our prop background we need to eat what we kill, we need to make money regardless, we can’t sit back and just patiently wait for that setup to play out. And so what we’ve developed is these two other prongs that come into actually quantifying and developing to our process. And so the first prong is our quantitative signals, and we’ve generated some signals. Some are mean reverting signals, some are breakout signals, we’ve got a trend trading signal as well just because we use that for positioning to understand where other positions are at. But these signals are multi-duration, so some single day signals, some 10 day signals, and some also multi-month signals and so we’re using those signals there as votes.
Aaron Larkin:
We don’t take every signal, we’re actually looking for clusters of similar signals. When you get those clusters of similar signals, that’s confirmation into what maybe our macro playbook is. And then the third prong approach, the third prong that we have is what’s driving price right now? What does the market really care about? Is it U.S. China trade tensions that was typically driving the headlines in 2019? Is U.S. and North Korea tensions? There was probably a month there that was really heightened, and typically the market was coming in risk off on Sunday night because there was tweets that were going back and forth over the weekend. U.S. Iran that we saw early in 2020, was that January or February Matt? I can’t remember.
Matt Laviolette:
Yeah, that was the second week of January 2020.
Aaron Larkin:
Yeah.
Matt Laviolette:
It seems like a very long time ago.
Aaron Larkin:
Exactly, yeah. That came in, and that could have been, as we’ve put, is like the trump card, that overlays what our macro view point is, that trumps what our quantitative signal is because if a war brews and breaks out in the Middle East, that’s what everyone’s going to care about, they’re not going to care about the other stuff. And so that comes into our decision and really what we’re looking for is when those three prongs align, and then that’s where you’re looking to execute. And so I skipped over that the macro is a three to six month duration, so you’re at a longer duration strategy, our quantitative signals are anywhere from one to 10 day signals, we use some other signals just for positioning that are longer duration. And then our current market environment is really what’s happening now, and what do we care about and what are going to care about in the next 10 days?
Aaron Larkin:
And so you’re looking at multi-duration signals that come in to making our final discretionary decision. And so those three inputs come into making our discretionary decision, and then when we get to our discretionary decision, we’re looking for trades that are anywhere from one to 10 days timeframe. We put those trades on in three increments, and then in those three increments as we get price confirmation, we add to those trades. And so really, what we’re looking for is a catalyst, we’re looking for a catalyst, a new vote, that is in favor of what our macro theme and what our quantitative signals are. So that’s at a high level of the process.
Jason Buck:
So talk to me a little bit about the longer term, the first prong if you’re looking at the world three to six months out, are you guys using a classic Harry Browne Permanent Portfolio four quadrant model? As you’re looking on the axes of inflation and growth, and which asset classes are going to do well in either of those environments, is that the first step is looking three to six months out and where do you think the puck is moving on any of the four quadrant model? Is that fair?
Aaron Larkin:
Yeah, that’s fair. That’s very much an important factor of where we think, where is the puck moving and how does that play out in various asset classes?
Matt Laviolette:
Yeah. One thing I’ll jump in there and mention is that, and that’s a great point, is we do look at the world in terms of a four quad model of growth and inflation and it not only matters where we’re at right now, but it matters where we’re going. And that’s where the nuance comes in because markets want to look forward and pull forward what’s coming, and so you don’t know if today’s the day we’re going to start pricing in the next piece of the market, or is it going to be in July? We have a pretty good idea of where we’re going, but we don’t know when, right? And we don’t try and predict it, and that’s something I think we’ve learned over a lot of years is just because you think something’s going to happen, it doesn’t necessarily mean that you’re right, and more times than not, you’re probably wrong. And you let the market tell you when you’re right, and when you’re wrong.
Matt Laviolette:
And I think that’s something that our prop skill set really ingrained in us is it doesn’t matter if you’re right or wrong, the market is what it is. And you have to play the game that’s in front of you and if you don’t, you’re not going to be doing this. And so that’s one of the main reasons we dove in when we designed our process, is to get inside of this one to 10 day timeframe because it doesn’t force us to marry an opinion, it doesn’t say, “Oh, hey, we’re bullish equities, we’re bearish bonds here and so we’re just going to be short bonds and buy some spoze, and see you later.” Our opinion has to be something that we have conviction in, but also there has to be a catalyst in place, and all of the items, the votes that Aaron just described, have to come into line to get a position on.
Matt Laviolette:
So we may have an opinion that we love something, and it might take us five weeks to get that trade on because the stars got to align to get that on. And sometimes that means we’ll miss a trade and sometimes that happens, and we’re fine with that. And we’ve learned over all this time that we’re always going to miss trades, but there’s always another trade, and you just want to be very picky and all of our signals that Aaron just mentioned are designed to be very picky. They’re not very active and so some of them may trigger, a cluster may occur and that’s what we’re looking for, but at the same time some of them it may be six months or nine months before they occur again. And so that’s all by design to be picky, so we want to be very aggressive when we have a cluster of opportunity and really take advantage of it, and when there’s not, we want to be equally less aggressive, we want to be out of the markets, we want to be flat a lot.
Matt Laviolette:
So if you’re an investor in Breakout what you’ll see is a lot of days now as an example, recently we’ve been flat a lot. One to two positions on at a low level of risk, but when the opportunity comes in line we’ll be very aggressive and that’ll go up quite a bit. And so you’ll see that a lot of our returns are clustered as well, so inside of the year’s equity curve while the end of the year knock on wood has been good since the beginning of our career, inside of that year the returns are always lumpy. So there’s three to five chunks of returns during the year, sometimes those are a week timeframe, or a few weeks’ timeframe, last year was a little different because of COVID non-stop there for about half the year. But those other times you really want to rein it in as I was saying and recognize that hey, that the risk reward is not there and just be ready for it and be okay with doing nothing for a while.
Jason Buck:
Yeah, it’s interesting that it’s almost like a combination of the lumpiness of discretionary global macro, but with the tight stops and the discipline of maybe a CTA trend manager, so it’s an interesting combination there that you barely see. But also Matt, if you think about the four quadrant model and the axes of growth and inflation, it’s easy to look in hindsight which quadrant we’ve been in, right? But then are you guys studying almost rate of change to see maybe where we currently are? And sometimes you’re in two of those quadrants, or how do you guys assess that? Do you have a different way of looking at it?
Matt Laviolette:
Yeah, well, what you just said is the most important thing, right? It’s the rate of change. So what we call the quad two right now, and that’s growth accelerating on a sequential basis on a rate of change basis. And that doesn’t mean just because… For instance, what we see on the back end of this is the bad quad, right? The quad four. So that’s going to be a major slowdown, but in our sense of, last year’s quad four and the economic shutdown of COVID that’s major negative growth. Whereas this time, it’s not going to be that simple, it’s going to be we’re comping at zero growth last year right now, so we could have 10% growth at some point between now and July. And on the back end of that we might have 8% growth which while it’s still growth, it’s a slowdown relative to the last measurable number.
Matt Laviolette:
So that’s something the market’s going to have to deal with, and that’s a different version of being in that same quad if you will, from a previous year or other years. So it’s just something we’re going to deal with, and I think that there’s a lot of opportunity as that transition happens here in the markets within the next again, like I said it could happen tomorrow, it could happen in July, it could happen… we don’t know. Something will trigger that and then we’ll be ready to move when that happens.
Jason Buck:
Great. And so when you’re talking about as you move from the four quadrant model and then the next prong you’re looking at is the quant signals, Aaron how do you guys assess the quant signals? Are you looking at hundreds of markets? Are you only looking at the markets you trade? Or are you looking at alternative data? What are you looking at for the quant signals?
Aaron Larkin:
Some of the signals are market specific, so some are just equities only. We’ve got a VIX looking at vol to vol in the VIX volatility signal which is unique, and then some of them are also looking across multiple markets. And so there’s blanket signals that are generated across… I think there’s about 80 markets that are in there and that’s a cluster, we want to see a cluster within that market of similar correlated products. So the answer is yes, some of everything actually is what the answer is.
Matt Laviolette:
Yeah, one thing I’d mentioned is that because Aaron and I began our careers trading for lots of years focusing in S&Ps and NASDAQ futures, and then before we evolved into the macro space of all the gamut out there. We do view in our eyes through the prism of equities and how they are going to react to a set of circumstances and then we branch out to other products. So what does that mean for FX, fixed income, precious metals, energy? But we view risk on and risk off in equities, and then we go from there. So while you may see a lot of our opinions may be based in equity land, the actual execution might not be because the risk reward is better to say, hey, I’ve got an equity opinion here, but risk reward-wise I can put a copper trade on for instance. Or silver trade that captures the same idea, but can bottle up risk reward profile in a way that we’re more comfortable with.
Jason Buck:
Part of that is it thinking about the S&P 500, it’s the most liquid market in the world, so a lot of times risk on risk off is really you see the signaling in the S&P 500 market versus other markets or is that fair?
Matt Laviolette:
Yeah, S&P is risk on risk off exactly, but in the same sense though equities have the most psychology in them, right? And so they have the most people freaking out all the time, right? And one way or the other their opinion changes from day to day, whereas everything else, it’s hard to read the body language if you will, or the price action of what’s really going on. And so in equities, you do have a lot of noise in there of some overreactions and over leverage or under leverage and whatever the case may be, and it does create a lot of opportunity. But it also in the same sense reveals what the market really wants to do, if you look at it in the context of what volatility is doing as relation to price and time. And so when you really dig in there, and you can read between the lines and confirm or deny what maybe your opinion is in the moment.
Jason Buck:
And Aaron I’d cut you off sorry, what did you want to add to it?
Aaron Larkin:
Oh, no, that’s okay. We already covered it so we’re good.
Jason Buck:
Got it. So those are the two prongs and then we talked about catalysts, or what’s going on the market now. And what’s interesting about a catalyst is you have your known unknowns, like whether it’s an election coming up, or you have a spontaneous, an exogenous event, like a war breaks out that you weren’t prepared for. So I’m curious to how you guys look at both sorts of catalysts, as something on the calendar and something not on the calendar?
Matt Laviolette:
Well, something not on the calendar a good example of that is January 2020, what we were talking about with that brief Iran situation. When we left 2018, or excuse me, 2019, the trade deal with China was finally done to some extent in October, and it was risk on into the end of the year. We got some FED clarity on what was going to be the policy going forward, and markets were performance chasing into the end of the year. The expectation was in Q1 and Q2 of 2020 growth was going to re accelerate, and so volatility was coming out of the market and basically, it was a risk on situation. And for us, that’s a time to hit some base hits, and build up some P&L on a smaller basis until something changes, and be nimble and be flat a lot. And so when that Iran attack in Baghdad there at the base on a Thursday night or whatever that was, at 5pm, that’s not in the playbook of everybody playing growth re-accelerating in three weeks from now.
Matt Laviolette:
So it forces a lot of hands that maybe were over leveraged to the long side to hedge off their risk very quickly, and those are situations that we will attempt to take advantage of. And it could be to capture the downside move and that’s it, or we could be using that to actually enter positions that we wanted to be a part of, but just because the risk reward wasn’t there maybe it does line up during one of those events. And you’ve seen all the way back since September 11th, markets have been so worried with all these events, in the mid 2000s we had the Madrid bombing, the London bombing, we had on and on and on, the half life of those events just keeps getting smaller and smaller. And that Iran situation, there was a few hours there that evening where it did look like there was going to be a major conflict, but three hours later it’s all off.
Matt Laviolette:
Your job as traders is just forget it even happened because as far as market’s concerns it doesn’t matter. And things don’t matter until they do, and when they do you’re really going to know it. And that was a situation where you had to go from one trading style to another very quickly, and just be ready to be nimble and move when you have to.
Jason Buck:
When I think about those discrete events it’s like you said, is this the trend of a new vol spike and is this going to continue, or is it going to mean revert in your face, like you’ve had in a few hours time? So that’s at least looking in vol space, but I guess in your situation it’s whipsawed and getting stopped out is the worst case scenario in those, right?
Matt Laviolette:
Yeah, well, I mean worst case for us that we’ve seen so far as is during the China trade negotiation. And as it was mentioned in October 3rd or something of 2019 there was a tweet again, during the evening same as this Iran we were just talking about, it came out and said that China’s Vice Premier was going to go home and he’s not going to meet Trump the next day, and so the deal’s over, forget it. Markets were down 2% very quickly in evening futures, and we were short, we caught that move and added to our positions as our process lays out, but a few hours later there’s an obscure tweet from some random reporter that said they’re going to stay. And so markets repriced right back up, and you’re left scrambling to get out of everything, and so you just get out. When markets move quickly and sharply in one direction and then they change, that’s when… When you’re just wrong you’re wrong, you just got to get out.
Jason Buck:
And that’s part of trying to capture trends, right? It’s that whipsaw or stop loss is basically analogous to your theta bleed in an options trading strategy, so it’s part of the process. Aaron I’m curious, let’s use a specific example and we’re going to this, let’s call it a contentious election in 2020, right? But what I thought was fascinating is just the recency bias, right? Because a lot of people were surprised by the original Trump election, it felt like volatility was skewing higher going into the 2020 election just because people is more like they had egg on their face from missing the previous four years prior election. So I’m curious when you’re going into the 2020 election, this might help for us to think about how you guys are looking at your signals, but then also how you’re then positioning on a discretionary basis. When the election can go either way, you can see a blue sweep, you can see Trump getting reelected, how are you guys assessing that scenario in real time?
Aaron Larkin:
Yeah, so actually leading into the election, or leading into an event that we think has potential for moving the market one direction or other, we’ll get flat. And so we’ll just get flat, and then we’ll wait for the event, wait for the news, and then position afterwards. And so typically, that’s where the discussion between Matt and I take place is we dive in and say, “What’s these potential scenarios? And what these potential scenarios, what are we looking to happen? And here’s the decision tree.” And then from there you’re looking for price confirmation to go along with it. And so that’s really how that’s actually executed, and then there’s also that scenario of basically, this is a dud and it’s nothing because to the point of everyone’s expecting high amount of volatility and expecting something to happen, typically it’s already played out, and so there’s not really as much to do and there’s not a lot of outcome from it.
Aaron Larkin:
So that was 2020, it was a toss up. It was a lot of unknown, and it was a toss up, and it was really a lot of waiting and waiting and waiting, not only did the President, then we were waiting for the Senate to be decided whether it’s red or blue. And in our eyes for 2020 specifically, there was maybe some tax harvesting that could have taken place if it was a blue sweep, that could have added some potential volatility into the market, but we actually didn’t get an answer to that until 2021 and so that scenario actually didn’t even play out because you’re already into the new year. So you got to walk through all the scenarios and really come up with a game plan. And then from there, we’re looking at price confirmation and it’s walking through okay, are we seeing price confirmation? Can we get on the trades that we’re looking to get on?
Aaron Larkin:
And then we typically have a list of priority of trades that we think has the best risk reward and the most potential, and typically the most potential lot of time is, where do we think the most pain is? Where is everyone positioned and that they’ll have to unwind those position, and that’s really where we look and say is the most opportunity. And so that’s the decision tree and the process of looking to where actually execute the trade at.
Jason Buck:
When you’re going down through that decision tree and all of your signals are starting to align and then you’re just waiting for price confirmation, are you in essence just preparing yourself for the trade and once that price signal confirms it, then you’re just in the trade? So you’re almost always doing a pre mortem and getting ready for that trade at all times?
Aaron Larkin:
Yeah, definitely. And that gets into as we would say, the art a little above actually executing and putting the trade on. Matt and I both have been trading and actually executing trades for 18 years now, and so there’s an art of how we used to enter trades that’s just not done on the mathematical standpoint of here’s the entry, here’s the math behind it. We’re looking at correlation between products, we’re looking for price confirmation, and we’re looking at price action and levels to get that trade on. Because one element that we do do, and this comes from our prop space, is we want to get the best risk reward position on, which means the largest position with the tightest stop and therefore, we have the upside potential in the trade versus a small position with a large stop.
Aaron Larkin:
And so that’s really a piece that I think that we do different than most other firms out there, is that coming from our prop background, that’s a skill set that we use and a skill set that has helped us generate returns over our career. And so we do bring that into the asset management side as well.
Jason Buck:
And before we get into trade construction because I do find it fascinating the way you guys set it up, Matt talk to me about, are there scenarios where all your signals are lining up, but you guys said you have a discretionary overlay? Is there any times when you guys are looking at that discretionary overlay and saying, “We’re not going to get in this trade, even though all the signals are lining up”?
Matt Laviolette:
Sure, plenty of times, more times than not to be honest. If there’s events coming on the horizon, there’s a jobs number last Friday when the markets are closed, things like that coming where we know that hey, people aren’t really executing right now and then we need to wait and see what’s going to happen here. Or the election as you just mentioned came, you just don’t want to be putting something on even though your stuff says, “Hey, this is a great trade.” And you may think that, hey, this fits in with our viewpoint and everything lines up, the risk reward is great, but it’s just not going to work right now because of XYZ. And you always have to be playing it out, and I was just thinking as you guys were talking, the decision tree is always what you’re thinking about of, if something happens right now, what is the market going to interpret it as?
Matt Laviolette:
It’s not necessarily as for instance a jobs number, and for the last 10 years a lot of the times good is bad and bad is good on the number front, and how are markets going to trade off that? And so with the election there was a six prong outcome of there what could have happened, and all of it led to bullish events unless there was a major blue sweep, which we even didn’t get after January, but almost. If it would have gone 50/50 Senate on election night and it was sure Biden was in there and it wasn’t the chaos, I think that probably the next few days would have been a little more chaotic, but then I think the outcome in the end we would still be where we are now. And maybe the trading event would have been better, but the ensuing time period would have played out the same.
Jason Buck:
And then Aaron, because you already hinted at it before we get into actual position sizing and stops and all those interesting pieces, is how do you think about the trade construction, right? If you have a basket of trades that you could put on, I mean, you’re looking at maybe market indices, maybe you’re looking at the energy space or metal space, and you have a lot of different instruments you can put on. Like you said, you’re looking for the largest trade with the smallest stop loss. So how do you run through those systems of putting on a directional trade knowing you have a lot of instruments to choose from?
Aaron Larkin:
Yeah, it really is digging in and saying, where are we at in price? Where are we at in the range and where’s positioning and where’s positioning which gives us… We want price confirmation immediately. I mean, the one thing that about us is that when we do put on a trade, we expect price confirmation to happen within that day. And if it doesn’t happen within that day, we’re happy to exit it and sit back and wait for another setup because in our eyes, if we’re not getting that price confirmation immediately, then we’re missing something or the market’s already has this priced in, or there’s something wrong. And so that’s the process, is that sometimes there’ll be a lot of small trades that get put out there and maybe in some small markets, but whatever one gives us the price confirmation is typically where the attention is going to go.
Aaron Larkin:
And then that’s where the attention goes and then you might exit the other trades or you never even got them on. Because there’s typically a leader, there’s typically a leader in price and that’s typically the one that you’re going to be involved in. And if you missed that one, then you’re looking for another correlated product that’s similar, that maybe is lagging and then you’ll hop on board on that trade. So there’s a little bit of an art, but for us the way that we manage it is that we’re looking as if every position gets stopped out to a loss, and so we’re not looking for those correlations to help balance our portfolio. The assumption is that every position is wrong and gets topped out, and that’s part of our risk management.
Jason Buck:
So thinking about just some examples of maybe a leading price indicator, and then a lagging one, would that be gold as a leader, and then you have a lagging with silver or choose our leader, and then you have a lagging with S&P? How do you structure those trades? The price action confirms whichever is leading, and then after maybe that price actions run out you’re looking for the laggard to catch up to pricing or how do you look at it?
Aaron Larkin:
Yeah, some of that all comes into that decision. It’s a little interesting right now just with all the rotation that’s taking place where markets are acting independently, and you’re not necessarily always that getting that confirmation that you’re used to getting. But traditional time, you are looking for a currency to confirm the move that’s taking place, and maybe one of your other assets that you’re allocating in, or you’re looking for another correlated product that’s at least moving in that direction. You don’t want to see them both one making a major move and the other one just sitting there, you should get some correlation confirmation across the board. If not, then typically I would say I know it’s called a false move, but it’s the move’s probably already played out and you’re going to get mean reversion. So that’s managing the trade after you’re already in it, it’s managing and looking for confirmation and that’s where a lot of time is spent. It’s literally looking for confirmation that this trade is holding strong in both in price and time, and it’s understanding that piece.
Jason Buck:
So Matt, tell me about… you guys put that initial position on, but almost like you guys tranche, legging into the trade so how to does that set up work?
Matt Laviolette:
Yeah, As Aaron is saying we expect markets to move right now, today, and if they’re not moving we’re out. And we’ll wait, we’ll put it on again next day, or a couple days later when we think that catalyst re-lines up or use that as information of maybe you’re wrong. Being wrong is awesome, because you can have the best trades ever when you have a whole legal pad of reasons why something’s going to play out, and the market just looks at you like hey, man, it’s not going to happen. And the market’s generally going to go the other way pretty hard, pretty fast, and so that’s a great opportunity. But we do put on our positions in three tranches, and so you assume and think prices move in our direction, we’ll add our first position depending on the risk reward of the market is going to be 25 to 40 pips of risk.
Matt Laviolette:
And as markets move we’ll define a couple places to add, and so we’ll add up to three times, so another 25 to 40 pips, taking it to around 1% of our risk per trade. And so we do run a concentrated book in that maximum positions you’ll see with us is five to seven positions, but even with that inside of that, really there’s probably two core positions. And as Aaron was saying, we don’t believe in portfolio risk mitigation, we think everything is probably highly correlated because their ideas lie in the same fundamental beliefs. So if one’s going to get stopped out, we’re probably going to be exiting everything even though other markets haven’t been stopped out, and we’ll reassess from there. But we add three times, take it up to around 1% and we add the winners, we don’t add the losers and that’s why we’re still here.
Jason Buck:
When you think about those three times is that also an aggregate? Say, if you had gold and silver positions on, is it the aggregate position in that sector, or is it individual position?
Matt Laviolette:
Individual positions. I mean, at that point we wouldn’t be viewing that, hey this is a very highly correlated position so adding another tranche might be taking it a little bit higher of risk than we’re comfortable with in that position or that sector for that asset class. But we do view everything as separate because at the end of the day prices move on their own until risk becomes one when volatility spikes of course, and then you’re all putting the same position on. But in a market like this what we’ve seen recently with relatively, something we’ve been talking about since last summer as we exited the lockdowns was what we’re going to look out on the back end of this is a world where volatility is going to be heightened relative to where it has been in the past. So the floor, which is to say the floor volatility is just way higher than it what was ever before.
Matt Laviolette:
So we’re in… other years when we’ve been pinned to all time highs as we are now, VIX might have been at 11, or 12, or nine, those were fun times. But now the floor is, we’re just below 18 for the first time in a year and a half now maybe, and so that’s really high level and markets are trying to digest that. And either this is going to be a springboard to higher volatility, or it’s going to contract quite a bit from here and I guess my personal opinion is that vol is going to stay high, but risk can still run quite a bit along with that. But we’ll see.
Jason Buck:
It’s interesting to me that like you said, you guys are managing via stop loss, so therefore you just assume correlations are going to one, but you don’t even refer back to even the four quadrant model let’s say if you had five to seven positions on. Say if you were long S&P, but long gold, you’re not thinking about those canceling each other out in a way, you’re just taking just correlations go to one across your whole book and that’s what the assumption always is?
Matt Laviolette:
Yeah, and it’s a P&L based decision. We’re not going to be reliant because hey, our S&P stop is in a spot where we wanted to get out of S&P, but gold’s working and offsetting that, we still get out. We’re not using that as an offsetting… If one product’s not working it’s just not working, and why would we stay in it? So we get out of them relatively quickly.
Jason Buck:
Yeah, that’s interesting to not look at the correlations, just look at the individual trades. If it’s not working, then you just get out. And so Aaron, I was thinking about also how do you think about the stop losses, or if you’re triggering multiple stop losses over a day, a week, a month, how are you adjusting the overall portfolio construction?
Aaron Larkin:
Well, I still think we’re sticking to the process. I mean, that’s part of it is with our strategy and with tighter stops you are going to get stopped out more. I mean, that’s the nature, is that stops are going to hit and that’s part of it, but it gets into the positive skew, is that you accumulate small losers, but when you actually do capture a move that pays multiple. Our minimum risk reward is like a three to one and typically we’re looking for much greater than that, and so one winner makes up typically three to five losers. And so that’s the way the model is written and the way that we’re looking at it.
Jason Buck:
Reducing position size in a drawdown if you guys are down two and a half or 5%, how are you reducing position size, but still staying in the game? As we like to say surviving is thriving.
Aaron Larkin:
Yeah, so at the two and a half percent, we reduce by 50% and at 5%, we reduce by 50% again. And that’s what we learned just from our career from day one in the prop space, and that’s be disciplined and stick to that process. Because markets go through periods of time where an approach doesn’t work, and they get choppy, and initially our approach maybe doesn’t work and markets get choppy, and so you do get chopped up and that’s part of it. And as frustrating as it is, which it is. As a trader it’s extremely frustrating, but it always makes a shift and typically when it does make that shift is when the best opportunity takes place. And that’s typically where historically for us, a lot of our returns have been generated. And so when that shift takes place, you’re still involved in the trade, and you’re in there and then as you come out of your drawdown is you’re sizing comes right back up and that’s how it’s worked for us over our career. Drawdowns happen, they’ve happened multiple times, and they’ll happen multiple times again in the future.
Jason Buck:
Aaron when you have systematic ways of managing risk, when it goes against and you hit your stops and everything that’s an easier way to get out, what’s actually more difficult is when the trade is running in your direction, right? So then what are the monetization heuristics? How do you assess the trade when it’s going in your favor? Those are a little bit more nebulous than just hitting your stop so how do you assess that?
Aaron Larkin:
Yeah. So in general, we’re still sticking to our process of that one to 10 days, and so what you’ll find a lot of times with us that, and I think of 2019 as a good example. We were long bullish gold Q4 of 2018, and really all the way up until almost Q3 of 2021 that we were super bullish gold, and we were sitting in a long gold trade for pockets of time. And so what typically happens as the market runs in our favor we’re sizing up initially on the move, but what happens is as the market is moving in your favor, the risk reward is changing. It’s the market has made its move now all of a sudden the risk reward is not quite what it used to be, and so then at that point we’re reducing and taking some profits. And sometimes we might even get flat and just turn around and wait for another setup, and that’s part of it. Typically, there’s some mean reversion in sideways movement that happens and so we’re waiting for some market structure, and waiting for another catalyst before re-entering that trade even though then we’re still super bullish at the same time.
Jason Buck:
Matt, Aaron referenced this seven to 10 day trading timeframe, and so is there ever a timestamp of 10 days, or you’re just reassessing if you think the trade is stale, or hasn’t gone anywhere in 10 days then it’s time to reassess?
Matt Laviolette:
What we’ve found with the way we approach our process is inside of that one to 10 days, and if we’re holding beyond that you’re at the whim of randomness and it doesn’t make any sense to go beyond that. So what even we find is that one to three days is really the sweet spot, you see the easiest money is made in that first three days unless there’s extenuating circumstances or some other reason that capital would have to flow and really make dynamic changes in the course of something might play out over 10 days. But like Aaron was just saying, it’s all about the risk reward and for instance, when we were buying precious metals all of ’19 and ’20, it would have been great to just buy call options and say, “See you later.” But putting that position on as it’s working, and we’re getting more and more convicted in our views, and everything else is lining up all the way along the line, when the risk reward no longer is as attractive as it was when you put it on you’ve got to take it off, you just have to.
Matt Laviolette:
And it’ll be okay if you miss the next little bit of a leg, but it’s going to reset up and wait a couple weeks, or it might be a day or a couple of weeks or a month, and we’ll get it back on and that’s fine. But if we stick to our process, which means a clearly defined risk reward, which is the most important, and the stop that we are comfortable with that’s a spot where we’re going to look to take advantage of, but sticking inside that one to 10 day timeframe is very important for the way we do it.
Jason Buck:
So for example… Okay go ahead, Aaron
Aaron Larkin:
Can I jump in? Sorry. I want to make a point here and this is something that we like to point out especially in most of our meetings is that, that one to 10 day timeframe is by design. That was quantified, and we dug into that and the reasoning is, if you look kind of… Let’s go pre 2019, or pre 2020. As we were discussing about volatility being so low, and there wasn’t necessarily a lot of opportunity, and so a lot of strategies struggled during that timeframe because they’re looking for longer duration trades, and markets just didn’t do it. And what would happen is you’d get a lot of these short term signals that started an initial move, and then they fizzle out and nothing happens. And so as I always say is that we’re really looking to capitalize on the part of the move that has the most momentum, and what can take place with that is that you get these as I call them false positives.
Aaron Larkin:
Meaning you get some catalysts, you get some strength that last one, two, maybe even three days, and then it mean reverts and gets back into the channel and nothing really happens. And so for us is that we want to capitalize on that one, two, three days, harvest gains, and sit back and wait for another setup. And I think that’s coming from the prop space of you need to make money regardless, and so you need to be involved and be able to make money. And I would say in general, that strategy works really well and that’s how we’re still in this game, in this business at this point in time, and there’s always pockets of times where maybe sitting in that trade and just sitting back and watching is a better approach. And let’s say that happens once every 10 years or something along those lines, but the other nine years is, we’re looking to try to make money consistently over time and so that’s really why that design came in, is that was a conscious decision making that one to 10 day timeframe
Jason Buck:
That’s interesting Aaron, so if you’re thinking about over a year or two if all your setups are saying long gold, but you have all the timeframes and you’re waiting for your setups, does that mean you may be long gold at 20 different occasions throughout a year just monetizing and waiting for the right setup? Is that [crosstalk 00:50:08]?
Aaron Larkin:
Yeah. And that’s actually exactly what happened in 2019, this was in the precious metals. And so there was a couple of reasons why more risk was allocated to precious metals and gold specifically in 2019, was as we mentioned that we like trading equities and equities is our space filler when we’re waiting for better setups. With the tweets that were taking place, we actually reduced risk to equities and reallocated that into our precious metal gold specific position. And so we had that position on I would say full position six or seven times throughout 2019, and then we were flat a lot as well and by design, we like to be flat because of those headlines or those unexpected risks. We want to be flat and be able to capitalize versus spending our time liquidating during those periods of times. So that’s by design as well is that we want to express our opinions when there’s the most momentum and there’s a catalyst behind it, and if there’s not a momentum and a catalyst, or that catalyst is stale, we want to be flat and just turn around and wait again.
Aaron Larkin:
And so it’s always in the back of our head, hey, we want to be long gold, we think there’s a lot of potential here, but let’s sit back and wait until there’s a new catalyst or new information that’s confirming price movement.
Jason Buck:
Got it. And Matt, my last question and it’s probably one you guys get often, is how do you guys deal with the two star problem, right? How do you guys argue? How do guys figure out who’s right discretionarily? And I guess one could say that every marriage is a two star problem at the end of the day, so maybe you have experience with both your personal marriages and then being married to each other. How do you guys argue well?
Matt Laviolette:
Over Slack?
Jason Buck:
Yeah, but over Slack is everything will get misinterpreted in text, you got to pick up the phone pretty quick if it’s immediate, right?
Matt Laviolette:
At the end of the day trading-wise I do have the final call on trading one way or the other, but in general, our process we’ve developed it to where we know what we’re going to do, it’s just a matter of style sometimes of how we’re going to execute that. It’s very rare that we have a different opinion on how things may play out, it’s just in timeframe that we always have a discussion. And we get around these transition periods where markets want to pivot one way or the other and that’s always the debate that we have constantly even when a market is very clearly in one quadrant or another and trading very clearly in one way or the other. You want to be able to take advantage of the shifts when they happen, and sometimes that means being early to the party and being wrong and just going right back to the playbook that you didn’t think you were going to be doing a week ago.
Matt Laviolette:
So yeah, I mean it happens, it’s a constant discussion, and one thing I found that 20 years ago way back in our prop days we had various guys leave, I think I hired about 100 guys and I don’t know how many made it, but the two who are still doing it are talking to you right now. And I think one of the keys that some of the people who quit the business or exited the business was they stopped the conversation and the debate, and they wanted to have their opinion the whole time. And that’s fine, to be good at this you have to have an opinion, you have to believe in what you think, but at the same time you have to have the conversation all the time. And so that’s what we try and do and at the same time let the math prove it in the background.
Jason Buck:
And Aaron I’m going to set you up, do you concur with what Matt said, or do you have a differing opinion?
Aaron Larkin:
No, I do. I mean, I think it really is typically our discussions are not necessarily on opinion, it’s more on execution. As I would say, I’m a more of a levels trader and Matt’s the more of a momentum trader, and so I’m just taking an example last night where we were in a trade. I liked the trade and I was just commenting on… The trade made a significant move, it was sitting at, in my opinion a significant level, and so I was making a comment on “I think this, this and this needs to hold to still stay in that trade.” And so it wasn’t that I didn’t like the idea, it’s just sharing from my opinion if these levels didn’t hold, that I would be exiting the trade or even taking the opposite position at that time. So that’s where I think sometimes the input comes in, it’s just sometimes it’s the risk management of the trade is really what that comes down to.
Aaron Larkin:
And that was really why Matt and I came together in the beginning, was this. As a trader I felt like I would always capture the initial move, I was great at capturing the edge and capturing that initial move, I would exit the trade and pat myself on the back feel pretty good. And at that point we could see who we’re trading with and Matt was always on the other side of the trade and taking it to the next level, and I’m like, “I just left all that money on the table.” And so that was really when we came together was just I knew what I was good at, and I knew what Matt was good at, and so let’s try to take some of our expertise and focus on what we’re both good at and do our part.
Jason Buck:
Yeah, that’s an excellent example of self awareness, to be able to combine complimentary strategies. So I just want to thank you guys for walking us through this because I find it’s a very unique approach where you’re combining that discipline of prop trading to opportunistic global macro and it creates a very unique firm and structure that you guys created. So just thanks for coming on the pod and we appreciate your time.
Aaron Larkin:
Great. Thank you. I appreciate you having us.
Matt Laviolette:
Thank you.
Taylor Pearson:
Thanks for listening. If you enjoyed today’s show, we’d appreciate if you would share this show with friends and leave a short review on iTunes as it helps more listeners find the show and join our amazing community. To those of you who’ve already shared or left a review, thank you very sincerely. It does mean a lot to us. If you’d like more information about Mutiny Fund, you can go to mutinyfund.com. For any thoughts on how we can improve the show or questions about anything we’ve talked about here on the podcast today, drop us a message via email, I’m Taylor@mutinyfund.com and Jason is Jason@mutinyfund.com. Or you can reach us on Twitter, I’m @TaylorPearsonMe and Jason is @JasonMutiny. To hear about new episodes or get our monthly newsletter with reading recommendations, sign up at mutinyfund.com/newsletter.
