With the recent events in Israel dominating the news, I see many people getting long OIL or defence stocks. I thought it would be helpful to discuss what my 30 years of experience has taught me about trading macro events are news.
When the news and social media is inundated with reports about a macro event, it is easy to get pulled into the "excitement" about the event and trade. But if you look at what's really going on underneath the surface of the trade decision, it is deeply flawed.
Let's take the events in Israel as an example. Watching the news you probably think to yourself: "There has to be a trade here." While you are not incorrect, analyzing what the best trade is and the best vehicle is almost always overwhelmed by the emotional desire to "get in a trade."
The first question is "WHY".
Our minds are structured to see cause and effect quickly. It's the way we choose fight or flight. This is a good thing in trading, when it is used correctly.
The problem is that a decision to trade an event is clouded by the emotional excitement to "get in on the action." This is a terrible variable that is almost entirely emotion driven.
Macro events create excitement, even terrible ones like Israel. Adrenaline rushes and we feed that by reading all the news constantly. Adrenaline clouds judgement and instead of taking a step back to really consider the Reward to Risk, many are overcome with the strong desire to somehow get in a trade.
This almost always leads to losses and discouragement. To prevent this, its important to complete the steps you should be doing for every trade.
You have come up with a thesis: the event offers an opportunity. But if you are like most, you stop your analysis there.
The Wrong Way:
So you have your thesis: this macro event provides a trading opportunity. That's good.
But if you stop there - you will lose.
Taking a macro event and then extrapolating a related asset move is incredibly difficult. Especially when you are talking about a geopolitical event such as Israel.
If risk is time then not knowing when the macro event will end means you are open to indefinite risk.
Also, jumping in with the herd means that its a crowded trade thesis and therefore, there is little room for you to gain alpha.
The Right Way:
There are two important steps to trading macro:
First, imagine a dart board. Everyone wants to hit the "bullseye" and in trading that means you want to identify those companies that will benefit the most from a macro event. This is very attractive to investors bc it makes sense: there's the cause, macro event, and the effect, companies benefit or lose. But when trading macro events, it is the wrong way and is low probability.
Before I continue let me comment on when "hitting the bullseye" works. If you can be at the very front end of the event, before everyone else rushes in, then you can take advantage of the "bullseye" seekers and exit when they enter for a gain. This is very very hard to do unless you are sitting at your screen and watching exactly the right news flow and the right stocks. Good luck with that.
Back to the dartboard. Instead of choosing companies that immediately come to mind relative to the macro event, go one or two "rings" out from the bullseye.
Let's use the Israeli war as an example. The natural inclination would be to buy all US defense companies or even better, buy the ones with that supply the specific weapons that are being used. In our example, this would be missiles, artillery, bullets. But here's the problem: since we do not know how long the conflict will last, that annoying time factor, we do not know how much of each weapon will be sold. Now you have really gone down the low prob rabbit hole.
Therefore, look for businesses that will be affected by the war, indirectly. Some examples would be fuel, food, money transfer companies. After verifying that they have direct exposure to that geographical region, then you can look at how much of a jump in revenues you believe will occur.
By doing this "off the bullseye" method you will have time to establish a position BEFORE retail rushes in. And you will avoid investing in companies that will pop short term but then drop when people realize that the macro related revenues might not be that much.
The second key is to only establish a starting position of the total capital exposure you want to commit. This will give you time to see how events unfold AND will reduce your risk substantially. Remember that the first goal of investing is to protect capital so you must be willing to do nothing because you cannot establish a good reward to risk profile.
I know that there are traders that will jump in with the herd and make money. But that is a low probability trade method and that's enough for me not to do it.
Let's look at the RTX chart. Raytheon would be a bullseye company. It most definitely supplies the weapons being used and they will increase revenues because of the war in Israel. But that's about as far as you can go since you don't know how much the increase in revenues will be nor for how long.
Looking at the chart, it's easy to see the initial spike in price as the retail herd jumps in. But since then, the price has really gone nowhere. So if you took this trade, your capital would be at risk just at the time the momentum has stopped. Not a profit producing trade.
FINALLY, even if you find a great company, you still need to look at the price action. You need to identify support and resistance levels. You need to this because you need to compute your R calculations. We still follow the methodology with macro driven trades.
A Word About Economic Macro;
Let's say you think the economy is going to collapse and you want to trade your belief. With economic macro there are three very simple rules:
Use an ETF for industry exposure - do not think you can pick the company that will be affected the most.
Use LEAPs (long dated options) to mitigate time risk. And go out far - like twice the amount of time you think it will take for the economic macro to affect the market.
Start very small. Do not commit all your allocated capital at once. By their very nature, economic macro takes time to "bleed" through the system and down to industries and companies.
At the end of the day, just because a macro event is happening or you think it will happen doesn't mean that its a good trade opportunity. Most of the time, I do not trade large in process macro events, especially geo political events. But if you must, at least reduce your risk and do not follow the herd. Find opportunities that are related but not directly to the event. Nine out of ten times, you will end up just not trading the event. This is a great result.
And the best macro trades are the ones that are economic in nature. Rises or drops in interest rates, economic cycles etc.
And if you just want to gamble, then make it a "Lunch money trade." You will "scratch your itch" so to speak, but you will not be at much risk. Remember that it is always better to own not enough than to own too much.