The Next Perfect Trade Summary

Introduction

Overview

The chapter opens with a powerful metaphor: the financial markets are a battlefield, and this book is a guide to forging and wielding a specific "magic weapon" called the Sword of Necessity. This weapon is not a quick fix but a sophisticated, intellectual framework for identifying trades that can succeed across diverse economic conditions. The author positions the work as the culmination of years of "financial soul-searching," designed to be valuable for both new and experienced investors. The journey begins by defining the author's own battlefield—his unique approach to investing—and tackling the fundamental question of whether consistent profitability in trading is a matter of skill or mere luck.

The Author's Arena: Defining a Discretionary Global Macro Trader

The author meticulously defines his professional niche: a long-horizon, discretionary global macro trader.

• Long-Horizon: He seeks trades that may take years to fully pay off, avoiding the frenzy of short-term speculation.
• Discretionary: He is a human decision-maker, not an algorithm. While he may use quantitative tools, he ultimately interprets and acts on the information himself.
• Global: His playing field is the entire world. He has preferences (like U.S. interest rates or certain currencies and regions) but is fundamentally unrestricted by geography.
• Macro: He bets on the directional movement of assets based on macroeconomic principles, as opposed to engaging in arbitrage.
• Trader/Investor: He uses these terms almost synonymously. His primary investment is in himself—his skill and judgment in deploying capital.

The Central Question: Skill, Luck, and the Search for "The Good Ones"

With his role established, he poses a critical question: If his method is so profitable, why isn't everyone doing it? He dismisses the simplistic labels of "genius" or "rock star," recognizing that past success can be misleading. To explore this, he draws a deep analogy to poker, a game of skill where luck still plays a significant role over even large samples. A startling simulation revealed that even a skilled poker player could lose money over a million hands due to statistical variance.

He argues trading is similar but with even smaller sample sizes (a long-horizon trader might make fewer than 100 crucial trades in a career) and compounded by survivorship bias—we typically only see the records of the "lucky" survivors, not those who failed and disappeared. This reality doesn't disprove the existence of true skill, but it underscores why investors seek more than just a track record; they demand a coherent, explainable philosophy.

The Core Philosophy: Dislocation, Elimination, and the Sword of Necessity

The author explains that his investment philosophy starts with a universal principle: "dislocation equals value." A profitable opportunity exists only when something is trading at the wrong price. Every trading style answers three questions: how to find dislocations, how to profit from them, and how to manage risk.

He then defines his approach by a process of elimination. He is not a deep quantitative researcher, a corporate intel gatherer, a complex model builder, a high-frequency algorithm coder, a technical chartist, or merely a disciplined intuition-based trader. His strategic thrust is distinct:

"THE THRUST OF MY INVESTMENT STRATEGY IS NOT LIMITED TO ANALYZING FORCES THAT DRIVE MARKETS."

Instead, his key advantage is:

"UNDERSTANDING THE FORCES THAT DRIVE SUCCESSFUL TRADES."

This book, therefore, is a guide to isolating superior trades by eliminating inferior ones. The promised "Sword of Necessity" is the tool for this task. The narrative is structured as a journey through the "labyrinth of intellectual and psychological fallacies" in investing, culminating in the revelation of "concurrent necessity" the author discovered in 2002, which he calls a "perfect trade."

The Roadmap: A Three-Part Journey

The book is structured to build understanding progressively:

• Part I: Focuses on developing a positive risk/reward profile by aligning with overarching market "tides" and avoiding stacked odds.
• Part II: Teaches how to minimize trades that can lose money even if your market view is correct.
• Part III: Provides the system for identifying "dominant" trades to achieve a profitable portfolio even when your underlying market view is wrong.

Key Takeaways

• Successful investing requires preparation akin to gearing up for battle; this book provides the training and the specific weapon—the Sword of Necessity.
• The author’s approach is discretionary, global, macro, and long-horizon, focusing on large-scale directional moves over years.
• Distinguishing between skill and luck in trading is profoundly difficult due to small sample sizes and survivorship bias, making a logical philosophy more important than a track record alone.
• All trading seeks to exploit market dislocations (wrong prices). The author's unique edge is not in finding what moves markets, but in understanding what makes a trade itself successful.
• The book’s methodology is built on eliminating bad trades and is structured in three parts: harnessing market tides, minimizing loss-prone positions, and building a robust portfolio through dominant, necessary trades.

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The Next Perfect Trade Summary

1. Trend

Overview

The chapter explores the concept of trend in financial markets, arguing that while following trends is a foundational principle, it is not a simple, universal rule. It examines why professional traders often fail to capitalize on obvious trends, using the year 2014 as a primary case study, and introduces a framework for understanding when and why trends persist.

The Paradox of 2014: Clear Trends, Poor Performance

The year 2014 presented stark, clear trends across major markets: the US dollar and long-dated Treasury bonds were in powerful uptrends, while oil trended sharply downward in the latter half. Despite this, the average global macro hedge fund returned a meager 3.1%. The author notes that to perform poorly, most managers had to actively disregard these prevailing trends. In contrast, the author's own portfolio had a record year by adhering to them. This sets up a core paradox: everyone knows the maxims about following the trend, yet professionals consistently fail to do so in practice.

A Note of Humility: The Author's Own Lapses

In a reflective aside labeled "NOTE FROM 2025," the author admits to their own failures in trend-following in subsequent years, specifically citing struggles with the bond market after the 2016 election and missing the yen depreciation trend of 2021-2024. This serves as an important qualifier: the author is not claiming infallibility but rather advocating for a disciplined intellectual framework to identify situations where trends should be respected. The process of writing the book helped enforce that discipline.

Defining "The Market" and a Nod to Currencies

The chapter clarifies that for macro traders, "the market" encompasses four major categories: equities (stocks), FX (currencies), debt (bonds and interest rates), and commodities. The author posits that interest rates are "at the heart of everything" but finds currency trends the easiest to observe and follow. A key insight is that major currencies (USD, EUR, JPY) tend to trend against each other more strongly and predictably than against emerging market currencies. A trend is defined not by the size of the move, but by a historical positive expectation that betting on its persistence will be profitable.

The Pendulum: A Framework for Currency Trends

To intellectualize trend persistence, the author introduces the analogy of a pendulum. Economic gravity (like a too-strong currency hurting exports) eventually slows and reverses a trend. However, accumulated momentum carries the price far past the equilibrium or "fair value" point. The critical mistake is exiting a trade at fair value, which is precisely when momentum in the new direction is greatest. Charts of EURUSD and USDJPY illustrate multi-year trends where selling a rising euro or buying a falling yen at seemingly "fair" levels would have resulted in repeated, painful losses.

Secular vs. Cyclical Trends in Stocks and Bonds

The pendulum effect also applies to equities and interest rates, but these markets exhibit another powerful phenomenon: secular trends. On a long-term logarithmic scale, the relentless upward trend of the US stock market since 1940 makes cyclical downturns look like minor fluctuations. Similarly, a chart of US long-bond futures from 1985-2014 shows an incredible, decades-long rally where attempting to "fade" or bet against the trend was disastrous. The author identifies being short US bonds in 2014 as arguably "the worst trade ever," not due to a flawed economic view, but a fundamental failure of logic that went against this profound secular momentum.

Key Takeaways

• Trends are powerful but not simple: While "the trend is your friend" is a cliché, professionals often fail to act on it, as seen in 2014.
• Context matters: The directive should be refined to "don’t trade against the trend in a market which tends to be trending."
• The pendulum analogy explains persistence: In currencies, momentum, driven by past economic imbalances and policy actions, carries prices far beyond fair value. Exiting at fair value means missing the move with the greatest momentum.
• Respect secular momentum: In equities and bonds, long-term, multi-decade secular trends can overwhelm cyclical moves. Fighting such profound momentum is a fundamental error.
• Intellectual discipline is key: Success requires a framework to recognize when a market is in a state where its trend deserves respect, a discipline the author admits is challenging even for themselves.

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The Next Perfect Trade Summary

2. Carry

Overview

Carry is the net yield or income generated by a financial position, separate from capital gains, calculated by subtracting funding costs from asset yields. This concept is universally relevant, from institutional trading to personal finance, like using mortgage debt for investments. A classic example is the currency carry trade, such as borrowing Japanese Yen to invest in Turkish Lira. While spot price charts might suggest shorting the Lira was profitable, the total return—including interest carry—reveals that holding the high-yielding currency long-term reversed losses into gains, demonstrating the power of positive carry and the peril of fighting strong trends.

US Treasuries embody perhaps the deepest carry trade. Though their yields seem modest, through the repurchase agreement (repo) market, leveraged traders can borrow at rates below Treasury yields, creating a positive carry spread. Their value extends beyond income to serving as premier collateral in a borrowing-driven system. For those without direct repo access, Treasury futures provide an alternative, where the quarterly roll—selling an expiring contract to buy a later-dated one—captures expected carry upfront. In a steep yield curve, this roll also incorporates a beneficial slide, as the underlying security's yield moves down the curve, adding returns and making it challenging to bet against such positions.

A modern case study with the US Dollar and Chinese Renminbi (USDCNH) highlights carry's decisive role. Even with correct directional forecasts, years of negative carry eroded profits, while a shift to positive carry later boosted returns, as seen in carry-adjusted charts. This underscores that profitability hinges not just on price movements but on the net yield dynamics. Underpinning these examples, currency speculation revolves around balancing interest payments and receipts tied to overnight rates, while total return charts offer a holistic view by blending price changes with interest flows.

However, returns must be considered after taxes and inflation, as nominal bond yields can mask real losses in purchasing power. Central banks, through tools like Quantitative Easing (QE) and rate hikes, profoundly influence interest rates and liquidity, shaping the environment for carry trades. In short-term funding, repo markets illustrate how collateral quality affects borrowing costs, with high-demand "special" securities often securing cheaper loans. Longer maturities in bonds bring higher volatility due to interest rate risk, and benchmark securities like on-the-run Treasuries anchor pricing, while the yield curve signals future rate expectations.

Derivatives like futures contracts require understanding rolling and pricing mechanics, such as with Eurodollar futures, where implied yields reflect short-term forecasts. Arbitrage acts as a corrective force, ensuring prices converge across similar instruments and accurately reflect carry and slide. Additionally, interest-rate swaps allow parties to exchange fixed and floating rates, and monetary policy adjustments directly impact carry dynamics. Ultimately, carry is a fundamental force in finance, and grasping its intricacies—from funding costs and total returns to central bank actions and market mechanics—is essential for navigating investments effectively.

Carry is defined as the net yield or income generated by a financial position, separate from capital gains or losses. It’s calculated by taking the yield of an asset (like a bond coupon or stock dividend) and subtracting the cost to fund that position. For a leveraged trader, this funding cost is critical. The concept is immediately framed as universally important, applicable not just to institutional derivatives trading but also to personal finance decisions, like using mortgage debt to fund an investment portfolio.

Currency Carry Trades: The Illusion of Simple Charts

A classic example is the currency carry trade, where investors borrow in a low-yielding currency (like the Japanese Yen) to invest in a higher-yielding one (like the Turkish Lira). At first glance, a chart of the Turkish Lira's depreciation against the Yen (TRY/JPY) from 1999-2014 suggests that shorting the Lira would have been perpetually profitable. However, this spot price chart presents a "skewed perception." The true economic picture emerges only when examining the total return, which includes the lucrative interest rate carry earned by holding the high-yielding Lira. Over the long horizon, this positive carry completely reversed the narrative, making the "carry hogs" who were long TRY/JPY substantial profits despite the currency's depreciation. The strategic insight is to avoid fighting powerful carry trends and instead look for opportunities to establish positions after a high-yielding currency suffers a crisis-driven blow-up, aiming to capture both future carry and potential currency appreciation.

The Ultimate Carry Trade: US Treasuries

US government debt is presented as perhaps the most profound carry trade. While its meager yield seems unattractive to a traditional asset allocator comparing it to stocks, the perspective shifts entirely through the lens of leverage and the repurchase agreement (repo) market. A leveraged trader can buy Treasuries and simultaneously borrow against them at a rate close to the Federal Funds rate, often for less than the Treasury's yield. This creates a positive carry spread. Historical analysis from 1990-2004 shows that buying ten-year notes and funding them overnight would have yielded an average net carry of about 2.3% annually—a return that could be massively amplified through leverage. The key is that Treasuries are considered the world's premier collateral; their "intrinsic value" to a leveraged trader isn't just their yield-to-maturity, but their utility in a system built on borrowing.

Capturing Carry Through Futures and the "Slide"

For those who can't access the repo market directly, Treasury futures offer a pathway to harvest carry. A simple price chart for these futures is "almost meaningless" because it doesn't account for the quarterly "roll." When a futures contract expires, the trader sells the near-dated contract and buys a further-dated one, which is typically cheaper. This price difference represents the market paying the trader the expected carry in advance. Furthermore, in a world with a steeply upward-sloping yield curve, each roll also incorporates a beneficial "slide." As the contract's underlying security matures by three months with each roll, its yield "slides" down the curve to a lower point, providing an additional source of return akin to carry. Betting against a position with positive carry and slide, therefore, requires being not just correct on direction, but dramatically correct to overcome these relentless costs.

A Modern Case Study: The USDCNH Trade

A note from 2025 introduces a concrete, decade-long case study: trading the Chinese Renminbi (CNH) against the US Dollar. While the author correctly anticipated a major trend reversal (CNH depreciation starting in 2015), the trade's initial years were plagued by extremely negative carry due to interest rate differentials. This period was a struggle. The dynamics flipped after the pandemic, as US economic outperformance led to rising US rates and falling Chinese rates, making the carry on the long USD/CNH trade positive. The spot price chart shows an uptrend, but the carry-adjusted chart reveals the true, volatile cost-benefit story: the trade was costly during the negative carry phase (2017-2018) and became highly lucrative when carry turned favorable (2022-2024). This real-world example underscores carry's decisive role in long-term profitability, separate from being directionally right.

Currency Speculation and Interest Rate Dynamics

In speculative currency positions, you borrow one currency to purchase another, creating a dynamic where you pay interest on the borrowed currency and receive interest on the acquired one. This interplay is at the heart of carry trades, with the yield on a currency rooted in the overnight interbank lending rate. It's a delicate balance where the cost of borrowing and the income from holdings directly influence profitability.

Visualizing Returns with Total Return Charts

To truly understand the economic effect of a position, total return charts are essential. They capture everything—interest payments, receipts, and price movements—offering a holistic picture. While tools like Bloomberg provide raw data, real-world factors like liquidity can cause variations, but these charts excel at conveying the general narrative of returns over time.

Accounting for Taxes and Inflation

For bondholders, the story doesn't end with nominal yields. After taxes, the real return might slip below inflation, quietly eroding purchasing power. Imagine a 2% Treasury yield shrinking to 1.5% post-tax; in an inflationary environment, this could mean your investment actually loses value in real terms, a subtle but critical consideration for long-term planning.

Central Bank Influence and Market Liquidity

The Federal Reserve's actions, such as Quantitative Easing (QE), are powerful forces that shape interest rates and flood the system with liquidity. When the Fed hinted at tapering in 2013, it was a signal of growing economic confidence. Liquidity—the ease of trading large sizes without big costs—is the lifeblood of markets, with instruments like Treasuries prized for their fluidity.

Collateral and Repo Markets

Repo transactions, where securities serve as collateral for overnight loans, are legally framed as sales with repurchase agreements. Benchmarks like the Fed Funds rate guide borrowing costs, but reality often diverges; for instance, "special" securities in high demand can secure loans at lower rates, highlighting how collateral quality tweaks the mechanics of short-term funding.

Maturity, Volatility, and Benchmark Securities

Longer maturities bring greater exposure to interest rate shifts, naturally coupling with higher volatility. Benchmark securities, such as the freshly issued "on-the-run" ten-year Treasury note, act as pricing anchors. The yield curve, built from instruments like swaps and futures, maps market expectations for future rates, with terms like "steep" or "flat" painting a picture of economic sentiment.

Derivatives and Futures Mechanics

Derivatives like ETFs track Treasury performance, while futures contracts—obligations to buy or sell at set prices—require periodic "rolling" to maintain positions as they expire. Eurodollar futures, for example, derive their pricing from three-month LIBOR, with implied yields neatly calculated as 100 minus the contract price, offering a window into short-term rate forecasts.

Arbitrage and Price Convergence

When price gaps emerge between similar instruments, such as futures and physical securities, arbitrageurs step in to sell the expensive and buy the cheap, driving convergence. This process ensures that carry and slide differentials are accurately reflected, keeping markets efficient and aligned with underlying economic realities.

Interest-Rate Swaps and Monetary Policy

In interest-rate swaps, parties exchange fixed for floating rates, with the swap rate quoted from the fixed side. Meanwhile, central banks like the Fed use tools such as tightening—or "hiking" rates—to manage inflation and growth by adjusting overnight lending targets, a reminder of how policy ripples through every corner of finance.

Key Takeaways

• Currency speculation hinges on the net effect of interest payments and receipts, core to carry trade strategies.
• Total return charts offer a comprehensive view by incorporating all economic factors of an investment.
• Taxes and inflation can turn nominal bond yields into real losses, emphasizing the need for after-tax analysis.
• Central bank policies, from QE to tapering, are pivotal in setting interest rates and ensuring market liquidity.
• Repo markets demonstrate how collateral quality influences borrowing costs in short-term funding.
• Maturity and volatility are linked through interest rate risk, affecting long-term security pricing.
• Benchmark securities and the yield curve provide valuable signals about future interest rate expectations.
• Derivatives like futures and swaps require understanding of rolling, pricing, and settlement mechanics.
• Arbitrage acts as a market corrective force, ensuring price alignment across similar financial instruments.
• Monetary policy adjustments, such as rate hikes, are key levers for controlling economic stability and inflation.

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The Next Perfect Trade Summary

3. Valuation Pull

Overview

This chapter examines the powerful, often slow-acting force of fundamental valuation in financial markets, contrasting it with the noise of daily news and sentiment. It argues that while stories and momentum can distort prices temporarily, an "economic gravity" ultimately pulls assets toward reasonable valuations. Through concrete examples involving stocks like IBM and Twitter, and extending into bonds and currencies, the chapter introduces practical frameworks—like the "all else being equal" principle—for identifying and capitalizing on these dislocations, even when perfect analysis is impossible.

The Fundamental Pull and the Stock Example

Financial instruments often trade at prices divorced from their fundamental value due to momentum or sentiment. However, a gravitational pull toward reasonable valuation exists. In stocks, this pull can manifest through mechanisms like dividends and, more powerfully, share buybacks. A company with persistently undervalued shares can aggressively repurchase them, effectively transferring value to remaining shareholders. The example of IBM in late 2014 illustrates this: trading at a very low P/E of 9.6, the market had priced in a dire future. The author's analysis suggested that even if IBM's profits halved, the valuation was so cheap that it would likely prove a sound investment if the company merely survived. A 2025 note adds that while IBM indeed underperformed, the extreme initial valuation cushion prevented the investment from being a disaster.

The "All Else Being Equal" Principle in Action

The author admits to not being a valuation expert but relies on a simplifying principle to avoid analysis paralysis: "all else being equal." This is demonstrated through a detailed case study of Twitter (TWTR) in 2014. After its IPO, the stock was volatile, and the author had no strong view on its intrinsic value. However, in early May 2014, the stock fell 28% in a week largely because a lock-up period expired, allowing employees to sell shares. The author reasoned that if the price before the sell-off ($38.75) was fair based on all available information, then the new price ($30.66) a week later, with no major new economic information, represented a bargain. This was a "forced" transaction creating a purely technical dislocation. Buying into this dip provided a "valuation pull" of roughly 25%, which was realized as the stock drifted back up to $40 by late July, absent any new material news.

Forced Transactions and the Limits of Market Theories

This example challenges pure theories of market efficiency. The author argues that both Efficient Market Theory (EMT) and behavioral finance often miss a key driver: forced transactions. Many market participants trade not out of opinion, but out of necessity—like a tourist exchanging currency for a trip, a corporation funding an acquisition, or a trader reducing risk due to a boss's order. These necessary trades can overwhelm the market's price-setting mechanism, creating dislocations unrelated to fundamentals. The author compares this to physics: EMT works well under "normal" conditions, but breaks down when "forced" transactions accelerate or volumes distort the market, creating relativistic-like distortions in the financial continuum.

Terminal Value and Trading Interest Rates

The concept of valuation pull is strongest for instruments with a clear terminal value—a known value at a specific endpoint. Stocks lack this, as they don't expire; an overvalued stock can remain so indefinitely. Currencies are also difficult to pin to a fair value. Interest rates, however, are exceptionally satisfying in this regard. Bonds and swaps expire on a set date with known final payments, providing a clear terminal value horizon. The author's approach to trading rates hinges on identifying a dislocation from a estimated terminal value and then increasing the position as it moves against them, maximizing size when the dislocation is greatest. This is the opposite of the trend-following "pyramiding" used in currencies. A key insight is the market's persistent failure to predict future rates accurately, often exhibiting a "negative predictive power": when the market predicts higher future rates, the act of pricing them in can slow the economy, leading to lower realized rates.

A Practical Interest Rate Bet

The chapter concludes with a practical application from early 2014. With the 10-year US Treasury yield near 3%, the author's analysis suggested a "fair" yield was closer to 2-2.25%. This cheap valuation provided a strong pull to initiate a long position. The author's central forecast for a slow rise in rates was wrong—global inflation fell, causing a larger bond rally than expected. Crucially, however, the extremely favorable starting valuation meant the position had a high margin of safety; being wrong on the forecast would likely have led to breakeven, while being right on valuation allowed for gains.

Key Takeaways

• A powerful, fundamental "valuation pull" operates in markets, often obscured by short-term noise and stories.
• The "all else being equal" principle is a powerful tool for identifying opportunities when prices move sharply due to non-economic, forced transactions (like lock-up expirations) without a change in fundamentals.
• Forced, necessary trading by market participants is a major driver of price dislocation that challenges pure market efficiency theories.
• Trading strategies must adapt to an asset's characteristics. Interest rates benefit from a clear terminal value, allowing for a strategy of adding to positions as they become more dislocated. Currencies, with their long trends, are better suited for trend-following pyramiding.
• Valuation provides a margin of safety. Being right on valuation can lead to profits even if your specific market forecast is incorrect, as a sufficiently cheap starting point protects against permanent loss.

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