One of the forefathers of system trading, Larry Hite explains his concept of Asymmetrical Leverage and reveals why diversification was the key to his ultimate financial success.
Asymmetrical Leverage (ASL) is a risk management concept I developed which affords you the benefits of conventional leverage with a very limited downside.
In 1983, ED&F Man bought a stake in my small company, Mint Investment Management which was a Commodity Trading Advisor (CTA). Man became a 50% partner exchange for paying the salaries of my staff and myself, access to their computers and a $5 million line of credit. The structural factors that supported the partnership were a pre-determined probabilities in trading risk and the fact the futures margins paid T-Bill rates and Man was able to borrow under prime, making financing cheap. I needed a way to attract more investors to my company and created the “Mint Guaranteed Ltd. Fund.” The fund offered investors above market rates of return. We invested 60% of their funds in zero-coupon, five-year U.S. Treasury bonds where it was not only protected but would double in approximately five years’ time. The other 40% was invested in our trading program. Worst case scenario, we lost everything in systems, but we could still return the entire principal to our investors within five years and cover our management fees. The guaranteed fund showed a profit of $75 million in our first year.
Diversification limited our downside exposure and was the key to our ultimate financial success.
If you equate diversification with a symphony, and one of the musicians was having an off-day, as the market might, he/she would be surrounded by other instruments contributing to the overall success of the performance. People who get really rich usually have found an asymmetrical position. Those employed by large companies often have stock options as part of their compensation package. Their salary may be stagnant, but their income can increase dramatically over the course of time.
To make Asymmetrical Leverage work, there are three main ingredients: time, knowledge, and money.
- Time – normally the faster you have to move, the riskier the move, but with time to identify the best opportunities, you can improve your odds. With the guaranteed fund, we made investors wait five years. The first one is time which is an especially powerful form of leverage in growing money. With time, we could take advantage of bond maturity and a good long stretch of trading opportunity. Investors were willing to give us the time because in exchange we offered no-risk profit.
- Knowledge – You can’t know the odds until you know the game. If you don’t know the odds, you can’t make an intelligent bet. Leverage applied without knowledge leads to either immediate or eventual disaster.
- Money buys you time, buys you knowledge, and allows the long-term odds to work in your favor. Money leverages the advantages of the first two ingredients. In the case of the guaranteed fund, we leveraged money that was not our own – money provided by the U.S. Treasury in the form of interest paid on a five-year bond. Using other people’s money provides great leverage in building wealth. We built Man using the start-up money provided by ED&F Man.
Risking less money to make more. It’s the key to financial wealth.
To read more from Larry Hite, check out his new book, The Rule.