Notes from "The Greatest trade ever" John Paulson's subprime mortgage trade.

I just finished the book "The greatest trade ever" by Gregory Zuckerman. This book has an interesting story of how John Paulson made billions from the recent financial crisis. I expected to read the book as a historical account, but gained some useful lessons that can be used in my trading.

Paulson made $15Billion in 2007 from the subprime mortgage crisis. His cut was nearly $4Billion. To put $4billion in perspective, this is more than $10million a day.

I found some interesting themes in the book and wanted to share it.

Salient points from the book

Being correct on the Market's direction isn't enough, you also need the timing component.

• Several characters in the book were bearish about the mortgage market several, however they were years before the mortgage collapsed in 2007-8. Many of the characters made bearish bets, but they were much too early. This kind of reminds me of my bearish trades in the market. I'm expecting some meaningful pullback of 5-10%, but it never materialized. The current market has been up since March 2009, without an substantial pullback.

Liquidity is critical in trading

• If you trade a product, the product needs to be liquid, so you can get good and accurate pricing.
• You want to be able to get in and out of your positions. In the book Paulson's group had a load insurance contracts on the BBB tranches and ABX index, which they have been accumulating over many months; they wanted to sell when the tranches and ABX fell. They couldn't sell too much at once fearing too much supply in the market may push prices lower, thus leading to lower profits for them.

Knowing when to sell or to stay to your conviction

• The first time mortgage markets sufffered a fall, Paulson's group made over $1billion. Only to loose some of the profits as the mortgage markets rebounded.
• You've made some profits, but the markets rallied back. This may cause some doubt in your conviction. Do you exit with a small gain or do you think you're conviction is correct and add more thinking the rally is temporary. Paulson thought there was more downside to the mortgage industry. He added to his insurance contracts. It is important to note that Paulson calculated the amount of risk the fund was willing to take, which was about 8% per year. He calculated that the risk to reward ratio was appealing enough to warrant making big bets.

Trading as an individual is you can get in and out of positions more easily than a large hedge fund

• A hedge fund may need to accumulated positions worth millions or even billions of dollars. It will take time for them accumulate the positions. A smaller investor is much more nimble and will not leave a footprint behind. The smaller investor is like a ninja, you won't be noticed. The hedge funds are like a titanic cruise, where it will take time to make turns.