How Do I Trade Thee? Let Me Quant the Ways

Bid and Tonic 1

The first “institutional” finance job I ever had was at a supposed quant hedge fund. It’s true, I did learn how to write python, work through a VM, blend various data feeds, and bucket them into interpretable candles. An infamous line I texted my then-CS major friend — “how do I put a Fast Fourier Transform into my code?”

The idea of the hedge fund was to use astrological sign time bucketing and generate signals using machine learning methods to take unique trades. It wasn’t a bad idea in theory — there are advantages to trading variable time frames (zoom out, as you might hear me say from time to time, comes from this), but for programmatic purposes, it’s frankly much easier to standardize your bucketing in the manner that everyone else does — divisors of 60, multiples of five, etc.

As to the astrological angle, let’s just say that when a woman at a bar asks me what time I was born, I know that it doesn’t matter what I say, there’s no actionable edge in the stars.

Bringing it back down to earth, though, I find that a lot of the more esoteric ways of looking at markets — orderflow, gamma, liquidity, etc. — simply aren’t processable enough. It really doesn’t have to be this hard, because, after all, retail sizing is edge (you didn’t think I’d stop the self-citing, did you?):

Something a lot of retail doesn’t realize is that small sizing is a big edge in markets. When you do not have to get off a block every time you transact, your price impact is virtually zero (and in fact, you can transact at prices better than your limit orders thanks to price improvement). Remember that old adage, “don’t trade against the size”? Well, there is a benefit to this - much like a bike at the back of a peloton, you can benefit from drifting along the price impact as size legs in to a position.

This is where the phrase “maker taker” comes from re: fees — every order placed makes liquidity, every order filled takes it. Intuitively, we must realize, that in an illiquid book, our tiny share punts must be valuable in some way. It shouldn’t take some novel code or deep research to take a broader view of the market and figure out where we can pick up some free lunch on someone else’s dime.

Let’s talk about lunch for a moment, because there’s a pretty good story about none other than Bill Ackman making, let’s say, a rather large investment on a whim back in 2016:

Mr. Ackman’s Pershing Square Capital Management acquired the option to purchase 2.9 million shares, which represents a 9.9 percent stake in Chipotle, according to a regulatory filing on Tuesday…

Shares of Chipotle have plummeted more than 40 percent over the last year after hundreds of people got sick after eating in its restaurants. A majority of the illnesses stemmed from norovirus contamination and strains of E. coli and salmonella.

The scandal has caused sales to slump, as customers stayed away from Chipotle restaurants out of fear of getting sick. Revenue during the quarter through June declined 17 percent, while comparable restaurant sales decreased 24 percent, the company said in its earnings report on July 21.

Ackman has made some pretty interesting decisions involving Chipotle, some of which definitely got him into trouble. Here’s an old anecdote about another snap judgment:

Years before Valeant became Ackman’s white whale, he was hanging out with the company’s then-CEO Michael Pearson at the drugmaker’s HQ, contemplating lunch. The chicken and salad in the cafeteria didn’t impress the hedge funder. “But they had a Chipotle around the corner,” Ackman recalled in 2014. “I actually asked if I could get a Chipotle burrito.”

Pearson’s gofer dutifully obliged. But when they sat to eat, Ackman got a surprise. “Mike walked into the conference room and asked me for 20 bucks,” he said. It was at that moment, a wad of half-chewed burrito hanging out of his mouth, that Ackman’s faith in Pearson was solidified. (The fact that the CEO was such a tightwad evidently convinced Ackman him that Valeant was “allocating its capital intelligently.”)

Ackman shoved a ton of his gains on the Allergan hostile takeover in support of Pearson (more on Valeant another day, as it’s one of my own “gut feeling” big shorts I’ve ever taken in my life), and we all know how that ended:

Perhaps in search of redemption — after all, Pearson was the problem, not his burrito — Ackman took a leap of faith. “I like the burritos” was a precursor to “I like the stock”:

Bill Ackman is hungry for Chipotle and everyone is piling on. “We are unclear if Pershing Square can add value,” analysts at Baird wrote, a day after Ackman’s Pershing Square bought up a 9.9 percent stake in the burrito chain, which is ailing from multiple disease outbreaks in last year.

Stifel was less forgiving: “We cannot fathom Pershing's operational or mathematical investment thesis.”

But there’s a simpler take here: Bill Ackman just likes Chipotle burritos. He doesn’t have some baroque hypothesis for how to wring value out of the company, as with his disastrous investments in Valeant and Herbalife. This one seems different. And that's not a bad thing.

Ackman, while being a fundamental activist investor, understands that the only thing that really matters is increasing forward revenue. A sales slump predates a stock price slump, at least in a fundamental-oriented market. Most fundamentals pretty much just amount to revenue projections — you can have all the ratios you want, but at the end of the day, it’s just about making more money. (Similarly, to trading, you can have a .01 Sharpe, but if you’re consistently making money does it really matter that it doesn’t “backtest well”?)

Chipotle has an interesting menu marketing model. Old advertisements of theirs used to advertise the combinatorial number of “options” their menu has to offer calculated off the unit ingredients, but realistically speaking, everyone has “their” order at Chipotle that regularly goes there. So what do you do when sales slump? You run a promotion.

Fast casual depends on recursive flow, much like “it trades because it trades.” If you just run flat discounts that kill your margins on the discounted sales, all you’re doing is losing money to pump up the illusion of foot traffic. It’s basically wash trading. No, what Chipotle did was much more insidious, akin to letting a rat smash the button as much as he wanted with a Kool-aid man sized button if it pressed the button fast enough:

Chipotle has been embarking on costly marketing campaigns to bring customers back to its 2,100 restaurants. Chiptopia is a three-month loyalty program (beginning July 1) that rewards customers with free food based on how many times they visit the restaurants.

I’m sure someone reading this remembers this very vividly, because Chipotle lost $20 Million on catering alone running this promotion:

Chiptopia officially launched July 1, and rewarded diners based on how often they visited, rather than how much they ordered. The program included three different status levels: Mild, Medium, and Hot. Those wishing to get the highest reward (catering for 20 people) had to dine at Chipotle at least 11 times per month, three months in a row.

CNBC reports “a whopping 85,000 people are slated to receive free catering from Chipotle for successfully completing the burrito chain's loyalty program.” That comes out to approximately $20.4 million worth of catering — and a lot of burritos for each of those 85,000 people.

Sometimes, all you need to know is that other people like the burritos, too. Personally, I think this is one of the best limit tests and gambles in a promotion ever done, and it’s clearly why Chipotle managed to recover from the scandal after fixing their food safety procedures. Their customers were still there, after all, and invested with their stomach capacity rather than with billions of dollars.

Lo and behold:

Ackman more than doubled his billion-dollar stake just because he likes the burritos.

In June 2024, Chipotle did a 50 to 1 split. Ostensibly, a share split shouldn’t change anything about the underlying business, but it does improve the ability of individuals to place round lot (multiples of 100 shares) orders, which improves the spreads on the underlying equity. In a sense, all a split does is make it so an individual who likes the burritos who doesn’t have all that much to trade can buy in without staring across an abyss of a spread. True fundamental analysts will condescendingly joke about how this isn’t bullish, and that you’re an idiot for thinking otherwise, but if you’ve read my exposition on the attention economy, it’s definitely bullish in that it induces attention flow, which, after all, is what drives stocks up, right?

If Bill Ackman can make over 1.5 billion dollars on a trade cause he likes burritos, we do not need to be solving partial derivatives and interpreting quant signals like they’re star positions indicating Chipotle is in retrograde to make money on a trade. Instead, we can go find where the liquidity needs to be, and provide it, and maybe we do it because we like the stock.

I’ve been trading ANF a bunch because, well, I like clothes. (Disclaimer — no position at time of writing, but I trade in and out of it frequently.) I stumbled into their store a while ago, realized the clothing is cracked compared to the cologne-overload strip mall layouts of the 2000s, and did a little bit of digging. Here’s what I found:

It’s weird turning people on to a “trendy” brand that’s best known from 2000s mall culture, but Abercrombie is a brand with a comparable length of history to Ralph Lauren. Much like how trends are cyclical, businesses success can be as well if you “reset” at the right time

People do not have money to spend on designer brand stuff, but they don’t want to wear fast fashion. Sustainability is a long-time trend thanks to Vivienne Westwood and others (see: rag & bone). So that tranche of spend is where the majority of spend will go from normal consumers

BR has gotten oddly expensive, don’t know who is paying retail for that clothing. They seem to be targeting a market that would rather, say, go to Nordstrom instead. The margins already suck on non-designer clothing, you can’t only drive spend through discounts and CC offers. It’s an outdated model

At the end of the day, good product = good revenue growth. And considering the number of people I’ve put on to Abercrombie and Fitch clothing in the past year, the appeal is clearly there, along with J.Crew (which isn’t public anymore, but is out of Ch11.)

I know big investors want to look for revenue growth. Everyone wants things to make sense and have easy-to-digest reasons rather than having to divine market astrology. So, I go trade what they want, because I like the stock, and the investment thesis makes sense. I don’t get a ton of size off, but the trading is unbelievably reliable. Every order I make provides liquidity, and it anchors any TWAP/VWAP execution algorithm to a “real” order in the book, and I am compensated with very timely fills as a result. Of course, there has to be more to a trade, but this is how you can trade illiquid stocks without simply trying to frontrun idiots (memecoins, pennystocks.) More to come on this soon, especially on how to estimate trade horizons, and whether people even want the stock (lest it turn into VIAC/PARA).

White rice, black beans, barbacoa/carnitas, cheese corn, red tomatillo salsa, sour cream, lettuce, at least until I found out how much seed oil they use. Alas, I gotta find a new joint.

If you did like the burritos back when the pinto beans had bacon/lard, share this as a reminder of the good ol’ days.