Surviving & Thriving, Chaos Investing for Retail Participants

Surviving & Thriving, Chaos Investing for Retail Participants


Black Swans in financial markets are extreme rare events. And how you survive and thrive when 1 happens is Key.

With that in mind let’s look at some Black Swan mitigation strategies, as follows:

In Nassim Taleb’s “Black Swan” (required reading) he suggests that he is constantly taking small losses in hopes of a big payoff in the future.

  • The Pro: if you win, you have bragging rights, if you lose keep quiet.
  • The Cons: as the 11 yr + Bull market preceding the market chaos this year has shown, being Bearish on the market can be very expensive. Many have had to wave the White Flag on negative carry strategies . The other big challenge with any bet against “the market” is that we do not know which market will provide a large payoff in a fall. It is easy to talk a Bearish bet, but when it comes to making it, 1 has to choose a the instrument, and there is no guarantee that the instrument will perform as intended when the moment of truth comes. The dislocations in March that a lot of instruments did not work, as the machines took over relentlessly.
  • When markets price in a Goldilocks economy, there are types of insurance that are attractively priced and protect against losses.

Avoid leverage if you do not want to be wiped out by a Black Swan event and only invest in assets that are positive carry, long-duration assets. You can only lose 100% that way. Odds are, though, that if you have a diversified equity portfolio, not everything will go to Zero.

Example: the May contract for WTI Crude Oil traded at -50ish, if you were a retail speculator in Crude Oil you wanted off your position at all cost, as the there are very strict commission delivery rules in that area, contracts have very specific terms.

Arbitrage: If there are real arbitrage opportunities, you may want to sidestep other sort of investments and simply focus on those. The small print is important as perceived arbitrage opportunities are often there for a good reason.

As an example, there are mundane ones, such as the breakdown of interest rate parity. Theoretically, it should be equivalent to buying a foreign currency, hold the cash Vs buying forward contract and earning interest domestically. If you do not have the balance sheet for low borrowing cost is is not profitable, do not forget that a forward currency contract contains counterparty risk. And as such, the arbitrage opportunity does have some small-print risk which matter when a Black Swan is flying.

There’s a breed of financial players that thrive on financial arbitrage. Take the MMs (market makers) that make a market in your favorite ETF products. While exchange rules are in the MMs’ favor, many do not seek to make an almost guaranteed profit on each transaction, but only on average. That is, they make a tighter market than their competitors and make it up through a large volume of transactions that are, on average, profitable.

This sort of arbitrage is an extremely competitive space, as with high frequency traders requiring substantial technology investment that most cannot participate in.

There is a lot to be learned from these participants, as follows:

  • The ability of a MM to make a market is as good as the ability to hedge its position. You may have noticed that for ETFs that trade with a very tight spread that are sensitive to economic data, spreads tend to widen just ahead of major economic releases. This is risk management of the MMs at work. Their own hedging cost goes up and they pass that cost along. The lesson here is that we may be better off if we know the risks associated with anything we do, and adjust as the environment changes.
  • During the extreme selloff days this March some market makers reached their limits, and stopped making a tight market. Market makers in ETFs can usually offload their risk at the end of the day usually they have plenty of buffer, but when caught in an extreme environment, they opted to preserve their business by stopping make a market. Investors may be left holding the bag with wider spreads, but MMs did what was necessary to preserve the integrity of the system. The lesson for civilian non-market-makers is to know the risk limit and have a plan when we get there. This is Key, as you do not want to get trapped in a situation where your back against a wall.

When we have a market panic, MMs often cannot internalize flow or crossing orders for spread, they have to trade with other MMs to sell them their risk to, and in times of market chaos it becomes a pit where nobody wants to trade with another because they fear they do not have the same information. That happened to some markets resulting in very poor market depth as seen with peer currencies that on a regular day move less than a % moved more than 10% in a few mins.

Statistical arbitrage: MMs are risk managers, statistical arbitrageurs are risk takers. Statistical arbitrage thrives when things are temporarily out-of-alignment and you bet on them converging to their statistical long-term mean. Those strategies were the ones hit the hardest in the selloff because markets kept cascading in the same direction and not normalizing. Instead, momentum-based strategies did very well.

Risk: The Big Qs: Did you think a global ‘pandemic’ would derail the world’s markets, and did you have any idea how it would/will play out?

The Big A: Of course not, where would you look for the indicators, once the numbers got crunched by the machines, the machines took over completely.

Below are some examples of risk parameters to look out for, the focus on the Forex (currency) markets, but similar monitors can be built for other financial markets:

  • Spreads. Spreads in the Fx markets are ultra mini during normal times, but at certain times (8:00a ET through 3:00 ET) are considered most liquid. Normal spreads are in the eyes the human trader and participants should not be decoyed into a new normal just because spreads have been widened for a few wks.
  • Implied volatility. For a primer on implied volatility, see investopedia. I do not encourage retail participants to trade options, but studying the options market allows 1 to get a right now read as to what those writing the options are charging. Think buying insurance as options are insurance, when there is a disaster the price goes up. You can gauge what it costs to insure yourself in the options market. You can look at the cost relative to a MA (moving average) to gauge whether costs are increasing. Note, insurance cost increases ahead of known macro events, like Presidential elections and the BREXIT vote. Just as with insurance, implied volatility can be looked at over different horizons. 1-wk implied volatility is going to be chnaging than 1-mo implied volatility; Looking at how the market is pricing risk is helpful in assessing an event, or picking up on risks not associated with a well defined event.

Along with market-based risks, it is prudent to look at risks in 1’s portfolio. Note: Many models are based on normal distributions, and that in a market waterfall, distributions are not normal.

In Summary: There’s no magic to managing a flock of Black Swans as they seem to come from nowhere, so:

  • Just as you do fire and earthquake drills to be better prepared when disaster strikes, you may be better equipped to deal with the next Black Swan when you monitor portfolio risk and have a plan. The plan is Key, as when the earthquake hits, you need to act fast; sure, you will adjust your action based on the reality that moment, but at least you have thought about the options beforehand. Similarly, consider having a plan for your investment portfolio. When events and news are most irritating, it may be helpful to breathe and think about options and get real professional advice or management and insure your positions.
  • Good risk management means the profits are not as high, but the losses are mitigated.

Wednesday, the US major stock market indexes finished at: DJIA +456.94 at 23475.82, NAS Comp +232.15 at 8495.39, S&P 500 +62.75 at 2799.31

Volume: Trade on the NYSE came in at 1.0-B/shares exchanged

  • NAS Comp -5.3% YTD
  • S&P 500 -13.4% YTD
  • DJIA -17.7% YTD
  • Russell 2000 -28.0% YTD

HeffX-LTN’s overall technical outlook for the US major stock market indexes is Neutral with a Bullish/Very Bullish bias.

Looking Ahead: Investors will receive the weekly Initial and Continuing Claims report and the New Home Sales report for March Thursday.

Have a healthy day, Keep the Faith!

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