Most Popular
1. Banking Crisis is Stocks Bull Market Buying Opportunity - Nadeem_Walayat
2.The Crypto Signal for the Precious Metals Market - P_Radomski_CFA
3. One Possible Outcome to a New World Order - Raymond_Matison
4.Nvidia Blow Off Top - Flying High like the Phoenix too Close to the Sun - Nadeem_Walayat
5. Apple AAPL Stock Trend and Earnings Analysis - Nadeem_Walayat
6.AI, Stocks, and Gold Stocks – Connected After All - P_Radomski_CFA
7.Stock Market CHEAT SHEET - - Nadeem_Walayat
8.US Debt Ceiling Crisis Smoke and Mirrors Circus - Nadeem_Walayat
9.Silver Price May Explode - Avi_Gilburt
10.More US Banks Could Collapse -- A Lot More- EWI
Last 7 days
Bitcoin Crypto Bubble Mania! - 4th Mar 2024
US Interest Rates - When WIll the Fed Pivot - 1st Mar 2024
S&P Stock Market Real Earnings Yield - 29th Feb 2024
US Unemployment is a Fake Statistic - 29th Feb 2024
U.S. financial market’s “Weimar phase” impact to your fiat and digital assets - 29th Feb 2024
What a Breakdown in Silver Mining Stocks! What an Opportunity! - 29th Feb 2024
Why AI will Soon become SA - Synthetic Intelligence - The Machine Learning Megatrend - 29th Feb 2024
Keep Calm and Carry on Buying Quantum AI Tech Stocks - 19th Feb 24
How to Profit from the Global Warming ClImate Change Mega Death Trend - Part1 - 17th Feb 24
Why Rising Shipping Costs Won't Cause Inflation - 17th Feb 24
Intensive 6 Week Stock Market Elliott Wave Training Course - 17th Feb 24
INFLATION and the Stock Market Trend - 17th Feb 24
GameStop (GME): 88% Shellacking Yet No Lesson Learned - 17th Feb 24
Nick Millican Explains Real Estate Investment in a Changing World - 17th Feb 24
US Stock Market Addicted to Deficit Spending - 7th Feb 24
Stocks Bull Market Commands It All For Now - 7th Feb 24
Financial Markets Narrative Nonsense - 7th Feb 24
Gold Price Long-Term Outlook Could Not Look Better - 7th Feb 24
Stock Market QE4EVER - 7th Feb 24
Learn How to Accumulate and Distribute (Trim) Stock Positions to Maximise Profits - Investing 101 - 5th Feb 24
US Exponential Budget Deficit - 5th Feb 24
Gold Tipping Points That Investors Shouldn’t Miss - 5th Feb 24
Banking Crisis Quietly Brewing - 5th Feb 24
Stock Market Major Market lows by Calendar Month - 4th Feb 24
Gold Price’s Rally is Normal, but Is It Really Bullish? - 4th Feb 24
More Problems in US Regional Banking System: Where There's Fire There's Smoke - 4th Feb 24
New Hints of US Election Year Market Interventions & Turmoil - 4th Feb 24
Watch Consumer Spending to Know When the Fed Will Cut Interest Rates - 4th Feb 24
STOCK MARKET DISCOUNTING EVENTS BIG PICTURE - 31st Jan 24
Blue Skies Ahead As Stock Market Is Expected To Continue Much Higher - 31st Jan 24
What the Stock Market "Fear Index" VIX May Be Signaling - 31st Jan 24
Stock Market Trend Forecast Review - 31st Jan 24

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

Keep Your Risk Managers Away From Me

InvestorEducation / Learning to Invest Jan 23, 2015 - 12:39 PM GMT

By: John_Mauldin

InvestorEducation

Jared Dillian writes: This week’s big news, of course, continues to be the massive revaluation of the Swiss franc (CHF). It’s perhaps the first instance of a G10 currency going up 16% in a single day.

From a strategy standpoint, there really is only one way to interpret this, as many people already have: it’s the end of central bank omnipotence.


Central bank says it’s going to do A, does B instead. For investors, it’s much harder to take risk in that kind of environment. So I think the logical thing to do is to look at other pegged/managed currency pairs in the world—like the Chinese yuan, the Hong Kong dollar, and the Danish krone—but also any situation where a central bank has said it’s going to do an unlimited amount of anything, because as you can see with the Swiss National Bank (SNB), it’s subjected to the same P&L forces as everyone else.

Moving right along, I want to talk about the risk management aspect of this trade.

Within a few hours, we knew that a couple of retail currency brokers needed capital, or else. And we learned that Polish and Hungarian folks who took out CHF-denominated mortgages were in big trouble too. But more important, anyone who was just plain old short the Swiss franc was also hosed with or without a stop loss, which wouldn’t have made much difference in this case anyway.

I’ve been trading for 15-plus years, and I have never blown myself up. (If I had, I probably would not be writing this.) Don’t get me wrong, I’ve done plenty of dumb things over the years, made lots of bad, even stupid trades, and I have occasionally let my losses run a bit too long. But I have never been hit by a Mack truck—walking into work and suddenly finding myself suffering catastrophic losses.

Knock on wood.

How Risk Managers Can Get You in Trouble

Let’s discuss the margin system that most FX trading shops use (and I use) for a moment. There are a lot of dumb journalists running around saying, “Why the hell are FX brokers offering their clients 25 or 50-to-1 leverage on currencies? More regulation!”

Well, this isn’t anything new, and the margin system works well most of the time (note that this is basically the same system used by derivatives exchanges, on which everyone wanted to list credit default swaps at one point, because exchanges don’t fail, remember?).

This time it didn’t work so well. The margin calculators looked at euro/Swiss franc (EURCHF) volatility, which was very low, and afforded their clients high leverage based on that low volatility. They didn’t take into account the fact that EURCHF was right in the neighborhood of the floor and that if the Swiss National Bank abandoned the floor, there would be a ridiculously large move.

This is one of the reasons that risk managers (i.e., non-traders in these positions) can mean trouble. An experienced trader looks at EURCHF at 1.205 and says, “Nope, not touching that.”

It has nothing to do with his opinion on the Swiss franc being undervalued but everything to do with the fact that the currency pair is near a self-imposed floor, and if the floor is removed, the risk is very asymmetric. A risk manager may calculate the volatility of EURCHF and find it negligible, but the trader looks at EURCHF and says, “This pair might have 2 volatility to the upside, but 80 vol to the downside.”

So it’s not the margin system itself that failed—it’s the idiots setting the margin levels who got it wrong. And even then, you still cannot plan for a black swan. Even if margin had been 10-to-1 instead of 50-to-1, people still would have gotten rinsed.

This is me editorializing: I think the scary thing about present-day markets is that you have fewer experienced traders in charge. In an age where 50% of stock market volume is algorithmic, it’s young folks with math and physics degrees who are building these models and who have no sophisticated understanding of actual risk, the kind that cannot be mathematically modeled.

They probably think they’re superior to people like me because they know math and I don’t, but when you’ve traded two of the biggest bear markets in the last century, you begin to learn that the market has a much bigger (and more malignant) imagination than you.

It’s funny—many traders are good at protecting against one specific kind of tail risk (the hypothetical terrorist attack), where they buy S&P puts and VIX calls. Yes, it’s possible that we walk in one day and the entire market is down 20%. And one thing you learn from being a floor trader is that nobody sleeps well at night, especially if you’re short volatility, because what if?

But tail risk exists all over the place, and I think the Swiss franc incident was a pretty good reminder.

I remember back in 2000-2002, you had companies that would gap up 50% (PaineWebber slapping a $1,000 price target on Qualcomm shares comes to mind) or down (Enron, WorldCom, etc.). You could not have any unbounded risk at all.

Nowadays, people have gotten more comfortable with unbounded risk. I pointed out a few issues ago that the volatility of volatility (vol of vol) was going up. It is still going up. Oil just went down 60% in a matter of months. Another black swan. One of the reasons I got to where I am today is because I was one of those guys who would buy back the nickel puts before expiration. It’s a good habit to get into.

Jared Dillian

The article The 10th Man: Keep Your Risk Managers Away From Me was originally published at mauldineconomics.com.

© 2005-2022 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in