Riley: If Only Our Treasurer Knew How to Hedge Properly, Now Would be the Time
Tuesday, June 27, 2017
The “world is flat” as Thomas Friedman wrote in 2005 and remains so today. I have been managing money and portfolios of risk assets since the 1970s, keeping up with any news that could affect the markets was always critical for a risk manager like me.
Whether I was on the trading floor or managing director of a large Bank derivatives division or in my current role as a hedge fund manager, I have placed a premium on cutting edge trading software, access to news and analytics. My trading software was developed at Interactive Brokers Inc. by a friend Thomas Peterffy, augmented by my MIT genius partner but even their outstanding software combined with my experience doesn’t stand a chance to the high-speed trading and algorithms dominating today’s markets. There is no question in my mind that when dramatic news hits anywhere in the world they will win and I will lose.
Last week I wrote about a few things that both traders and Investors should be concerned about even though risks are always present, I have always counted on liquidity, market access and reaction time to put on hedges to my portfolio, but in today’s fast moving markets I am becoming increasingly concerned that the next stock market crash in America will look like the “flash crashes” of several years ago when a “fat finger” or something else causes a sudden collapse in prices. Only this time they will not quickly rally they will just stay down or even close the market.
GET THE LATEST BREAKING NEWS HERE -- SIGN UP FOR GOLOCAL FREE DAILY EBLASTI have been professionally managing money and hedging portfolios nearly every day since 1979. I have been directly affected by every flash crash, or market event and so far I have been able to maneuver (that is hedge) almost all the time.
Things Changed in 2015
In August 2015, an unfamiliar disaster scenario became clear to me when suddenly the stock market became very soft and illiquid.
Stocks and underlying derivatives quotes widened dramatically while simultaneously the implied volatility (prices) of hedges exploded. It was as if a giant warning was sounded. Buyers of stocks disappeared and put prices exploded and then the combination of wide markets and high implied volatilities caused margin calls. My trading systems were frozen by interactive brokers until they could verify I had appropriate capital. This was happening to everyone. Not since Bear Stearns and Lehman Brothers in 2008 had I seen implied volatility rise to well over 200% annualized.
The strange thing about this sudden illiquidity was my experience with previous triple digit volatility markets 1987, 2000 and 2008 was that I recognized what was going on and why people were worried. In August of 2015 I had no idea what was happening. Fear came out of nowhere. The market wasn’t overheated at all, and all the talking heads were clueless as usual yet the losses were painful and we were frozen.
Once I was helpless to hedge I was educated to another scenario where everything could suddenly go wrong. In my nightmares and in all likelihood I imagine the next crash will be swift and devastating.
The cause could be literally anything, a major bankruptcy/scandal (think Anbang in China), or housing collapse in Canada or Australia, an assassination or impeachment, who knows? My concern is that the markets are now so connected to each other and worldwide news sources that risk managers, AI deep learning computers and other participants won’t take long to react and that their immediate actions will reveal the fragility of the market as well as the underlying liquidity vacuum below. A week or month long 25%-30% sell-off could take place in a single day. The current period of market calm and record low implied volatility are evidence that portfolios are not currently hedged and instead are relying on liquidity to manage their downside risk. This will be a classic error.
In 1987, the popular imputation was that the newly popular “portfolio insurance” had caused the crash. Alas, the cause of the crash then in 1987 and the one that’s about to happen is too many investors were complacent and were forced to sell at the bottom. I’ve seen this happen over and over again. We saw the panic liquidation bottom in crude oil just 2 years ago in January and February 2015. Don’t be caught off guard! Most investors should get into a “comfortable and well hedged” position now so they can actually buy the market if it should drop 40% or so by year end instead of being frozen in fear.
Could it happen tomorrow? I doubt it, but I fear it and so should you.
Michael G. Riley is vice chair at Rhode Island Center for Freedom and Prosperity and is managing member and founder of Coastal Management Group, LLC. Riley has 35 years of experience in the financial industry, having managed divisions of PaineWebber, LETCO, and TD Securities (TD Bank). He has been quoted in Barron’s, Wall Street Transcript, NY Post, and various other print media and also appeared on NBC News, Yahoo TV, and CNBC.
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