InvestInU's Three Things, March 2020 edition
Mar 16, 2020
Practical insights to help you break into and thrive in the investment industry
In this edition
- Big Picture: Markets highly v(oil)atile this week
- Let's Discuss: What is the VIX index and how can you trade it?
- Trading Lesson Learnt: How insanity cost us $$$ last week
1. Big picture: Markets highly v(oil)atile this week
- WTI crude oil below $30, down >50% this year.
- Markets across the board remain extremely volatile. Last week, the US stock market had back-to-back moves of almost 10% on Thursday and Friday. And the VIX index, a market gauge of future equity volatility, hit the highest level since the 2008 financial crisis. More on that later.
- Most equity markets are now down more than 20-30% from their peaks.
- Safe-haven assets (gold, government bonds, the Japanese Yen, etc) are all grinding higher.
- Treasury bond yields are hitting new record lows and last Monday (9-Mar), the entire US Treasury yield curve dipped below 1% for the first time in history as a big flight-to-safety pushed bond yields down.
- Risk-parity (going long bonds and equities with roughly equal risk) suffered one of its worst weeks since 2008 as gains in bonds were not enough to offset sharp losses in equities.
Why are oil prices plunging?
- On Monday the 9th of March, oil prices dropped 20% – the largest one-day price decline since 1991.
- This happened after OPEC+ failed to reach an agreement on oil production cuts over the weekend, and Saudi Arabia and Russia essentially started an oil war with both countries pledging to pump as much as possible = big increase in oil supply.
- In the meantime, the coronavirus is bringing global travel to a halt = big decrease in oil demand.
- Increasing supply + decreasing demand = massive fall in oil prices required to clear the spot market.
What are the first-order effects of lower oil prices?
- Stocks and bonds issued by energy companies took a massive hit on Monday.
- An ETF of oil and gas producing companies in the US fell almost 40% in a single day (9-Mar).
- Normally, falling oil prices would be a tailwind for the airline industry but the coronavirus has hit travel demand so hard that some of these airline companies are now on the verge of bankruptcy. And the falling oil price doesn't even matter to them right now.
- Currencies of oil-dependent nations also took a hit on Monday (RUB, NOK, MXN).
What are the second-order effects of lower oil prices?
Lower inflation expectations:
- Lower oil prices reduce energy costs for everyday consumers and businesses, bringing down the overall level of inflation. This is good for government bonds because nominal yields can be decomposed into real yields and inflation premiums. Lower inflation premiums = lower nominal yields = higher bond prices.
- Gold prices trading sideways, rather than rallying sharply in this risk-off environment, helps demonstrate this too (gold prices fall when inflation expectations are falling).
Credit market stress:
- Oil companies represent a large fraction of the high-yield credit market, and after the oil price plunge on Monday, their ability to repay their debt is in serious doubt. That's causing credit spreads to widen across the board, making it significantly more expensive for companies to borrow.
- And companies heavily rely on short-term credit markets (e.g. commercial paper) for their day-to-day business functioning. They also need that credit now more than ever to smooth over demand declines or supply chain disruptions caused by the virus.
- So if credit markets are getting more expensive or, worse, are drying up (similar to the 2008 financial crisis), then it can cause even further massive corporate disruption.
The credit market stress highlights the two-way relationship between financial markets and the real economy, with both impacting each other simultaneously. This is what George Soros calls "reflexivity" where investors' perceptions (declining credit conditions) affect economic fundamentals (companies find it harder and more expensive to borrow), which in turn changes investor perception (their view of declining credit conditions is validated), and so on.
2. Let's discuss: What is the VIX index and how can you trade it?
The VIX index – also known as Wall Street's "fear gauge" – hit 78% today, the highest level since the 2008 financial crisis.
What is it exactly?
- The VIX is an index that gauges the market's expectation of future volatility.
- A low level means investors expect calm markets whereas a high level indicates investors expect turbulent markets.
- The VIX's long-term average is around 20% and the highest it ever hit was 89% in October 2008.
How is it calculated?
- In option pricing theory, one input that determines a call or put option's price is volatility (the higher this is, the higher an option's price).
- We can observe the actual price of the option in the market and reverse engineer the pricing formula to calculate the implied volatility.
- The VIX is the implied volatility using options on the S&P 500 index.
How can you trade it?
- The actual spot index is not directly tradable. But traders can replicate volatility exposure using a portfolio of S&P 500 options, and that led to the creation of tradable VIX futures and options that you can use to bet on the future direction of volatility.
- There are also VIX ETFs (both normal and inverse) but note that they ultimately invest in VIX futures.
Going long VIX can serve as a hedge against falling markets. That’s because the VIX tends to spike up during rapid market sell-offs, offsetting any losses from stocks. The problem? Making money by being long volatility is extremely difficult for three main reasons:
- It is short the volatility risk premium (implied vol > realized vol)
- Long VIX is a negative carry trade (the curve is generally in contango)
- It's almost impossible to time a spike
Let's explain in a bit more detail:
- Empirically over the past decade, realized volatility has mostly been lower than implied volatility (see chart below) i.e. the market tends to overestimate future volatility, leading to the existence of a risk premia for those willing to short volatility. Going long volatility is paying this premia, which can be very costly over time.
- Since the VIX futures curve tends to be upward sloping (i.e. in contango) during normal times, the roll yield is negative from going long futures. That is, the futures price will converge to the lower spot price over time, guaranteeing a loss for the investors if nothing else changes.
- Those two factors explain why a long VIX ETF tends to lose so much value over time, even with the VIX remaining flat.
- So when markets are calm, being long VIX will bleed money. What about trying to time it before it goes up? This is very difficult to do in practice. That's because when markets first sense there might be trouble up ahead, the VIX tends to spike up quite significantly – making your entry point less attractive.
3. Trading Lesson Learnt: How insanity cost us $$$ last week
“The definition of insanity is doing the same thing over and over again, but expecting different results.”
Well, insanity cost us a lot of money this week...
The volatility we're witnessing in markets is providing a real test not only to investors' nerves, but also to their investment processes. It’s easy to follow some trading rules when markets are well-behaved, but when s*** hits the fan, resisting our most basic urges and keeping our emotions out of the game is much easier said than done.
So what lessons did we learn this week?
- Your game plan must be fully defined before putting the first trade on
- Position sizing is key and should be based on the maximum loss you can handle on that specific trade
- Stop trading and take a step back the moment you break your game plan
Let us explain.
In our personal trading account, we went against the most basic trading concepts we believe in. Ironically, while our market views played out perfectly, we still ended up losing money!
The first mistake was entering very large short positions in S&P futures when we turned negative on equities. Why was it too large? With any intra-day rally, we were not only losing a lot of money but those losses also led us to doubt our conviction. What if we already experienced a market bottom? What if we’re wrong? When the market rallied +5% last Tuesday, we couldn’t take it any more and closed our shorts. Just at the top! Fast forward a few hours and markets are falling sharply again. Dammit, we knew it! What did we do? You guessed it: we reentered our shorts. A few more intra-day rallies later, we exited our positions and compounded our losses, despite markets being significantly lower than when we initiated our initial short.
What could we have done to avoid this painful experience?
1) We should have defined a clear stop-loss based on a price level that would have proved our thesis wrong. Given the high volatility in markets, this should have been much higher than 5%. If markets are going up and down by 4% every day, we can easily say that any move between 0-5% is just noise. Stop-losses should be set outside of noise and in this case at least 10-15% higher (than the short's entry point). A good rule of thumb is to have a stop-loss at least 3x outside of the daily trading range (as a proxy for noise).
2) We should have sized the position such that if the stop-loss is hit, the loss on our trade is bearable. In this case, if we’re willing to risk 1% of capital on the trade and the stop-loss is 15% above the current price, it means we should have only invested 6.7% of capital in the trade (1% max loss at the portfolio level / 15% loss on the trade = capital weight to put in the trade).
A good rule of thumb for position sizing is:
Capital weight = max portfolio loss you're willing to lose on the trade / max potential loss on the trade itself (stop-loss)
3) We should not have re-entered the short trade after we first closed it. Or at least, not without having a more well-defined game plan first.
Hopefully this lesson will avoid you learning it the hard way.
Happy trading to you all!
Reda & Stephane