This is one of those moments most currency traders and macro hedge funds feel REALLY sheepish/scared:
That’ll hurt: Swiss Franc futures reverse mightily. Source: thinkorswim by TDAmeritrade.
Imagine the situation:
- Beginning: the Swiss Franc seems a safe play. Very carefully managed by the Swiss National Bank (SNB), which REALLY doesn’t want much variation in their safe-haven currency, you assume a stable relationship.
- The initial trade: Swiss interest rates are very low – in fact, negative. This sets up the proverbial carry trade – borrow in Swiss francs to fund a bet in any currency. Let’s just use the USD, as it has a terrible low interest rate too, but is still pretty safe. So you pick up 50bps (around 0.25% in the US, set against -0.25% in Switzerland) in a pretty safe pair.
- Life is good: this interest rate differential is picked up in the futures through the near-continuous downward trend we see in the chart above. Ahh, relax and go short this futures contract.
- Today: Oh Shit. The SNB decides enough is enough, and stops putting a floor on its safe-haven currency. Interest rates move to -0.75%, so your carry signal says stay short the contract. But the underlying moves about 30% against you, negating about 60 years worth of the old carry returns. Oh dear. Hopefully you didn’t cash out at the worst point, as the pair has only moved about 15% at this point.
- Statistics?!? Who cares? The implied volatility of the future has been around 10% p.a., or around 0.7% daily. So a 30% daily move is about…45 standard deviations. We’re talking infinitesimal probabilities.
- When writing uncovered calls really sucks. God forbid you had a system of writing calls to collect the carry here. Suppose you wrote a $1 call on the contract above yesterday, giving yourself a bit of room on yesterday’s $0.987 close to collect the carry. Your premium? About $.005 for a 30-day option, which is now MTM at about $0.124 (essentially delta=1 here, so whatever the difference between $1 and the current market price). Your loss is about $0.12 per contract, or $15,000. So you collected $625 in premium to now need to post $15,000. Ouch.
In sum: I’m sure we will find out about certain funds which collapse from this type of trade, or those who trade against consensus and made a ton. I am very happy not to have been playing this currency. For option traders – this is the reason you use defined risk trades: yes, you give up a fraction on every trade you do, but it can save your bacon when things like this happen.
…and it’s Groundhog Day. Another CB steps up with monetary easing – this time China – and the markets continue their ascent. And ‘Super’ Mario Draghi helped by hinting ECB easing will continue or grow. Shares rejoice.
Aside from the boredom-inducing, low volatility appreciation this is bringing to risk assets, I’m frankly amazed/impressed with how well central bankers seem to have tamed equity markets. The ‘Greenspan put‘ doesn’t even come close.
Perhaps a good reason the CBOE Skew index is remaining elevated. Plenty of folks don’t believe this rally can continue, or at least are willing to lay down some decent put premium to insure against a collapse:
Skews me… S&P Skew index. Source: thinkorswim by TDAmeritrade.
There have been several times in the past where I’m explaining ‘XYZ strategy’ to someone (hopefully they asked me beforehand), and the concept of skewness comes up. A couple examples:
- Several (successful) strategies lose far more frequently than they win. It’s not always like playing the lottery…
- Sometimes ‘the sure thing’ trade, which has made money every day, suddenly blows up.
Thus loops in the concept of skewness – how big are losses relative to gains? On the lottery side, you’re almost certainly going to lose USD 1 on a game with a (highly improbable) gain of USD tens of millions. But other examples abound in financial markets:
- Long-only (just about) anything: this is a negatively skewed strategy. Most months/years you will have a gain, but some months will be TERRIBLE. Don’t think about the little correction we just had…think about 2008. It can take years to recoup the losses from long-only: for example, notice that the NASDAQ is still about 10% below its 2000 peak.
- Venture capital: this is a positively skewed strategy, in its most basic form. The VC fund manager selects (say) 10 companies at an early stage of development. Financials don’t really mean much at this stage – they could do anything. The hope is that, out of 10, there will be 1 big winner and maybe a few small winners. The others are expected to be written off. So, one gain outweighs the many.
- Volatility selling: this is a classic negatively skewed strategy. VERY negatively skewed, epitomising ‘picking up pennies in front of a steam roller’. After premium selling funds lost about 50-70% in 2008 (or went completely bust), several actually hit high water marks in the past couple years. So it’s a sustainable, if nerve-wracking, strategy. By the way, insurance products and market making are roughly the same as option premium writing, in terms of performance characteristics.
- Momentum trading: a classic positively skewed strategy. Frequently momentum is classed as ‘long volatility’, which it is…kinda. More long gamma…but anyway. This is a ‘pain trade’, in that most of the time you’re losing money as markets oscillate back and forth and you’re trading with the trend. Only occasionally do the big trends come; you can’t really forecast them, and you MUST be in the market when they come. Otherwise this is a losing strategy.
I leave you with the following track records, harvested from Altegris’s managed futures website. Interesting place to learn about volatility and momentum offerings.
Classic example of a higher-geared momentum fund. Notice how the fund spends most of its time below high water mark; this is broken up with infrequent, large gains. Source: http://www.managedfutures.com
Extra credit: those seeking more technical info on return skewness, and particularly how the time-variance of skewness is a function of strategy design, should look at this wonkish paper.