Isolated shocks and the increase in market volatility
05/12/2018In our meetings with clients the topics for conversation vary, but 99% of discussions include reference to at least two or three of the themes listed below.
- Isolated
shocks (e.g. recent events in Natural Gas)
- ETFs
- Emerging
Markets FX and Bonds
- Corporate
Share Buybacks
- Weak Oil
- Volatile arbitrage and spread markets (LME/Comex copper arbitrage is a favourite of ours)
What connects these things?
Let’s look first at the events in Nat Gas over the last few weeks:
A pretty shocking move even as cold weather hit the east coast. It soon
emerged that the volatility was driven by two main factors (which are well
covered in other articles):
- A leveraged ETF (DGAZ)
- A hedge fund known as optionsellers.com
Optionsellers.com had sold low delta natural gas options. When prices started to gap higher they were unable to manage their delta risk and ended up taking a catastrophic hit. This sort of ‘nickels in front of a steam roller’ mentality has been around for as long as options have existed and does not warrant much analysis. It is worth noting though, that the prices of very low delta options in other unrelated markets also rallied during the demise of this business as their clearer covered their risk (Z19 30.0 calls in silver for example).
The leveraged ETF also involved selling convexity, but in a way that many market participants still struggle to come to terms with. This is a subject unto itself and not suited to our little note. Suffice it to say it adds stop losses to the market and, in times of distress, those stop losses can get very large.
In combination these two effects put huge gap risk into a market
already prone to shock events. What is really fascinating is how much this mirrors events we observed in February in the VIX, in the summer in Emerging Markets, and increasingly in some of the spreads and inter-market relationships we look at (see chart of Comex Cooper dec18/Mar19 spreads below - a huge move which none of our trading network has been able to explain).
Artemis Capital Management; Volatility and the Alchemy of Risk
This piece is quite comprehensive, and benefits from excellent analysis. However, its focus is chiefly on equities and credit markets and sees any future market event rooting itself in corporate debt markets.
At Arion we are mostly agnostic, but see three main drivers of uncertainty in current market conditions:
Strong Dollar / Fed Rate Cycle
Increased Political Uncertainty
Decline of discretionary risk capital across all markets (but especially in commodities)
The Artemis piece analyses the leverage at work in equities markets, but commodities futures are naturally leveraged, and lack smoothing mechanisms (OPEC and some specific market entities notwithstanding, commodities lack enough natural flow to smooth leveraged speculation, especially with the retrenchment of banking names from the space). It is our belief that commodities are naturally given to extreme movements, but that with markets as they are - more volatile moves are liable to be exacerbated by liquidity conditions. This view was recently echoed in a note put out by Goldman Sachs and repeats a view we have raised with clients repeatedly over the last 18 months.
So what’s next?
A candidate for a highly illiquid/volatile
commodities move would have some of these characteristics
- Large amounts of leverage
- One-sided positioning driven for logic such as roll yield (i.e. short in contango markets, long in backwardation)
- Thin liquidity, with a high degree of financial positioning relative to
fundamental positioning
- Extreme Pricing
- Historically low realised volatility (this drives leverage at CTA and
risk parity style funds)
To our eye a prime example of this is Nickel. It ticks all of the above boxes and increasingly looks vulnerable to a correction.
Watch this space.
Author; Darius Tabatabai, Portfolio Manager at Arion Investment Management