Tag Archives: Trading

margin trading and margin calls: is this what’s happening now?

May 26, 2010 By in Current Market Thoughts, Portfolio management, Recent Market Action, Strategy, Trading Tags: , , , , , , Leave a comment

It’s possible, in every market in the world I’m aware of, and in any asset class–stocks, bonds, derivatives–to borrow money from your broker to fund investments that are collateralized by the “equity” you have in your investment account.

The minimum amount of collateral you have to have to support a given level of borrowing is set by regulation in each country and varies by the type of assets you own in the account.  Brokers are usually free to apply more stringent standards to their customers and to change those standards as they see fit.  In some countries the financial regulator has the power to change margin requirements as a way of regulating the rise and fall of asset markets, much as regulators routinely do in changing short-term interest rates to try to control the credit markets.  This isn’t common, but the US did this routinely in the first half of the last century, Japan in the second.

The main characteristic, for good or ill, of margin buying is that it amplifies returns.  Let’s say you have a $1 million margin account that’s $500,000 of your own money and $500,000 of borrowings.  If the assets you have bought double overnight, then you have $1,500,000 of your own money and $500,000 in borrowings.  Your equity has tripled.

If, on the other hand, markets decline by 25%, you have $250,000 of your own and $500,000 in borrowings.  Given that the emotional tendency of most investors is to buy high and sell low, this latter outcome is more common.

If your “equity” declines enough in value that it reaches, or breaks below, the required minimum, you receive a “margin call”  from your broker, apprising you of the situation.  You have two choices:  either add enough assets to the account to restore the minimum equity balance, or have the broker liquidate enough assets to do so.  If you opt to add assets, you may have anywhere from a few hours to a day or two to accomplish this.

If you choose the second option, your broker will immediately begin to liquidate assets.  He will not be a careful seller.  His main concern is to reduce the margin debt exposure his firm has to you as quickly as possible.  He will simply dump the assets on the market to get whatever price he can.  Since every other margin account is probably in the same position, a massive wave of relentless selling will hit the market all at once.  Because this selling will depress asset values, the liquidation itself will likely engender more margin calls the following day.

This is a really ugly process to be caught up in, but is usually washes out any excesses in the markets where this happens.

One more thing:  selling doesn’t necessarily occur in the assets that caused the problem.  When the idea is to raise cash quickly, you sell:  (a) stuff you own, and (b) what is most easily salable–namely, commodities and  stocks.  By the way, I’ve always thought that, following the unconscious suicidal tendencies that margin traders exhibit, they never sell the “bad” assets that have caused their problems; they liquidate the “good” ones they own.  Sort of like–your dog keeps you awake all night with his barking, so you give away your cat.

Why am I writing about this?

Margin call liquidation is what the trading in global equity markets over the past week or so reminds me of.

In today’s world, the main margin participants are hedge funds, not individuals.  Their assets under management are very large.  Therefore, any forced selling would be correspondingly big.  It would also likely come as a result of changes in brokers’ rules on extending credit, rather than clients’ hitting statutory minima.  Also, given that the EU, and Germany in particular, are blaming their current woes on hedge funds and beginning to legislate/regulate against them, it would be very surprising if they weren’t privately telling the banks under their control to cut back on the supply of ammunition they are supplying to this enemy.

I have no direct evidence that this is the case.  But the current selling seems excessive to me.  In particular, yesterday’s trading–massive early decline followed by recovery–doesn’t seem to me to have been driven by fundamentals (yes, recent escalation of tensions between the two Koreas always causes an immediate selloff in Asia, but that should only create minor ripples elsewhere).  As you cross off more and more items on the list of possible reasons for selling, forced margin-related selling appears to me to be prominent among the reasons left.

Margin liquidations typically don’t last very long.  Rebounds are typically sharp.

Should you “buy when there’s blood in the streets”? … or “not try to catch a falling knife”?

May 17, 2010 By in Constructing a Portfolio, counter-trend movements, Current Market Thoughts, Inventory Cycle, Portfolio management, Strategy, Trading, trading: how valuable? Tags: , , , , , , , , Leave a comment

Wall Street has spawned millions of clichés.  They run from capturing the essence of stock investing, “Buy low; sell high” to not-so-useful chatter (for investors) from traders, like “Wait for a pullback,” to the inane natterings of cable TV show personalities.

Market truisms are often mutually contradictory.  But, excepting the ones from TV, they often outline possible approaches to important investment issues.   That’s certainly the case with the two I’ve cited in the title for this post, which talk about how to deal with sharp drops in the market in general, and how to play a possible upturn in the business cycle (and therefore in the market cycle as well) in particular.

the big middle

In the old days–meaning pre-Eighties, professional investors in the US customarily talked about working the “big middle.”   The idea was to avoid undue risk at potential cyclical turning points in the market.  A manager would do this by becoming more defensive as he saw three signs:  the economy beginning to expand at an unsustainably high rate, the market becoming fully valued and the Fed about to shift money policy from expansive to restrictive.

He might miss the actual market peak by months.  But he was prepared to profit from the subsequent downturn.  As he sensed the opposite signs, however–the economy flagging, the market cheap and the Fed about to reverse course–he would do nothing.  He would wait for the market to clearly turn upward again before becoming more aggressive.  Again, he might miss the absolute bottom by months, but he would avoid coming out of his defensive position too soon and he would gain performance for a year or more after he turned his portfolio more positive.

No one talks about this overall strategy anymore.  Why not?

–For one thing, as a result of deliberate policy decisions by the major governments of the world over at least the past quarter-century, individual country economies are much more closely linked in a global network than they were.  The closed economy model is a thing of the past.  Markets are affected, sometimes profoundly, by events that take place elsewhere and over which the local government has only limited control.

–The investment business is much more competitive today than it was then.  Underperforming for six months or a year may be enough to get a manager fired before the “big middle” strategy allows him to catch up.  His clients may say they’re ok with the risk mitigation his approach provides, but when the numbers fall behind the peer group, memories can be very short.  And it’s always the customer’s right to take his business elsewhere if e chooses.

–For thirty years, we’ve been seeing the creation of ever newer derivatives tools that allow the manager to change portfolio composition much more quickly than before.  In addition, volumes in the physical market have been steadily increasing as well, allowing managers whose contracts with customers bar the use of derivatives to act swiftly, too.  Maybe we’re now seeing the limits to this speed, even large market participants have the flexibility to alter their portfolio structure in a matter of a few weeks if they choose to.

To sum up, linkages with the rest of the globe mean more chances for sharp short-term market movements, which new tools and increased competition have professionals increasingly focused on.  Also, as the recent “Crash of 2:45” shows, the new tools themselves may be another source of temporary market instability.

the falling knife

Opinion is divided on how to approach sharp market declines.  “Don’t try to catch a falling knife” expresses one technique.  I’m not sure what the origin is.  I’ve only begun recently to hear it in the US, although it was already very common among British investors when I began to look carefully at foreign markets in the mid-Eighties.

The “falling knife” idea is a variation on the “big middle” theme.   The thought is that when investors are selling aggressively and stocks are dropping sharply, it’s better to wait until this energy has exhausted itself before going in to pick up the pieces.  See the bottom and watch the turn happening before entering the market.

blood in the streets

The “blood in the streets” approach is to some degree the opposite idea.  Buy when everyone else is selling, when the predominant emotion in the market is fear, and when stocks are cheap.  Don’t wait for the turn.  By the time you’ve convinced yourself that the worst is over, the best buying opportunity is long gone.

more professionals are embracing the “blood” idea…

…in my opinion, anyway, for two reasons.  The opportunity to profit from market disruptions, and by doing so to perform better than one’s peers, is too great to ignore.  Increasingly, the time period over which clients are judging professionals’ performance is shrinking.  Hedge funds, where returns may be scrutinized and evaluated on a month by month basis, are the limiting case.  But this performance pressure is also being felt by long-only managers.

What should individuals do?

The most important thing is to ask yourself two related questions:

–Are you willing to accept the extra risk of trying to trade a downdraft in the market?

–Is your financial situation strong enough that you can absorb possible losses if you turn out to be wrong?

Assuming the answer to both questions is “yes,”  these are my thoughts:

1.  Ask yourself what the primary trend in the market is.  Are stocks generally going up or generally doing down?  Are we in a bull market or a bear market?

In my opinion, you should only be interested in counter-trend movements.  Only think about buying, or about replacing defensive stocks with more aggressive ones, during a decline that happens in a bull market.  Conversely, only use a sharp upturn to become more defensive during a bear market.  Otherwise, do nothing.  During the past twenty years, the lows have typically been much lower, and the highs higher, than anyone would have predicted.  Welcome to a world with derivatives trading.

2.  Calculate probabilities as best you can.  The point is that you don’t need to find the absolute bottom in order to act.  For me, if I can satisfy myself that a stock might go down 10% but has an equal chance of going up 30%, I’m happy to buy.  Your own risk tolerances will determine what the appropriate ratio is for you.

3.  Separate market events from stock-specific ones.  In a temporary downturn, more economically sensitive stocks will typically decline more than defensive ones.  Similar stocks in the same industry should show roughly similar volume and percentage change patterns.   These patterns should also be similar to the stocks’ behavior during past declines.  An individual stock decline that is, say, twice what one should expect and that happens on much higher than expected volume can be a warning sign that sellers are acting on newly developed negative information that you may not be aware of.  In such a case, discretion is the better part of valor.  Choose a different stock to buy, or don’t transact at all.

4.  Don’t force yourself to do anything you don’t feel comfortable with.  I think it’s a characteristic of today’s market environment that if you miss an opportunity today, another one will likely occur in a month or two.

financial indictments: suppose the worst is true?

April 19, 2010 By in Banks, Current Market Thoughts, Industry Analysis, Investment firms, Recent Market Action, Strategy, Technical Analysis Tags: , , , , , , , , , , , , Leave a comment

The Goldman indictment

This morning’s Wall Street Journal has an article in it which, while neatly summarizing the SEC case against Goldman Sachs, also states that the SEC is investigating other investment/commercial banks for similar possible violations.  (By the way, the WSJ is also running an opinion column arguing that the indictment is a mostly political move, and more a “water pistol” than a “smoking gun.”)

how true? how pervasive?

Stock market reaction around the world to the Goldman indictment has been immediate and negative, giving rise to the question:  what happens to the overall stock market if the worst turns out to be true?

I would define “worst” as meaning

–that ultimately most big bank are brought up on charges similar to Goldman’s (a JPM indictment would be particularly bad) and

–that legislation is enacted that restricts the future profit-making activities of the banking sector.

My guess is that convictions and fines would be much less important for the fate of the financial sector on Wall Street than a loss of trust in the companies and a shrunken future stream of profits.

how I handicap the issue

1.  Start by observing that the financial sector makes up 16.5% of the S&P 500.  Just to pick a number out of the air, let’s say that if the combination of social stigma and legislation that limits growth were factored into today’s prices, that would take a third off the sector’s market capitalization.  That’s too much, in my opinion, but let’s just say.

This would amount to a fall in the S&P of 5.5%.

2.  We might reasonably argue that the transactions in question didn’t do much overall economic good and might have actually been damaging.  That is to say, they moved money from the pockets of one set of brokerage clients to another, but provided no real other economic benefit.  To the degree that they helped the housing bubble to expand, they might have been harmful.

If so, requiring fuller disclosure or otherwise making them harder to do wouldn’t really hamper economic growth.

3.  If we lived in the simplified world that academics inhabit, and if we knew 1. and 2. for certain, investors would probably make a very swift adjustment in the prices of financial firms (and no others), dropping the S&P to 1130 or so in a couple of days.  As far as the S&P is concerned, that would be the end of the matter.

In the real world, we don’t know many things for sure, however.

uncertainty has consequences

Uncertainty has two main consequences:

–although I think that whacking a third of the value of all financials is much too much, the market–an emotional beast–could overreact

–declines are almost never isolated to a single sector.  There are always relative value arbitrageurs, who will regard financials as cheap and sell other sectors to get the money to buy them.  This process means the entire market, not just the financials, will go down.

two conclusions

The first is that while the SEC action may not exactly be a tempest in a teapot, I don’t see that it is anywhere near important enough to undermine the case that we’re in a bull market–or to be anything more than a temporary setback to the market’s advance.  Ultimately, the simple-minded 5%-6% drop in the S&P will likely prove correct.  But we probably get there by a roundabout route.

My guess is also that financials won’t regain in the near future the stock market leadership role they have played so far this year.  IT is my candidate for its replacement, but that’s been my position for a long while.

the timing of the case?

The Goldman indictment comes at a delicate point for the market.  After declining in late January-early February, the S&P has been marching upward very consistently, to the point last week where it had achieved almost all the gains that even bullish market commentators had predicted for the full year.  The index was also flirting with its (technically/psychologically important) levels just before the Lehman collapse in September 2008.  So it was arguably due for some sort of correction.

To some degree, then, the Goldman indictment should be seen as the trigger, or excuse, for something the market was going to do anyway, rather than the cause.  But the correction will likely be deeper and more prolonged than it would be otherwise.  Maybe we have a repeat of the January-February decline.  One positive sign I’ll be looking for would be that other sectors would perk back up even though financials languish.