The Leverage Trade

There is no doubt that fear and loathing is now driving the market. Just as greed and fear of missing out drove it higher, leverage can be having a large effect on the momentum swings in the market.


A quick explanation of how it works.

Let us assume that you are a hedge fund or any investor/fund that uses leverage to ratchet up the money they have available to invest.

If you have $1m to invest and you’re are a small hedge fund, your prime broker may leverage that up to say $3m. So of course, when the market goes up you are doing well and investing $1m of yours and $2m of their money. As valuations increase your margin requirements fall. This gives you more money to play with and as the market is going up still, you have to play. So, you increase your bets and momentum continues. But the problem is that you are now increasing your exposure. When the cracks appear the prime broker, who has lent you money in the good times, now wants more margin or collateral. So, you have to sell something to pay that margin call. As the market falls that margin requirement grows so you have to sell more. If it tanks you are scrambling to get out, along with all the other leveraged funds. It is a race to the bottom. As it goes lower you effectively get longer and longer in your exposure and so selling to raise cash and pay back your prime broker is your only option.

CFD trading is a similar thing. Leverage is their thing. The system is designed to look a little like a pokie machine on some platforms. The higher your CFD position goes if you are long the more margin you have spare so you can buy more. Pyramiding into bigger positions is thus encouraged in fact it’s almost compulsory. Trouble is when it turns your exposure is far bigger than you thought and as it falls you are required to put in more cash or sell. And as it goes lower and lower, you have to sell more and more or put in more and more cash. That is why CFD trading is so dangerous. Not recommended even in the good times.

The same happens in the option market. Many funds sell puts on quality stocks. The reasoning goes like this. You are happy to own these stocks if they fall a little bit and the premium you receive for selling the puts is a handy income source especially when the market just goes up forever. Some call it picking up pennies in front of a steamroller because if the worst happens and the markets turn quickly south then the seller of the puts gets longer and longer. They are now panicking and want to reduce their exposure and so are forced into selling. Once again this just exaggerates the moves. We see that panic as it becomes about survival rather than performance.

The computer programs now do all this automatically. As it falls some funds get longer and longer and their risk increases the lower it goes. Then the computer programs kick in to rebalance. These programs are all linked to other assets too, so the money has to go somewhere and floods into T -Bonds and other safe havens. It is a big bathtub fall of money sloshing from equities into risk-free T-Bills.

If you are a rubber duck on the surface, you can get sloshed around and tossed here and there.

It is painful. Even rubber duckies take on water and splutter and cough. Try not to be a duckie.

Source: Marcustoday – 2 March 2020