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And Now Something About Volatility.

Here is a news flash for. Nobody in the financial media has any understanding of volatility at all – if you are surprised then you probably shouldn’t be trading.  Much of the talk surrounding the issues with Greece have centred around how volatile markets have become, these statements are made without even understanding what volatility is let along whether they have become more volatile. There is a presumption ( and this is made by traders too ) that price movement or trend is volatility – it is not, the two are very distinct and to confuse the two is to confirm your status as a peanut. Consider the chart below which is of the VIX – a default standard for volatility within the US market.

Screen Shot 2015-07-01 at 4.01.35 pm

The red line is the average volatility for the past decade – yep its a quick an dirty measure that is somewhat distorted by the GFC. However, excluding the GFC and just taking the last five years gives me a figure of 18.1%, so volatility at present is about average.

In Praise of Short Sellers

In November, 2013, Whitney Tilson, who runs a small hedge fund called Kase Capital Management, gave a presentation to a group of money managers. Tilson’s talk was about a flooring company called Lumber Liquidators. In the previous two years, its profits had more than doubled and its stock had risen sevenfold. But Tilson made a case for selling the company short—betting on its stock to fall. He thought that its profit margins were unsustainably high and suspected that it had driven down costs by buying wood illegally harvested in Siberia. (The company denies buying illegally logged wood but says that it may face criminal charges relating to this issue.) Months later, a whistle-blower contacted him. “He said the story was much bigger than the sourcing of illegal hardwood,” Tilson told me. The contact alleged that the company was saving money by buying laminates made of wood soaked in formaldehyde (a carcinogen) from Chinese factories, and that the resins these factories used also contained the substance. Tilson hired a lab to test the laminates, and it found formaldehyde levels two to seven times the limit established as safe by California, on which forthcoming federal standards are based. A small investor named Xuhua Zhou had already published a detailed report alleging similar problems.

Shorting Lumber Liquidators turned out to be a good call. On March 1st, “60 Minutes” aired a blistering exposé on the company. The segment included tests showing high formaldehyde levels and hidden-camera interviews in which workers in China admitted lying about quality. The next day, Lumber Liquidators’ stock fell twenty-five per cent. It then recovered a bit as the company mounted a P.R. offensive—insisting that its products were safe and that “60 Minutes” had used “improper” testing procedures. But the stock is still down more than forty per cent in the past three weeks.

More here –  The New Yorker

Context Is Everything

As someone who comes from a data driven background one of the things that has always intrigued me about financial markets is that despite being a wellspring of raw data it is driven by narratives. Humans do seem to prefer stories over data – in effect we are a hairless ape that prefers stories to data. In many ways this is understandable since our ancestors only possessed an oral tradition. We had no means of capturing and analysing data until relatively recently. There is some evidence of “scientific” or “rational” thinking data back to 1600BC but these are one offs – the natural world was still explained by superstitious narrative. The scientific method in its modern form only dates back to the 19th century.

Part of the primacy of the narrative is that it offers explanations for things that may be either too hard to understand or simply unexplainable by those reporting on them. The financial media is full of what I would call the narrative fallacy, that is people making post hoc rationalisations for things they do not understand. In part this lack of understanding stems from a failure to understand the context in which data is being received. For example this morning the ANZ bank reported what has been interpreted as a stagnant profit result.

ANZ has reported first quarter profits unchanged from last year, in part due to an increase in loan loss provisions.

The bank posted an unaudited first quarter statutory profit of $1.65 billion, unchanged on the same period last year.

Its preferred cash profit measure, which excludes certain one-offs, edged only slightly higher from $1.73 billion to $1.79 billion.

Both figures were substantially lower than the bank’s most recent $2.23 billion fourth quarter statutory profit, and its $1.93 billion cash profit.

In response, ANZ shares had dropped 2.5 per cent to $34.99 by 11:22am (AEDT).

By way of contrast, Westpac and NAB were both 0.5 per cent higher, while CBA was down 2.7 per cent to $90.96, but a large part of its fall was due to trading without rights to its latest $1.98 interim dividend from today onwards.

ABC News Online

The implication of this narrative is that ANZ has done poorly today whereas other banks have done well. This poor result is therefore due to what the market considers a mediocre result. Implied within this is that ANZ represents a poor investment than its cousins. If I tracked the relative performance of the banks in the morning session this would seem to confirm this perspective. It would seem as if data and narrative are in alignment.

However, what is lacking is context – the data needs to be seen within the framework of the longer term. If we look at relative performance for the past five years a different narrative emerges.

ANZ is now the second best performing of the domestic big four banks. The narrative has been altered by the data. However, there is another element to this that needs to be touched on. Too often the narrative seeks to explain something that needs no explanation. Markets are simply dynamic nature systems, as such they obey normal laws of distribution. My expectation would be that the prices of something such as ANZ would have a natural movement pattern a little bit like the ebb and flow of a tide. The Average True Range of ANZ at present is $0.55 – on any given day my expectation would be that ANZ might move by a proportion of this defined movement. In part some of the movement today could be explained by reference to its standard distribution of prices. This, however, would make for boring reading. You could hardly have a news item that said XYZ share went down today and this was expected as defined by the structure of its volatility. Truthful but boring and definitely lacking in the emotional engagement we seek from narratives.

Long Term VIX

I thought it might be a bit of fun to look at the VIX and the S&P 500 over the longer term.

Screen Shot 2015-01-29 at 9.02.54 pm

Assumptions

Assumption is the mother of all fuck ups….

The recent fall out from the movement in the CHF has been interesting to watch. If ever you wanted to clear out the retail FX space I dont think anyone could have come up with a better plan than the actions of the SNB, it was a wonderful nuking of an entire industry that probably needed a good enema. It will also give some comfort to those who were annoyed that most of these firms would trade against them using their B book and in doing so they sealed their own fate. As much fun as it has been it has caused me to pause and think about some of the assumptions I use in trading and whether they were ever valid. Within FX trading it was always assumed that the depth of the market would save you, therefore, slippage was not an issue. In fact most discussions of slippage being a potential problem were dismissed out of hand. The same was true about the assumption of needing tremendous leverage. FX is not like stock trading where it is theoretically possible to buy a stock at $1 and have it run to $20. Hence, it was necessary to leverage positions up to generate an effective rate of return.

I dont think either assumption is necessarily invalid in the light of the actions of the SNB. However, no one ever considered what would happen if a quote provider simply stopped offering a market. It needs to be remembered that retail FX is an unregulated market in the sense that there is no central governing body. When a firm is making markets in a given pair it is not analogous to when an options market maker is generating quotes in say BHP.  Market makers on regulated exchanges have a series of quoting guidelines they need to adhere to – these will never be perfect but they cannot simply abandon the market.

Given that it is not an unreasonable expectation that a firm you deal with would firstly manage its own internal risk correctly and secondly enable you to keep dealing the question needs to be asked as to how does the events of recent days impact upon the way we trade. To get a sense of how likely this sort of failure is Matt Levine at Bloomberg did a more comprehensive job of looking at the probability of a complete market meltdown in a pair such as EUR/CHF. His job is more complete than my simple guess and my guess looks like it was out by several orders of magnitude. Levine found the following –

Goldman Sachs Chief Financial Officer Harvey Schwartz said on this morning’s earnings call that this was something like a 20-standard-deviation event, and while the exact number of standard deviations is of course a subjective matter, that’s the right ballpark. Over the 12 months ended on Wednesday, the annual volatility — that is, the annualized standard deviation of daily returns — of the euro/franc relationship was a bit over 1.7 percent; over the last three months of that period the volatility was less than 1 percent.  That converts to adaily standard deviation of something like 0.1 percent.  On Thursday, the euro ended down almost 19 percent, or call it 180 standard deviations, depending on what period you use.

An 180-standard-deviation daily move should happen once every … hmmm let’s see, Wikipedia gives up after seven standard deviations, but a 7-standard-deviation move should happen about once every 390 billion days, or about once in a billion years.  So this should be much less frequent. Good news I guess, Switzerland won’t be un-pegging its currency for at least another billion years, go ahead and set your Swatch by it.

However, this raises another question which is a bit beyond the scope of what I am talking about and that is whether it is sensible to have rational expectations at all regarding the behaviour of markets. This is a debate that is currently being fought between traditional economists and behavioural economists. My own view is that markets have a somewhat skewed rationality – that is since they are made up of people then anything can happen and you can adopt rational framework for interaction with the market based upon this assumption. However, we are back to the notion of assumptions.

Assumptions are the only mechanism we have of dealing with markets and it is reasonable and rational to assume that some events will occur with extraordinary regularity and some will occur very rarely. However, it is always worthwhile to see whether the assumptions you have built your system on make sense and whether you have a back up plan if they fail. For example, I make certain assumptions about where prices will be filled in my options trading and the majority of the time I will be filled at or near the price i have stipulated but there may come a time when I am not. It is this event I need to plan for and make certain my Plan B enables me to fight another day. As abalone divers are prone to saying, it is not the shark you see that kills you but the one you dont see.

“I like… fat… tails and I cannot lie, You vol sellers can’t deny…”

I like… fat… tails and I cannot lie
You vol sellers can’t deny
When a hot trend breaks with a well-timed stop
and a great big black swan pop you get
Paid… P&L year gets made
‘Cause you noticed that trade was packed
Buncha mean reversion suckers got jacked

Oh baby I wanna get lumpy
Long gamma for when it gets bumpy
Central banks tried to haze me,
But those carry trades just don’t faze me!

More here from The Mercenary Trader

And for those who cant remember the 90’s


 

That Has to Have Hurt

With the repercussions of the wild swing in the CHF still to be felt there has been some attempt to quantify the losses being faced by various FX providers. The table below was generated by FOREX MAGNATES

Screen Shot 2015-01-17 at 5.00.12 pm

General Advice Warning

The Trading Game Pty Ltd (ACN: 099 576 253) is an AFSL holder (Licence no: 468163). This information is correct at the time of publishing and may not be reproduced without formal permission. It is of a general nature and does not take into account your objectives, financial situation or needs. Before acting on any of the information you should consider its appropriateness, having regard to your own objectives, financial situation and needs.