OlsenBlog

In the first blog on how to trade I have tried to explain why traders should not rush to open positions and that there was always another profitable trading opportunity in the waiting. The second blog is devoted to the phenomenon of the butterfly effect of cascading margin calls, which in my view is one of the most important forces driving market prices that few people talk about. Cascading margin calls come about because a butterfly; be it  a random news event or large market order, triggers a price spike, which leads to a margin call with one trader somewhere in the world who then has to liquidate a largish position enough to fuel a continuation of the price move triggering further margin calls. Cascading margin calls may last only for a few minutes or hours, but can also take days, weeks or even months. They can be so strong that they turn fundamentals upside down. To become a successful trader it is important to understand the phenomenon.

1.4 trillion USD turnover per day translates into trickles per second

Currency markets have a daily turnover of spot transactions of approximately 1.4 trillion USD, this is a mind boggling number, equivalent to approximately 10 percent of the annual US GNP. The daily turnover translates into a flow per minute of 1 billion USD, which is still a lot of money. If we go a step further and compute the volume per second, then the turnover collapses to only 16 Mio per second, which equates to 8 Mio buying and another 8 Mio of selling volume for all exchange rates together. For the individual exchange rates the numbers are a lot smaller:  for EURUSD with the biggest turnover, the volume per second is 3.5 Mio USD and for a minor exchange rate, such as USDCAD, only a trifle of 250′000 USD per second. The trickle volume on a second by second basis is also true for other markets, such as equity and fixed income markets. There the situation is even more extreme, the volume in these other markets are 10 times smaller for the fixed income and 50 times smaller for the equity markets.

In foreign exchange, the spreads are microscopic, for EURUSD they are as low as 0.006 percent. Market makers generate a profit from their transaction volume, if they manage risk and balance the volume of buys and sells. To achieve this objective they skew the prices aggressively up or down depending on the flow of buying and selling. This has the effect that even small orders, as long as they are bigger than the average second by second transaction volume, move the price. So price spikes are nothing extraordinary, they just reflect the risk aversion of market makers.

Compared to the trillions that are traded every day, it is thus paradoxical that already small market orders can choke the market. For minor currencies, 50 Mio is enough to move the exchange rate by 0.2 percent. For the major currencies of EURO or USD the critical amount is between 100 to 200 Mio depending on the time of day; these numbers are peanuts in the bigger picture. The US GNP is roughly 14 trillion USD and it takes as little as 200 Mio USD to move the USD exchange rate by 0.2 percent – is this not astounding?

Why butterflies cause avalanches of cascading margin calls

These price spikes are dangerous; they trigger margin calls with traders, who have already accumulated large unrealized losses and whose positions are hovering close to the stop loss, be it their own stop loss or the threshold. So a small price spike is enough to trigger the stop and initiate a closeout; this increases the imbalance of buyers and sellers and fuels a continuation of the price move triggering further margin calls with other traders. There are whole avalanches of margin calls, where one margin call triggers the next.

A successful trader needs to be on the lookout for likely avalanches. This is similar to predicting the likelihood of snow avalanches in meteorology, where factors are: the amount of snow on the ground, the rate of snow fall, overall temperature, wind and the specific profile of the mountain. The open positions of traders around the world are the equivalent to the snow on the ground. Similar to a card game, a successful trader tries to infer from the price action, what traders in the market are doing. Are they all long, or is the majority of traders short? Whenever the trader infers that many traders are herding and have the same position, such being long EURO, then he knows that the market is getting closer to a likely avalanche.

Herding behavior is a frequent phenomenon during periods with strong price trends. Contrary to general belief, these price trends do not signal an excess of long positions but an overhang of counter-trend positions instead. How does this happen?

The mechanism is as follows: traders, who were lucky and had positions in direction of the trend, have by and large realized profits early. So if the market price goes up, the positions of traders is typically counter-trend, where the winning positions have been closed, whereas losing positions that were counter-trend, were left open in the hope of an eventual rebound. When there is such an imbalance, any small price spike, for whatever reason, can trigger a margin call with one or several traders with losing positions, so the closeout can then trigger further closeouts, etc.

Importance of contingency reserve

There is no way to correctly anticipate the behavior of all traders around the world. For this reason, we need at all times be ready for an unexpected price spike that may trigger an avalanche of orders turning a seemingly innocuous price spike into a trend that can dominate the market for a brief moment in time or much longer. To prevent being caught by such an avalanche it is important to maintain a large cash reserve of free margin capital. I recommend that a responsible trader puts aside 50% trading capital as a reserve to offset unrealized losses and as a cushion for unforeseen events. The remaining capital may be used as active margin capital to fund positions. This capital has to be deployed wisely: a small percentage, such as 20% of the capital can be used to fund current positions; the remaining 30% can be used as contingency reserve to increase the position under special circumstances. In the next blog, I will try to explain, how I propose to use this contingency reserve. Later, I will also explain, how traders can detect potential avalanches building up.

Disclaimer: I have proposed some percentage numbers of how to split the capital; the concrete numbers very much depend on the trading style and are therefore indicative only.

January 21st, 2010 | Market, News | RSS feed