OlsenBlog

THINK ABOUT PRESS: How to Trade

richardo — Thu, 22 Jul 2010 08:49:12 +0000

We are publishing a small booklet on how to trade. The content is based on previous posts on the subject. I have expanded the material and hope that you will find the text helpful. The booklet is also a non-technical description of how the trading models powering the Olsen investment programs operate. We program our trading models to be good traders; our algorithm spots imbalances of supply and demand and takes positions when price overshoots occur. If the price rebounds, then the model takes profit but if the price continues to move in the adverse direction, the model trades the coastline to improve its price average and eventually gets out of its position at a profit. As explained in the booklet, there are more decision rules that make a good trader. Have fun.

THINK ABOUT PRESS: Global Economy Under Siege – Possible Initiatives

richardo — Thu, 06 May 2010 17:45:11 +0000

We have published a small booklet ‘Global Economy under Siege – Possible Initiatives’. The booklet is based on a post that I published 14th December 2009. The booklet includes visuals created by Lisa Wilkens. Pictures can mean so much more than words. I hope that you enprepared a small booklet that you can download as a pdf or have us send you a copy. It includes the text of a post that I published on the 14th December 2009 and has since been edited. Lisa Wilkens has created visuals to accompany the text. A picture is worth a thousand words, thank you Lisa. I hope that you enjoy the booklet. I look forward to your feedback.

How to hedge: currency overlay

richardo — Thu, 29 Apr 2010 12:48:17 +0000

Price moves in the currency markets can be disruptive and lead to large losses with investors and corporations. In general, institutions do not protect themselves against this risk, because the cost of hedging is high. In this post, I try to explain how dynamic hedging improves the cost structure and makes hedging appear indispensable.

Currency risk is incurred, whenever assets or liabilities are denominated in a foreign currency. Liabilities are the opposite of assets and can basically be hedged in the same way as assets. Assets, just as liabilities, can be of any shape or form; they can be financial instruments, fixed assets, such as a house or factory; or an income or payment stream, for example pension receipts or payments for project work. Whenever the foreign currency appreciates, the value of the respective asset increases, whenever the foreign currency drops, so does the value of the asset. Any rise or decline in value of an asset represents volatility and is an incremental contribution to risk. Investors can improve risk adjusted performance, if they can lower risk without reducing return expectations.

The price movements in the currency markets are an important risk factor for assets and liabilities denominated in foreign currency. Currency movements of plus or minus 10 percent in 6 to 12 months are nothing extraordinary. Occasionally currency movements are far bigger and may move by plus or minus 30 percent in only six months. This explains, why in principle there is a lot of interest in neutralizing currency risk through hedging or currency overlay, as professionals call it. There are the following methodologies to hedge currency risk.

Static hedge

The institution hedges its currency exposure by selling the equivalent amount of foreign currency and buying the home currency. The selling of the foreign and buying of the home currency occurs at the exchange rate that is quoted at the time of executing the hedge trade. As long as the hedge stays open, the institution has to pay credit interest on the foreign currency and receives the debit interest on the home currency.

The operational details of the static hedge are the following: it is necessary to setup an account to execute the currency hedge. This involves putting up collateral to fund the hedge. The collateral is the margin capital to fund the hedge and absorb potential losses during the lifetime of the hedge. The collateral is typically roughly 10 percent of the value of the foreign asset. The collateral is used as margin capital for the actual hedge and to offset losses, in case the foreign currency appreciates and the hedge is under water, i.e. the current market price is higher than the price at which the currency was originally sold.

The hedge neutralizes the currency risk because in accounting terms, when summing up the value of the foreign asset and of the hedge, changes in valuation of the foreign asset and the hedge offset each other. A loss incurred on the hedge is compensated by a profit on the foreign asset. If on the other hand the foreign currency depreciates, then the hedge generates a profit that compensates a loss made on the foreign asset. Large institutions hire overlay managers to execute the hedge.

The static hedge can be established through a bank, a specialized market maker in foreign exchange or through a futures contract.

Establishing a hedge is not free of cost, the institution has to allocate funds or provide a credit line that is used as collateral for the margin capital of the hedge. Even though the collateral earns interest, this ties up capital and thus implies an opportunity cost to the overall institution.

Another drawback of a static hedge is that the value of the hedge is as good as the timing of the hedge: when the position was opened and closed. If the institution times its hedge well, it is the big winner, but if it fails to pick the peak of the value of the foreign currency, the profitability of the hedge is disappointing.

Due to the cost of putting up collateral to fund the hedge and the need to have a good timing for the static hedge, institutions have not embraced currency hedging. They prefer to endure the risk of currency movements than to hedge their exposure. This strategy has the benefit that management has a good excuse: if overall performance is below par, they can always blame the currency markets.

Options

Another approach to currency hedging is to buy put options to offset the risk of currency depreciation. A put option gives the buyer a right to sell a defined amount of foreign currency at a specific strike price, typically the current price minus any interest rate differential between the home and foreign currency for the duration of the option. The cost of a put option is high: typically, a put option for one year can cost as much as 10 percent of the underlying asset. So the price depreciation of the foreign asset needs to be at least 10 percent to break even. The cost of put options can be reduced by implementing a more complex option strategy, e.g., by buying a put option and at the same time, selling a call option. Such a strategy adds risk and complexity to the transaction making it more difficult to manage the hedge. Institutions rarely use options to hedge their currency risk because of the cost and complexity.

Combining static hedge with dynamic hedge

At Olsen we have developed a hedging program that overcomes the deficiencies of a static hedge. The program has two components a static hedge and a dynamic hedge. The dynamic hedge buys and sells the foreign currency in tandem with price action in the currency markets: whenever the foreign currency appreciates rapidly, the dynamic hedging program makes incremental sales of the foreign currency and buys the home currency. As soon as the foreign currency starts to drop again, the program closes out these short positions by buying the foreign currency and selling the home currency. If the foreign currency drops further, the program continues to build up the offsetting hedge by buying the foreign currency and selling the home currency.

The dynamic component can in this way take advantage of the many ups and downs in the foreign exchange markets. During the course of one year, the sum of all the up and down movements bigger than 0.05 percent are a whooping 1600 percent for a typical exchange rate after accounting for transaction costs. The price curve with all its up and down movements is the coastline of the exchange rate. The dynamic hedging program takes advantage of the length of the coastline and the temporary price overshoots, which are then reversed, to increase and reduce the total size of the hedge to generate incremental return.

Let me give an example:

If the foreign asset has a value of 100 units, then the static hedge is short 50 units of the foreign currency and long the equivalent amount in home currency. The net exposure of the investor to the foreign currency is then 50 units. In addition to the static hedge, the Olsen program includes dynamic positions that are opened and closed in response to the price overshoots. The dynamic hedge can in an extreme situation, when the foreign currency appreciates rapidly, increase the hedge by selling an additional 50 units of the foreign currency and buying the equivalent of home currency; the hedge is then the same size as the foreign asset. If the reverse happens and the foreign currency drops rapidly, the dynamic hedge starts to buy the foreign currency and incrementally builds up a long foreign currency position that offsets the static hedge. In an extreme situation, the dynamic hedge may be as large as the static hedge thus equivalent to a closeout of the hedge.

The advantage of this approach is that the overall size of the hedge changes dynamically. Whenever the foreign currency appreciates rapidly, the dynamic hedge adds to the overall hedge, whenever the foreign currency drops rapidly, the total hedge size is reduced. By dynamically changing the overall size of the hedge the program generates a profit, which is welcome revenue that can offset the opportunity cost of setting aside margin capital for hedging.

The dynamic hedge is a benefit because it reduces the importance of getting the timing of the static hedge right – if the static hedge was initialized at an inopportune time, when the foreign currency had already dropped, then the dynamic hedge will make up for some of the lost opportunity.

Most importantly, the dynamic hedge increases the size of the hedge. Whenever the foreign currency appreciates; the dynamic hedge reduces the size of the hedge, and whenever the foreign currency depreciates, the dynamic hedge cushions the impact of the price movements of the foreign currency and reduces risk by lowering volatility of the net value of the foreign asset including its hedge. Differen to the option strategy, which costs money, if the price moves do not happen as expected, the dynamic hedging strategy does not cost money because the profits from the dynamic hedge pay for the opportunity cost of the capital dedicated to the hedging strategy.

How to trade: managing exposure

richardo — Thu, 18 Mar 2010 15:30:21 +0000

The biggest danger for any trader is excessive exposure. An unexpected price spike can then trigger a margin call that wipes out all the profits generated over months of hard effort. This is the most frequent reason why traders lose money. How can we prevent this from happening? What do we have to know?

Diversification

As there is no such thing as perfect foresight and an unexpected price spike can occur at any time, a trader should always diversify his risk and trade not just one, but two or three ideas at the same time. It is through diversification that he can improve his risk profile – when one trading idea is in the profit, the other runs a loss and vice versa. Overall his performance is smoother and more importantly, this approach reduces the pressure to perform. The trader is then more relaxed and less emotional in managing the exposure of his trades.

How to realize profits?

Whatever the underlying trading ideas are, the method for converting an idea into a realized profit is always quite similar. First, the trader should define a budget in terms of assets that he intends to commit to the trading idea. It is best to divide the budget into targeted position size and additional capacity that he intends to use in case that the market turns against him. I advise that the targeted position size should be only one third of the overall budget of the trading idea – a large two thirds are additional capacity that is kept in reserve. When he opens his position based on his trading idea, he should split the initial trade into three tranches, because there is no way to know the optimal timing for an opening a trade, so it is better to diversify this risk into three opening trades.

How to manage a trade?

In the blog on why butterflies cause cascading margin calls I explained that a trader needs to be on the continuous lookout for unforeseen events that can trigger a cascade of margin calls. When this happens, any trade can turn into a losing position, where the entry price is so far from the current price level that the profit target is out of reach.

Improving price average to turn losing position into a profit

A losing position can be turned into a winning trade by turning the negative development into a positive and take advantage of the new price level to add to the existing position thus improving the price average of the whole position. In doing so, the trader shortens the distance between price average and current price thus increasing the likelihood of a price bounce that is sufficiently large to turn his position into a profit.

Why are price rebounds bound to occur?

In liquid financial markets up to 98% of all the trading is based on speculative positions and the hedging of those positions. These positions being speculative are temporary and any opening trade will need to be closed. When the closing trade happens, this has the effect of inducing a price reversal. Due to the duality of the opening and closing trade the price movements are never fully one sided. At some stage, sooner or later, positions will be closed and then the price rebounds occur.

A trader can use these reversals to turn a losing trade into a winning position. The method of increasing the position size to turn a losing trade into a winning position has, however, big drawbacks, which the trader has to be fully aware off.

Smoke and mirrors

Human beings do not find it easy to correctly identify price extremes. They typically interpret relatively small price moves as extremes, where in actual effect the moves are only moderately larger than average. This deficiency is even more pronounced when a trader faces mounting losses. When under pressure, the trader’s internal clock ticks faster and he poles the market price at a higher frequency. Time will seem to flow more slowly, minutes will feel like hours and days like weeks. Under these circumstances, the trader’s natural instinct is to time his trades in terms of his internal clock, but this is wrong. Unaware he will focus on smaller-scale price movements that are out of step with his overall trading strategy. He will decide to increase his bet too early. There might be a bounce back, but this will not be enough for him to exit his position with a profit. If the price resumes its slide, the trader will accumulate losses even faster than before because of the larger position.

A trader needs to take into account that his sense of timing is skewed when under pressure: he needs to lean back and slow his natural instinct and wait for a price overshoot that is in sync with his regular trading frequency. Patience is of essence.

Reducing position size

If a trader has increased his position size to improve the average price of his position, he has to reduce the size of his position at the next opportunity, when the price rebounds. This is important because he has to free up margin capital, so that he can increase his position, when the price falls back again. By carefully managing the position size during the ups and downs in the price, he earns incremental profit that turns a losing position into a winning trade.

Trader deep freeze

The biggest danger for a trader is the so-called ‘deep freeze’ mode: a trader, who is close to a margin call, freezes up and does not have the mental energy to take decisions and blindly hopes for a price rebound. He can be lucky once, twice or three times, but not on an ongoing basis. Similar to a mouse that is hunted by a cat and cannot move for fright, the same happens to the trader. It is important to preempt this situation. The trader has to set himself a stop loss, where he will get out of his position, whatever may happen. Ideally, the stop loss is never triggered and he is able to maneuver out of any unrealized loss by increasing and decreasing his position size in response to the local highs and lows of the market. In case he fails, he has to have a stop loss strategy in place that limits his overall risk. It is all too easy to close one’s eyes and hope for the best.

Why policy makers need to take note of high frequency finance?

richardo — Thu, 25 Feb 2010 14:44:12 +0000

Policy makers are typically concerned with long-term economic issues; so why should they be interested in the field of high frequency finance that seems to deal with short-term market phenomena? High frequency finance has the potential of biotechnology and can revolutionize economics and finance by turning accepted assumptions upside down and offering novel solutions to today’s issues.

Why high frequency finance turns economics and finance into a hard science

High frequency finance is a new discipline in economics that was officially inaugurated at a conference held in Zurich in 1995 organized by Olsen. Over 200 researchers from the most renowned universities from around the world came together to start up the new field, which has resulted in a large number of publications including a book with the title ‘Introduction to High Frequency Finance’.

High frequency data is a term used for tick-by-tick price information that is collected from financial markets. The tick data is valuable, because they represent transaction prices, at which assets are bought and sold. The price changes are a footprint of the changing balance of buyers and sellers.

The term ‘high frequency finance’ has a deeper meaning and is a statement of intent and indicates that research is data driven and agnostic. There are no ex ante theories or hypothesis. We let the data speak for itself. In natural sciences this is how research is conducted: the first step towards discovery is pure observation and coming up with a description of what has been observed; this may sound easy but is not at all the case. Only in a second step, when the facts are clearly established, do natural scientists start formulating hypothesis that are then verified with experiments.

In high frequency finance the first step involves collecting and scrubbing of data. As a second step, the data is analyzed and statistical properties are identified. We are on the look out for stylized facts which are significant and not just spurious. Due to the masses of data points available for analysis, for many financial instruments we collect more than 100′000 data points per day; the identification of structures is straight forward, either there is a regularity or there is none. After identifying specific patterns, we formalize our observations and provide tentative explanations and develop theories.

The abundance of data in high frequency finance has profound implications on the statistical relevance of its results. Unlike in other fields of economics and finance, where there is not sufficient data to back up the inferences, this is not an issue in high frequency finance. The results are unambiguous and turn economics and finance into a hard science, just as is the case for natural sciences; not a bad thing.

High frequency data as an answer to singularity of macro events

Today, we are all grappling with the economic crisis and have to make hard decisions. In living memory, we have not seen a crisis of a similar scale, so policy makers are in a vacuum and do not have any comparable historical precedents to validate their policy decisions. If the global economy had been in existence for 100′000 years, this would be a different matter. We would have had many crises of a similar scale to compare with and we could use these previous events as a benchmark to evaluate the current crisis. The modern economy with financial markets all linked up through high speed communication networks trading trillions of USD on a daily basis is a new phenomenon that did not exist 20 years ago. People do refer to the events of 1929 and subsequent years: these events can be used as one possible point of reference but they are not meaningful in the statistical sense. There is a void that researchers and policy makers need to acknowledge. On a macro level we can only make observations, but no inferences because we do not have the historical data. On a macro scale the events today are singular; policy makers need to be aware of this.

High frequency finance can fill the void with its huge amounts of data. Inspired by fractal theory that explains, how phenomena are the same at different scales, we search for explanations of the big crisis by moving to another time scale, the short-term. At a second by second level, there are an abundance of crisis and systemic shocks, just imagine the occurrence of the many price jumps due to unexpected news releases and political events or large market orders. Albeit on a short-term time scale we study, how regime shifts occur and how human beings react. The large number of occurrences allows for meaningful analysis. We study all facets of a crisis, how traders behave prior to the crisis, how they react to the first onslaught, how they panic, when the going gets hard and finally, how their frame of reference which previously was a kind of anchor and gave them a degree of security breaks down and how later, when the shock has passed, the excitement dies down, there is the after shock depression and then eventually how gradual recovery to a new state of normality begins.

The everyday events sum up and shape the tomorrow

High frequency finance has another big selling point, why policy makers should take note: the study of market events on a tick-by-tick basis brings to the surface the detailed flows of buying and selling that occur in the market. From this information it is possible to build maps of how market participants build up positions and how over time asset bubbles develop. By tracking price action on a tick-by-tick basis, it is possible to make inferences of the composition of those bubbles similar to the work of geologists studying rock formations. Researchers can identify, who has been buying and selling, on what time horizons they trade, how resilient they are to price shocks, what makes them turn their position and become net sellers as buyers. Based on this information we can make inferences of the likely collapse of those bubbles. High frequency finance opens the way to develop economic weather maps. Just as in meteorology, where the large scale models rely on the most detailed information of precipitation, air pressure and wind, the same is true for the economic weather map. We have to start collecting data on a tick by tick level and then iteratively build large scale models. Today, the development of such a global economic weather map has barely started. The scale of market quake that Olsen offers as a free Internet service is a first installment, but just a start of an exciting development.

High frequency finance turns economics and finance into a hard science by the sheer volume of data and its ability to set events into their appropriate context by mapping rare events into a short-term time scale with a near infinity of events, albeit at a shorter term time scale. Second, the tracking of events on a tick-by-tick basis opens the door to identify underlying flows and develop economic weather maps – not a bad thing?

U.S. will never lose Aaa rating – is Geithner the captain of the Titanic?

richardo — Wed, 10 Feb 2010 13:48:04 +0000

The sovereign debt crisis that started with Iceland last year has now spread to Greece, Spain and Portugal. Other countries with large deficits are on the firing line as well, the US is one of them with a deficit of 12 percent of GDP, the same as Greece. Treasury Secretary Timothy F. Geithner tried to shore up confidence in an ABC News interview by claiming that the US would never lose its Aaa rating. A number of commentators have picked up on this news and have ridiculed Geithner saying no way; the US will lose its Aaa rating.

It is no trifle matter, if a country has a government budget deficit of 12 percent; this is even more perilous when interest rates are at an absolute low as they are today and there is the danger that interest rates snap up dramatically increasing the cost of servicing debt and the size of the public deficit. There are also the private house holds, which make up for 70% of GDP with their consumption, who are heavily indebted. So rising interest rates will also depress private consumption. If worst comes to worst, we have a culmination of negative factors: shrinking GDP due to reduced government spending and lower consumer spending, contraction of leverage and falling asset prices in response to bankruptcies and lower economic activity.

I regularly question friends and other people with extensive market expertise. They agree that sooner or later the U.S. will hit the equivalent of an iceberg, just as the Titanic did, which will tip the precarious balance of the US economy. Such an event is just a matter of time, we do not know, when or how it will unfold, but it will definitely happen. Judging by earlier crisis, the onset will be rapid and there will be little forewarning. Given the inevitability of events, we have to ask ourselves, how do we as individuals and political leaders in particular need to react.

Should the captain in the hope of better times to come delude his people, even though he knows better? A manager or political leader is worth his mettle, if he has the courage to live up to his responsibility and warn the people of the inevitable. Yes, as soon as political leaders speak up and tell the truth, there will be a shock wave, there will be selling in the markets and an initial wave of uncertainty. The payoff of the initial stress will be trust in the leadership, which will be invaluable, when the going gets really hard. Geithner’s “keep smiling” strategy can keep things going in the short-term but will ultimately result in complete public disillusionment and weaken the government, when we face the next Six Sigma event.

Reference

Survey by McKinsey Global Institute, January 2010, Debt and deleveraging: The global credit bubble and its economic consequences

http://www.mckinsey.com/mgi/publications/debt_and_deleveraging/index.asp

Trading: Meltdown of Carry Trade: Strong JPY Market Quake

richardo — Thu, 04 Feb 2010 18:52:32 +0000

USD_JPY collapsed from 90.60 to a low of 88.65 in 30 minutes taking down AUD_USD from 88.00 to 86.15. The Scale of Market Quakes for AUD_JPY recorded a strong quake of 4.4. Three trades triggered the move: margin calls on long AUD positions, liquidations of short JPY and short USD positions. The market was building up to such a move because there was a bifurcation in the market, where one group of traders believing in the long-term collapse of the USD turned a blind eye to their increasing losses due to the gradual rise of the USD, while on the other hand there were the traders with the growing confidence in the continued strengthening of the USD. Similar to children that rock a rowing boat the combination of margin calls and aggressive trend following trades triggered the sell off.
What do we make of all this? We are at the start of the month, so it is unlikely that this is the last storm. Traders will want to make up for any losses incurred, so they will increase their bets. If tomorrow Nonfarm payrolls are equal or worse than expected, we might see a strong wave of selling of the USD reversing the USD appreciation. If this happens, then the natural response of traders, who failed to participate in the rise of the USD is to jump ship and turn their positions from shorting the USD to going long. From my point of view, this would definitely be a mistake. The USD has staged a strong recovery over the past few weeks. There are growing signs that the USD longs are becoming increasingly exuberant an early indicator of a pending reversal.

At the same time, as the currency moves, gold dropped from 1105 USD to a low of 1063. Under normal circumstances one would expect that talk of government default would provide support for gold, but this was not the case. The dynamics of margin calls can create havoc with fundamentals, as witnessed with gold. So at all times it is important to trade with sufficient reserve margin capital.

Most likely, the coming days will be volatile. If the Nonfarm Payrolls are positive, then the appreciation of JPY will continue for another two days, because markets are illiquid on Friday afternoons and it only takes a small volume to move the price even further, triggering more margin calls. When a reversal finally starts, traders need to be careful and not jump ship. The USD downtrend can be far stronger because there will be another round of margin calls, but this time for the traders, who are long USD.

How to trade: Why butterflies cause cascading margin calls

richardo — Thu, 21 Jan 2010 13:54:26 +0000

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.

Why financial markets need a Richter scale

richardo — Thu, 14 Jan 2010 17:40:55 +0000

The international response to the Haiti earthquake was immediate and illustrates the benefits of the Richter scale. Thanks to the global seismic surveillance systems, geologists could accurately measure the strength of the earthquake: it was a major earth quake of strength 7.0, there was no need for second guessing. A major earthquake in a densely populated area causes huge personal suffering requiring international aid. Without waiting for more detailed analysis, international rescue operations went into action to mitigate hardship.

It is crucial for financial markets to have a similar Richter scale for events in the financial market, because political, economic and other events can trigger seismic shifts that derail the economy. Decision makers have to know about the occurrence of these events as soon as possible. The earlier that people learn about an event and the more precise their knowledge of its nature, the better their reaction. The Scale of Market Quakes (SMQ) service that Olsen Ltd offers for free on the Internet has been designed to fulfill this objective. Users are kindly invited to provide their feedback and suggestions of improvements.

Why we need second by second interest rate payments

richardo — Thu, 14 Jan 2010 17:23:09 +0000

Financial markets still follow business conventions that were adopted at a time when transactions were executed manually. Hidden to the public are the details of processing of the trillions of USD transaction volumes traded on a daily basis in the world’s financial markets. Given the huge amounts of money involved, one would assume that the technology is state of the art but in actual fact this is not the case. The settlement of financial market transactions follows business conventions that were defined, when banking was done without the help of modern computers and processes were manual. This explains, why even today international payments take two business days, which is quite extraordinary in our age of instantaneous communication. This archaic payment system has a significant impact on financial market stability.

Financial markets as a nervous system

The global economy is a complex system where financial markets are the nervous system that disseminates signals. From our every day experience with complex systems – our human body is such a system – we are aware that minor deficiencies can have a disproportionate impact. Financial market conventions may appear as petty details of execution and therefore irrelevant, but in actual fact the subtleties of execution have a big macroeconomic impact.

Electronic trading

Today, there is a stark contrast between how traders initiate and conclude trades and how these transactions are settled where financial assets are actually exchanged between buyer and seller. 80% or more of the transaction volume is concluded electronically over a computer: traders sit in front of computer screens observing price graphs with real time bid and ask prices. Literally, with a mouse click they buy and sell millions of assets, such as buying EUROS and selling USD. Within seconds and minutes they can make any number of trades.

2 day settlement of trades

Settlement of a trade is the exchange and delivery of the underlying assets. The completion of a transaction occurs two business days after its conclusion; if for example a foreign exchange deal is concluded on Friday, it is settled the following Tuesday. The time of delivery varies for different assets; for currencies it is generally 2 days, for equities typically 3 days, and only for a few assets is it a day. Delivery takes so long because the banks use old mainframe computers that process transactions in batches. During the course of the day the computer queue the transactions and then process them at night. Transactions are processed in batches, which run in 24 hour cycles and so the banking infrastructure can only make interest payments for positions that are open over night. For currency markets, the positions have to be open at 5 PM Eastern Standard Time. If positions are closed out before 5 PM EST, they do not pay interest, whether they have been open for a few seconds or 23 hours. The batch based banking infrastructure means that intra-day traders, who open and close position during the course of a day and do not have open at 5 PM EST do not receive or pay interest.

90% is intra-day trading

The daily transaction volume in today’s financial markets is gigantic, for the foreign exchange market alone the transaction volume is close to 4 trillion USD or equivalent to 30% of the US GDP. Trading happens at a high pace with traders opening and closing positions in rapid succession. It is estimated that 90 to 95 percent of the positions are held for less then 24 hours, typically for only minutes or a few hours. So it is only 5 to 10 percent of the total volume of positions opened and closed that pay interest. The standard textbooks discussing interest rates assume that interest is paid on all transactions, but this is not the case, quite to the contrary, 90+ transaction volume pays no interest.

Payment of interest is a compensation for the risk of holding the underlying asset, which needs to be paid pro rata temporis, as is the case for the billing of electricity usage or the time spent on a telephone conversation. Today, interest rate payments are discrete, no interest payments are made for positions held intra-day, i.e. not beyond 5 PM EST. Interest is only paid, if positions are held beyond 5 PM and then accrues in daily increments.

Phenomenon of carry trade

For the Japanese Yen, which pays a paltry 0.05 percent interest, the bias introduced by the batch based settlement system is marginal, whereas for the South African Rand, which today pays 7 percent interest, the bias is big: the intra-day trader pays no interest, whereas the inter-day trader keeping the position open over night that is longer than 5 PM EST receives interest. This has the effect that traders going short South African Rand intra-day, do not have to pay interest and there is thus a hidden subsidy to sell the South African Rand. Because of this subsidy there are at the margin more traders shorting the South African Rand than would otherwise be the case. The central bank of South Africa has to compensate for the downward pressure exerted by the intra-day traders shorting the currency by setting daily interest rates higher than would be the case otherwise. This gives rise to the so-called ‘carry trade’, where intra-day traders earn a higher return than warranted by the long-term risk. Long-term investors regularly take advantage of this outcome and buy currencies paying a high rate of interest with the effect that high interest rate currencies have a tendency to appreciate, which is, however, interrupted by occasional rapid sell offs, when the market has gotten ahead of itself and there is a cascade of margin calls.

For a long time Economists have observed that high interest rate currencies have a tendency to appreciate. They have been at a loss to explain this behavior, because according to standard theory, high interest rate currencies should depreciate. In our analysis the explanation is the bifurcation between intra-day trading, where no interest is paid, and inter-day trading with interest rate payments.

Yield curve starts at 1 day

Today, the shortest interest rate payment is for positions held over night, i.e., one day. Accordingly, the yield curve starts at one day and extends up to ten for most fixed income markets and occasionally up to 30 years, as in the U.S. The one-day interest rate is a benchmark in the financial system, which is used to price a whole range of other interest rate products. Changes in the one-day interest rate permeate the fixed income market and affect the real economy, where increases in the one-day rate of interest, stifle the real economy.

In extreme situations, when confidence in global currency markets wanes, central bankers have to hike the one-day interest rate as a measure of last resort to protect the currency. As the one-day interest rate is a reference for the real economy, any increase in interest rate disrupts the real economy and is a huge cost. In Turkey, in 2000 and 2001, for example, the central bank had to increase interest rates to 8′000 percent at the height of its crisis, driving many banks and corporations into bankruptcy with over 1 Mio people losing their jobs.

If the yield curve starts with the one-second interest rate, the central bank can, in an emergency, increase the second interest rate as a signal to the currency markets to bring the flow of buyers and sellers back into balance. The second interest rate is a factor of 86′400 (number of seconds per day) away from the daily interest rates, thus there is a lot of time for the second interest rate to drop back to its normal level, so central bank intervention will not impact the real economy that relies on the daily interest rate as a benchmark.

Secret central bank interventions

During the past 12 months the central banks appear to have been intervening in the currency markets to stabilize exchange rates. The apparent calm in the currency markets is thus deceiving. Global investors are increasingly nervous about the finances of governments. It is only a matter of time before there will be a run on a currency. When this happens secret interventions will not be enough to stem the tide. The central bank under assault will be forced as a measure of last resort to increase the one-day interest rate, which in turn is a harsh break on the real economy. This is the last thing that the government and central bank want in such a situation but is unavoidable under these circumstances. To make things worse, the central bank action has the perverse effect within the currency market, of providing an added incentive for the intra-day traders to short the currency: this is like flying a plane with inverted steering, where pulling up the plane actually has the reverse effect. So initially, the action of increasing the rate of interest will actually make things worse and the currency will drop even faster. So the central bank will be forced to raise interest rates even more than initially anticipated. The way out is to introduce second-by-second interest rate payments, where all traders, both intra-day and inter-day traders, have to pay interest.

Digital Age

The global economy is based on instant communication, be it over the Internet or telephone. The financial system, which transacts trillions of USD on a daily basis, is electronic in terms of trade initiation but settlement is batch based and takes two business days. This is an anachronism and has the effect that 90 percent of all the trading is subject to the wrong incentives, because there are no interest rate payments. This destabilizes the currency markets and is the reason for the existence of the carry trade. Even more dangerous, the central bankers do not possess the appropriate tools to stabilize currency markets in case of emergency.

Technology of second by second interest rate payments

The technology for second by second interest rate payments has existed for several years and has withstood the test of practice and is ready for large-scale implementation. Introducing it is not expensive. As first step, we need public awareness for the issue. Second, central bankers and governments have to twist the arms of the big investment banks that dominate the currency and fixed interest rate markets and force them to introduce instant delivery with second by second interest rate payments. The big investment banks will need some convincing to give up the hidden profit margins due to the non-transparency of the old system. These vested interests cannot stand in the way of the overall social benefits of instant delivery with second by second interest payments. The benefits include more stable financial markets, disappearance of misalignment due to carry trade, lower interest rate volatility with improved economic growth and last but not least a reduction of systemic risk due to instantaneous settlement.