The Second Leg Down

Strategies for Profiting after a Market Sell-Off

Hari P. Krishnan

• Publisher: Wiley
• Year: 2017
• Print ISBN: 9781119219088
• eBook ISBN: 9781119219002
• Edition: 1
• Topic: Economics
• Subtopic: Banks & Banking
• Index: Economics

Cut risk and generate profit even after the market drops

The Second Leg Down offers practical approaches to profiting after a market event. Written by a specialist in global macro, volatility and hedging overlay strategies, this book provides in-depth insight into surviving in a volatile environment. Historical back tests and scenario diagrams illustrate a variety of strategies for offsetting portfolio risks with after-the-fact options hedging, and the discussion explores how a mixture of trend following and contrarian futures strategies can be beneficial. Without a rational analysis-based approach, investors often find themselves having to cut risk and buy protection just as options are at their most over-priced. This book provides practical strategies, expert analysis and the knowledge base to assist you in recovering your portfolio.

Hedging strategies are often presented as expensive and unnecessary, especially during a bull market. When equity indices and other unstable assets drop, they find themselves stuck – hedging is now at its most expensive, but it is imperative to hedge or face liquidation. This book shows you how to salvage the situation, with strategies backed by expert analysis.

• Identify the right hedges during high volatility
• Generate attractive risk-adjusted returns
• Learn new strategies for offsetting risk
• Know your options for when losses have already occurred

Imagine this scenario: you've incurred significant losses, you're approaching risk limits, you must cut risk immediately, yet slashing positions would damage the portfolio – what do you do? The Second Leg Down is your emergency hotline, with practical strategies for dire conditions.

Chapter 1
Introduction

Finance is full of colourful stories and the most exciting ones tend to involve someone on the verge of collapse. We feel a mix of thrill and schadenfreude when we read about the traders who blew up or the elite hedge funds that had to liquidate after failing to meet their margin calls. In a moment of panic, investors can do the strangest things and this can make for great theatre. Arrogance and overconfidence are punished by the markets, which seem to have a life force of their own. Many shrewd investors have completely lost their way in a moment of crisis. There are numerous stories of portfolio managers who have patiently extracted profits from the markets for years, then had a large and unexpected loss. It might have been advisable for them to exit the position (“cutting their losses”) and try to claw back using their core strategy over time. Yet, the temptation is to put all the chips on black in an attempt to make the money back quickly. In principle, this is a wretched idea, as the profit from a long series of rational trades over time may be overwhelmed by a single irrational bet.

THE AIRPLANE TICKET TRADE

The legend of the airplane ticket trade is an extreme example of bad judgment under pressure, yet it is sometimes presented as rational decision-making. The story goes as follows. A trader has been losing money and is unlikely to collect much of a bonus this year. So the trader decides to dial up risk in an attempt to make it all back in one go. This backfires horribly, leading to further losses. The trader expects risk to be cut at any moment now, so he does two things. He makes a very large short-term trade that will either make or lose a large amount and he simultaneously buys a ticket to South America. It's a tactical play, with little edge but lots of risk. The trader then goes to the airport and repeatedly checks his price feed in the lounge. If the trade goes in his favour, he closes the position then goes back to the office. If it goes belly up, he buys a bottle of vodka from the duty free then takes the flight. The trader's behaviour might seem reasonable at 30,000 feet. In the best scenario, he gets a large bonus; in the worst, he takes a long tropical holiday. There doesn't seem to be much downside and one could argue that from the trader's standpoint, he is long an option. But would you want to be that trader at the moment of crisis? If the position is going slightly against you, are you willing to hang on for dear life, with no conviction that you are making the right trade? If it is your own money, do you want to risk everything on a roll of the dice? If you are a fund manager, how can you rationalise what you have done to clients if it all goes wrong?

THE BULL CYCLE

In reality, most institutional losses and disasters are not caused by trading reminiscent of the Wild West. Rather, they are caused by somewhat predictable behaviour through the market cycle. In bull markets, portfolio managers tend to increase exposure in an effort to chase the market and outperform competitors and benchmarks. Ten basis point differentials in performance seem important. By the “market”, we mean risky assets such as stocks and corporate bonds. Investors eagerly buy into every dip in the market, dampening volatility. As the value of collateral increases and volatility declines, banks lend more and the market eventually becomes overextended. This applies to equities, corporate bonds and other risky assets. When risky assets appear to be vectoring toward infinity, we would argue that it is a good time to hedge. Risk embedded in the system has increased, yet the market is practically giving away insurance. The painful memories of the last crash have been erased, making investors particularly vulnerable to a random shock.

Investors who chase returns after a large sustained move tend to have relatively low pain thresholds. They worry that they have missed the move, but are equally likely to bail out at the first sign of trouble. So long as the rally persists, the cost of insurance (i.e. options) tends to be low. The latecomers to the market do not want to erode their return by hedging and the longstanding bulls are complacent. You could sensibly argue that if the market continues to rally, hedging costs should be more than offset by profits in the rest of the portfolio. Yet there is a natural human reluctance to “waste” money on insurance when everything seems fine.

As the animal spirits take over, investors attempt to rationalise their behaviour in a variety of ways.

• “This time it's different.” There is a central bank put on the market, as monetary conditions will be eased whenever there is a risk event. Regulators can prevent extreme intra-day moves by disqualifying trades that occur very far away from recent prices.
• Calm periods are persistent: they tend to last for a long time. Not very much happens from day to day, suggesting that there is plenty of time to prepare for the next correction.
• Over the long term, hedging is largely unnecessary. For example, some institutions don't hedge their currency risk. Over the long term, they assume that currency moves will wash out. Buying insurance on risky assets such as equities is a losing strategy over the long term. According to academic theory, hedging must have a negative risk premium, as it reduces the non-diversifiable risks in your portfolio. Insurance companies are generally profitable because they sell individual policies that are statistically overpriced. So long as the policies are relatively uncorrelated, insurers are able to collect more than they pay out over the long term.

If you are not careful, you can convince yourself that selling insurance is an unbeatable strategy. Short volatility strategies tend to perform magnificently in back-tests, without much parameterisation. All you need to do is persistently sell downside protection on equity indices, risky currencies and corporate bonds, or so it would seem. When volatility is low, these options appear to be slightly but consistently overpriced. It is tempting to conclude that you can make small but very steady returns in this environment. As volatility rises, your profits become less reliable from day to day. However, this might be more than compensated for by an increase in the premium you collect when volatility is high. Most active management strategies are short volatility in one way or another. Whether you buy equities, take long positions in risky bonds or engage in spread trades, you will tend to perform better in flat to rising markets than highly volatile ones. The vast majority of hedge fund strategies are structurally short volatility. The incentive structures for many hedge funds and proprietary trading desks favour collecting pennies in front of the bulldozer. However, this does not imply that selling volatility universally has a positive expected return. Once you put a back test into action, you are vulnerable to large jumps that may not have appeared in the sample past. As soon as you introduce leverage, you are vulnerable to risk and margin constraints that can force you out of a trade at the worst possible time. Markets don't usually collapse because investors want to sell, but because they have to. Liquidation is forced, in the presence of margin calls. We will examine the effect of margin constraints on short volatility strategies in Chapter 4.

THE RENEGADES

There is a small but dedicated group of defensive, bear market managers in the investment universe. The financial media trots them out every so often, typically after a market sell-off. However, in rising markets these managers are largely invisible or the subject of criticism. Profiting from panics, bankruptcies and liquidations requires patience and does not necessarily win you many friends. When equities are ramping up, bear-biased managers spend more time banging their heads against the wall than raising assets. The cost of insurance is steadily declining, yet there are no takers. The inveterate bears write long and engaging manifestos in an attempt to identify cracks in the financial system. In rising markets, the potential end users of these products generally can't or don't want to buy them. Some institutions take a crude “line item” approach, where they rank their funds according to recent performance and periodically redeem from underperforming managers. This approach seems oblivious to the idea of marginal risk, i.e. how much you can improve the risk-adjusted performance of an existing portfolio by adding a new asset or strategy. In reality, if you can find a strategy that performs strongly during crises yet doesn't lose too much over a market cycle, it can have a dramatic impact on portfolio performance over the long term.

Uncontaminated bear strategies have a hard time competing in a world where allocators believe that emerging markets, high yield bonds and carry trades are “diversifying” investments. While it is true that these asset classes can reduce realised volatility during normal market conditions, they typically amplify losses when conditions become extreme. Some strategies, such as the FX carry trade, seem innocuous during bull markets. They grind their way upward with low volatility. However, it is categorically not true that a strategy with relatively low volatility in a bull market will dampen risk during a crisis. If the strategy collects premium while taking extreme event risk, the opposite is in fact true. A manager who combines carry strategies with a modest number of equity index puts will often appear to be over-hedged most of the time and severely under-hedged when the protection is most needed.

In rising markets, dedicated bears have to overcome time decay as well as markets that are moving in the wrong direction. The portfolio manager who takes the opposite side of the trade by selling insurance has an optical advantage. Investors seem to prefer a sequence of returns of the form {+1%, +1%, +1%, +1%, +1%, –5%} to {–1%, –1%, –1%, –1%, –1%, +5%}, even though the compounded return of the second strategy is a bit higher. In the first scenario, you can always say to your client that you are an alpha manager who had a few issues with risk control that have now been resolved. This cynical approach may well salvage the mandate. Even the most dedicated bears are incentivised to scale down their hedges when threatened with redemptions.

The best time to buy outright volatility is when it is low, in a counter-cyclical way. You want to swim against the tide of short-sighted overconfidence. Investors are more than happy to sell volatility when they are feeling confident. However, implied volatility is low precisely because there is virtually no demand for hedging or long volatility strategies in general. Hence, long volatility managers struggle to raise assets in situations when the best risk-adjusted returns are available. Our book acknowledges the perverse nature of hedging mandates. When assets are pouring in, outright volatility tends to be overpriced. We try to identify ways to minimise drag while still offering protection after markets have started to tumble.

CLAWS OF THE BEAR

---

[T]o borrow the term, your sense of time does change when you are running real money. Suppose you look at a cumulative return of a strategy with a Sharpe ration of 0.7 and see a three year period with poor performance. It does not phase you one drop. You go: “Oh, look, that happened in 1973, but it came back by 1976, and that's what a 0.7 Sharpe ratio does.” But living through those periods takes – subjectively, and in wear and tear on your internal organs – many times the actual time it really lasts. If you have a three year period where something doesn't work, it ages you a decade. You face an immense pressure to change your models, you have bosses and clients who lose faith, and I cannot explain the amount of discipline you need.

– Cliff Asnessⁱ

---

Once you put real money behind a short volatility strategy, the situation changes. Now you have some skin in the game and things aren't quite so comfortable. Your margin levels can change dramatically over time, requiring that you cut positions that look very attractive from a valuation standpoint. In Chapter 4, we show that wildly fluctuating margin requirements can force you out of a short volatility strategy at the worst possible moment. A historical series of daily NAVs is devoid of emotion and assumes that you have sufficient capital to keep playing indefinitely. It can't capture gut wrenching intraday moves or account for price action that is different from what has been observed in the past. If the worst 1 day historical loss is –10% and your strategy is down –9% at mid-day, there is no guarantee that losses will be bounded at roughly –1% thereafter. In rising markets, investors are quite happy to sweep latent risk under the carpet as risk and margin limits are never reached. Inevitably, at some point, risky assets take a significant leg down. The “stocks go up in the long term” bulls can no longer buy the dip as they approach their risk limits. Large institutions spend ages deciding whether “this is the one”, whether credit and equity markets will plunge further into the abyss. Their portfolios might already be down –5% or –10% on an unlevered b...

Table of contents

• Cover
• Title Page
• Copyright
• Dedication
• Table of Contents
• Preface
• Acknowledgements
• About the Author
• Chapter 1: Introduction
• Chapter 2: “Safe” Havens and the Second Leg Down
• Chapter 3: An Overview of Options Strategies
• Chapter 4: Hedging the Wings
• Chapter 5: The Long and the Short of It
• Chapter 6: Trend Following as a Portfolio Protection Strategy
• Chapter 7: Strategies for Taking Advantage of a Market Drop
• Chapter 8: “Flash Crashes”, Crises and the Limits of Prediction
• Glossary
• References
• Index
• End User License Agreement