August 24, 2012

What do you do if you manage many billions in bonds and you're concerned about high volatility? Maybe there’s nothing you can do.

On the other hand, perhaps there’s a way of preempting spikes in volatility that can help traders deliver both profits and peace of mind in reducing the overall negative effects of high volatility. Planning for and potentially mitigating high volatility not only allows for a better night’s sleep but also can be profitable as a trading strategy.

As both regulatory and investor concerns have tended to favor focusing on "downside" volatility, or rapid sell-offs in the markets, our primary focus will be to help reduce the impact of disorderly markets, panic selling and other rapid types of market declines. This market-making strategy treats both the symptom and the cause of sell-offs and can be summarized in a single sentence: Buy incrementally during periods of high volatility on the downside.

In other words: Staged purchases by traders can counter-act a slew of selling, or more effectively, provide liquidity in the marketplace.

An interesting example of this is the 2008 Troubled Asset Relief Program (TARP) and other government bailout programs. Acting as "market makers of last resort," government participants unwittingly became astute securities traders by effectively buying securities in stages during periods of high volatility on the downside. In some cases, they bought during outright market failure as liquidity dried up in credit markets, for example. Media reports showed that the Capital Purchase Program (CPP), a central aspect of the TARP, had actually turned a profit of just over $8 billion thanks to the purchase and later sale of preferred securities, warrants, etc. relating to bank bailouts. (Granted, many illiquid securities -- particularly mortgage-related ones -- still exist on the Fed’s balance sheet.)

The issue of whether government should intervene in private business becomes less contentious: It’s likely to be a good business opportunity to assist established entities when they’re in trouble. And, who can forget the handsome profit the government made on Chrysler stock (warrants) after stepping in with loan guarantees at the moment of truth back in 1979? Still, most Americans would probably prefer a separation of "church and state" in that private entities are best served without intervention.

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Who could benefit from using this kind of strategy? The answer is everyone. From Wall Street to Main Street, people can find greater financial certainty with an overall reduction in downside volatility.

What Causes High Volatility?

High volatility generally results from a range of market and other forces. In recent years, with the remarkable development of modern finance, markets have grown exponentially – handling an order-of-magnitude or more volume that high finance has never seen before. What looked like a small variation in yesterday’s pricing has today grown in size as a result of increased scale.

As a case in point, when regulators first implemented circuit breakers in order to "allow time for buyers to enter the market,” the market was a small fraction of the size it is today and "trigger points" for halting trading required adjustment for increased activity over time. While causes may be impossible to fully understand, some of the higher-profile candidates impacting volatility include: new information such as updated corporate earnings, good or bad news, technical pricing analysis, disruptions, and adjustment for risk. Conditions can cause high volatility to occur on the "upside" or "downside" at times when the market is either rising or falling.

Different Types of Buyers

Today's buyers fall into three categories: normal, aggressive and reluctant. When markets are orderly and performing well, supply fairly matches demand and trading may cause incremental shifts in pricing, but, otherwise, prices remain relatively stable. Here a "normal" buyer can enter the market make a purchase in an uneventful manner. High volatility on the upside – or where markets are rising -- might also be described as "irrational exuberance" as famously coined by Alan Greenspan in front of numerous congressional hearings during his term as Fed Chairman. Here buyers are being aggressive – sometimes at the expense of careful analysis and balanced valuation. This can be a pre-cursor or signal for a bubble, where, at some point, rationality returns to the market and valuations adjust to the downside, accordingly. Aggressive buyers generally demand more quantity than is available – resulting in an increase in price to attract sellers into the market.

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Reluctant buyers deserve special attention. These are the folks who tend not to show up when the going gets tough – or, put it in a less-kind way: They run to the exits when markets are plummeting. This compounds the problem. As buyers disappear during a sell-off, liquidity dries up -- adding to execution difficulties and creating greater downside price movement – or volatility. Being a reluctant buyer is driven by natural instinct. Who can forget the run on the bank in It’s a Wonderful Life, where, despite the coaxing of Jimmy Stewart's George Bailey, desperate people demand their deposits?

In other words, individual survival instincts take over at a moment of crisis and may not be swayed by reason of the highest order. It is therefore important to prepare for periods of high volatility by training oneself to act exactly opposite of one’s “natural instinct” to flee, and, instead, become a careful buyer and provider of liquidity. This may be easy to state but harder to execute. Strategies can be designed, however, with targets in mind: if an asset’s price falls X percent in Y time, then acquire some percentage of additional asset (fill in the variables to suit specific investing objectives). Traders already know this activity as "averaging down" – or buying more of a security if prices decline in order to reduce the basis on a given position. And, if they are seasoned, they are generally aware of – and have probably implemented - the practice at one time or another.

But, inherent in using this kind of market-making strategy is the risk of obsolescence. In other words, markets sell off because of market participants discounting price on account of risk – caused by many contributing factors. And, price recovery is dependent upon markets being able to function structurally and not being disrupted to the point where they cannot.

So, if there is a case where markets are disrupted to the point where they cannot function under any circumstance (obsolescence), then extreme downward pricing may be justified and this strategy will do little more than illustrate the decline and incremental buying in this case would result in losses. It thus becomes dependent upon traders to assess risk of any given market disruption, to determine whether the use of this strategy will be effective – or that recovery can be achieved.

At any given moment, a trader must assess the risk of obsolescence, and thus discounting (or downside movement) may be justified by uncertainty regardless of potential market recovery. The good news is clear: History tells us that markets usually recover.

Nathan Kay is a senior management consultant with more that 20 years of experience in the financial services industry. He has served as a business analyst for a range of money management firms where he specialized in strategic planning, research, portfolio management, trading and execution and risk management.