In early August 2024 the:

• Nikkei plummeted more than it ever has in a day
• VIX index spiked more than it ever has in a day
• Japanese Yen witnessed a very large rally, reversing years of malaise
• USD dominance was challenged vs. traditional safe haven currencies.  

What do all these things have in common?  Leveraged liquid trading strategies have contributed to these market moves and have been affected by them.  Here are some of the strategies impacted:

Strategy #1: FX Carry.

Buy a relatively high yielding currency like USD with proceeds from borrowing in a lower yielding currency, size according to realised volatility of the pair and what you can stand to lose vs. the income you stand to gain.  Adaptations on the strategy abound, substitute any higher expected return asset with any lower expected return asset.  Rinse, repeat, borrow more.

Strategy #2: Short volatility.  

Sell an insurance policy on losses in the equity market.  People like to buy insurance when they have something to lose.  US Tech stocks are the house on the hill.  When payouts are large, the kindling is dry.  Vol sellers' insurance premiums don't come close to covering the payouts required when the claims roll in.

Exhibit A: SVIX  

Strategy #3: Trend-following.
Buy what goes up, sell what does down.  Run winners and cut losses.  Seek as many uncorrelated assets as you can find.  Size positions in a portfolio according to the inverse of their volatility and target a certain portfolio level volatility, that is, get smaller in the trade if volatility rises and/or correlations rise.

What are the lessons for investors?

1.        All three strategies have a reflexive property, i.e. positions get larger in terms of their footprint in the market as volatility comes down and positions get smaller when volatility rises.  

2.       Wall Street banks have estimated that the majority of capital engaged in the above strategies has reduced positions completely, either because their risk models told them to, or their positions were liquidated by their counterparties.

Long-term, fundamental investors have the luxury of looking at the new "sale" prices that have been created by these dynamics and deciding whether to dollar-cost average in at lower levels.

For active traders and liquid alternatives managers, these are treacherous waters and portfolio management decisions will be scrutinised heavily in keeping with the widening spread of outcomes for similar strategies.  If you don’t like this month’s outcomes with your managers, it may be time to dig deeper into how their strategies interact with changes in implied and realised volatility across asset classes.

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Nathan Peters
Advisory Board Member

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‍Disclaimer
This article is intended for wholesale investors as defined under the Corporations Act 2001 (Cth) and is not intended for retail investors. The information provided herein is for general informational purposes only and does not constitute financial, investment, or professional advice.
The views expressed in this article are those of the author and do not necessarily reflect the official policy or position of Kings Gate Capital Partners. While every effort has been made to ensure the accuracy of the information, Kings Gate Capital Partners makes no representations or warranties, express or implied, as to the completeness, accuracy, reliability, suitability, or availability of the information contained in this article. Any reliance you place on such information is therefore strictly at your own risk.
Investing involves risk, including the potential loss of principal. Past performance is not indicative of future results. Before making any investment decision, you should seek independent financial, legal, and tax advice tailored to your specific circumstances.
This article may contain forward-looking statements that are subject to risks and uncertainties. Actual results may differ materially from those expressed or implied in such statements. Kings Gate Capital Partners disclaims any obligation to update or revise any forward-looking statements to reflect new information or future events.

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