Photo by Alicia Kozik / stock trader trading the bear markets via Pexel.com
It is quite ironic how the recent surge of volatility caught financial markets off guard, despite its predictable nature.
Trades that are only viable—and only very profitable—in a world of low volatility are suddenly vulnerable when “vol” spikes. Although traders may hold onto these positions for extended periods, it is important to note that they are inherently volatile, making it extremely challenging to consistently time them correctly.
These bets involve FX “carry trades,” which many believe have played a significant role in the recent turbulence experienced by global markets, as well as the “basis” trade in U.S. Treasury securities, where hedge funds exploit the small price discrepancy between futures and bonds.
Crucially, the use of leverage to enhance the profits of these arbitrage trades also increases the risk involved and intensifies the consequences when the inevitable turning point occurs.
On a theoretical level, these opportunities should not persist for long if one has faith in the effectiveness of the free market and its inherent ability to rectify any discrepancies that arise.
The truth is quite distinct, naturally.
Sophisticated, speculative bets capitalizing on interest rate or price differentials can endure for an impressively extended period. Observe the yen carry trade. It endured for years, supported by a decade of “Abenomics,” during which Japan intentionally devalued its currency through loose monetary policy.
There is absolutely nothing wrong with this, of course. Financial markets attract participants from diverse backgrounds, each with their own agendas, time horizons, and risk tolerance levels.
However, as we witnessed recently, risky bets can quickly turn sour when the need to sell assets to offset losses and meet margin calls leads to a vicious cycle of more selling.
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