Wednesday, June 11, 2008
You can never say never in this business. Although it's not a terribly noble thing to admit, many market participants, Macro Man among them, have felt a bit of schadenfreude at the travails of serial turd-buyers, equity quants, and other erstwhile Masters of the Universe who've recently fallen on hard times. As Cassandra has observed on several occasions over the past year or so, the fatal flaw in the business model of these funds has been the systematic overestimation of the market liquidity available for them to exit their positions. The outcome of this miscalculation has been brutal. Those of us observing from the peanut gallery have resolved not to repeat the errors of these hedge fund Icaruses (Icari?) and to concentrate on liquid investments that can "never" share the liquidity characteristics of the likes of, for example, structured credit.
It is thus with great regret that Macro Man is forced to admit that he's been living life in the fat tail on the left side of the return distribution so far this week. You can see him in a recent portrait below. The culprit has, ironically enough, been an instrument that is both exchange-listed and highly liquid (with an aggregate volume yesterday of 4.3 million contracts.) Macro Man refers, of course, to the eurodollar futures contract. What makes the fat-tail phenomenon particularly bemusing is that it's a non-directional curve strategy rather than an outright directional bet. What makes it irritating is that Macro Man identified significant fixed-income distress in this very space on Monday, yet failed to connect the dots to his own position because it was trading resiliently in the European morning.
In any event, he was long a spread, which, for the past month, had traded in a pretty smooth intraday fashion, albeit with a bit more volatility towards the end of last week. The chart below shows the intraday price movements in the four weeks ending last Friday.
Now look at the chart below, which includes the intraday price action so far this week. Ouch! The arrow indicates where the spread was when Macro Man received his 1.15 am phone call early on Tuesday morning. When he picked his jaw up off the floor and checked the contract table on Bloomberg, he observed that one of the contracts in his spread had traded exactly one lot over night. When he asked his Singapore futures broker for a price in the spread, he was made 12 ticks wide in 100. Hint: his position was considerably larger than 100 contracts.
For the first time, he felt that same pit in his stomach that the turd buyers and equity quants have felt intermitedly over the past year. And all for a spread in the most liquid futures series in the world!
The ultimate outcome, while highly unpleasant, has fortunately not been crippling. After incurring a 2.4 standard deviation loss on this position on Monday, Macro Man was forced to eat a 4.8 standard deviation loss on Tuesday. It didn't feel good, he can assure you.
Fortunately, this strategy was only a modest piece of what is a reasonably diversified book. And while yesterday's P/L report was not pleasant, happily Macro Man is still up on the month and year, albeit only modestly.
As for the offending eurodollar trade, he still believes in the rationale for it. However, if we're living in a world where a simple curve trade can be 25 ticks offside at 1.15 in the morning, position sizes need to be cut or optionalized. Fortunately, Macro Man was able to steel himself yesterday and reduce his curve trade 13-14 ticks from the low once liquidity improved in London and New York.
Having experienced life in the fat tail this week, Macro Man can report to you that it ain't pleasant, and he doesn't want to go back there any time soon. Still, it's important to always look on the bright side of life, and there's been a happy side effect to this week's trauma: Macro Man set personal bests at the gym on Monday and Tuesday while working off the stress of his positions. Perhaps European footballers should consider a p.a. investment in US subprime mortgages over the next few weeks....