Wednesday, June 11, 2008

Life in a fat tail

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....


Charles Butler said...

Given the general environment at the moment, my own feeling when MM announced that he was starting from scratch was, ummm, what's the opposite of envy? Or, the question I asked myself was, 'How the hell's he gonna do this?'

Fear and loathing from the bleachers aside, today's report moves the blog a few notches further out on the right hand side.

Alejandro said...

What is the spread trade with ED that you are implementing and what the rationale is?
thanks a lot and good luck!

Macro Man said...

CB, I think the word you're looking for is "pity." Still, it was cathartic to write about this trade, and I can only hope that pros can empathize with my story, while non-market pros can get an insight that this job isn't all champagne, fancy dinners, and private jets to the Monaco Grand Prix.

Alejandro, it was a trade designed to profit from the Fed hiking more in 2010 than they will in 2009.

spagetti said...

the climate is better in heaven, but in the fat tail hell the company is more interesting..

my gutt feeling tells me that equities are at the edge of a cliff and we'll end up at 1250'ish or maybe even 1170-1200 without any significant move up in the process.

also.. still think TRY, ZAR, HUF maybe even AUD are toast.

any view on Aussie 10yr rates ?
im long and wrong.. for once i went with a GS recomm. and while they stopped themselves out around the current levels im still in it.

Macro Man said...

Spag, I don't know how interesting it is, but I think I do have plenty of company.

No real view on 10y Aussie rates, but given that global inflation now becoming a real issue, it's hard to see a real bid to duration...particularly in a place like Oz, where there's plenty of room for a fiscal response to any cyclical slowdown.

Grammar Nazi said...

>>>quants have felt intermitedly over the past year

I hate to add insult to injury, but the correct spelling is "intermittently"

spagetti said...


count me in that company, along with some of your readers im pretty sure. we could have our own MM Blog Cauldron

Anonymous said...

I have a lot of sympathy for your trade, Macro Man. I have a straight long (losing) FF futures position myself, and I just can't believe that the market assigns a greater than fifty percent chance of a hike in August (just a week after a very likely negative second quarter GDP print).

Anyway, in regards to your phone call, it seems futile to me to try to value that (and similar) position(s) at that time of the day, with such low liquidity. Many of the "twenty-four hour" futures trade light volume (and wide spreads) until Europe opens.

Macro Man said...

GN, I originally had it with two t's, and bloody blogger kept giving it the red underline "misspelling" on it, which vanished with 1 t. Not sure what happened to the n as well.

Anon, yeah I wasn't expecting a great price, but you need to check when the old P/L is plummeting before your very eyes. As I said, I had the sense to wait and exit at better prices in London!

D said...

Macro -

When you live to dance the grave another day, even if it comes at a financial loss, you are still a winner. I know a guy who's fund triggered a liquidation provision from the drawdown over the January meltdown...various volatility bets being the culprit. The US equity markets were closed that Monday and he had a red eye. The worst part was being right...but we know what being right buys you sometimes.


Macro Man said...

D, sounds like your mate's eye may have been more black than red.

Unfortunately in this business, there is only one arbiter of right and wrong, and that's the P/L, as many strategists-turned-traders have learned to their chagrin. Actually, make that two arbiters, with solvency being the other...

D said...

Yea, habitual volatility salesmen always die in this business. He had a huge August 2007 and was up nearly 30% ytd, but then shorted crude oil in November and the January short volatility trades were the last straw. Those stochastics emboldened him to test if he could survive throwing himself under the bus.

The funny thing is that he opened up a new fund in! Tis a strange business.

Macro Man said...

Well, as the investors in JWM have learned to their detriment this year:

Fool me once, shame on you; fool me twice, shame on me.

Macro Trading Ideas said...

I, sadly, am with us, and also today a loss!!! But as you MM, i'm beating my records on MTB's races!!!!
Maybe it's better that i spend more time on bike than in front of PC..
Unbeliavable also today, after Noyer and Stark comments, schatz goes down??? poor auction but it isn't enough.. stocks in free-fall, Uk financial armageddon and what about russel2000?? It overperforms!!!
At least a few days ago on BBG there was an article about an index's reshuffle, less oil and more destroyed financial as AMBAC..

Mr. Prop said...

I have a lot of sympathy with ANON regarding the Nov Fed Funds. Who can believe the risks these central banks are taking with equities? Equally, the about-face is astonishing. For months the argument was weaker growth would solve the inflation problem. All of sudden they collectively gave up on that. Apparently, and perhaps not without justification they have worked out that the longer inflation stays too high, the harder it is to claim that inflation expectations are anchored. Like most on this blog, I am shattered by the volatility and coming to the conclusion that "if its too hot, get out of the kitchen" Wimp or prudent?

Macro Man said...

Mr. Prop...I saw your missive this morning and almost pinged you, given the subject matter of today's post.

In this fat-tailed market, there's no such thing as a "wimp" or a "macho man."

There are those who stay alive....and those who don't.