After a relatively non eventful August for markets (the steady climb in US market indices being almost volatility free of late), September kicked off with a bang.
Two declines and some stutters
Readers will have noted the sharp sell off, especially of the NASDAQ, last week, sharp enough to break some short term trading records, although only taking index valuations back a few days in reality – just very suddenly.
The fall in the dollar (until this morning, which change I don’t yet understand) suggested that markets were taking the same view that I expounded in my monthly commentary: that US interest rates are not rising any time soon and the the Fed may be the most accommodative of the global central banks.
This morning we see a very sharp sell off in the Japanese conglomerate Softbank (about which business I have written before). This is a business that appears to be operating to make money from trading the shares in other firms, not actually being interested in operating them. Such ‘corruptions’ of management as I would phrase it usually end in tears.
Other troubling stories are also rumbling around, like suspension of a rather obscurely run set of funds sold in the UK by Nataxis H2O, but after intervention by the French regulators.
Baillie Gifford, whose enthusiasm for Tesla stock seemed to be one of the main driving forces behind the share’s literally incredible rise have now sold out a large chunk of their holding and that spooked the markets too.
They say that the price rise had put the investment into an overweight and that must be true, but I wonder if even the manager of The Scottish Mortgage Trust (which now seems to be absurdly named given it invests mainly in US and Chinese technology and consumer services) has decided that he has travelled long enough on a bandwagon that he was helping to propel along with his legs over the side.
A technical helper on the extra volatility
Readers probably know that there are these days many millions of people trading in shares using newer technologies (mainly apps) who are without that much experience. I am not talking about people who build and maintain long term portfolios of funds but those who are often called ‘day traders’.
Because such people are often looking for a better life than one that has maybe not gone too well so far, they frequently start with very little capital, maybe even borrowing to get started. That makes it attractive for them to buy derivatives, rather than actual shares, because you get a large market exposure for not much money that way (ie you are ‘geared’). Courses are offered to people by experienced professionals to help them get started, but in my experience, even people sensible enough to take the training have only a limited understanding of what they are getting into.
One of the safer ways to play the markets with a small sum of money is to buy call options. For a premium that is much less than the price of the share or index you want to back, you buy the right (a contract) to purchase it (or a fixed number of shares in reality) at a future date at a given price. If the price is higher than the contract price on that date, you make a profit which might be a huge multiple of your small stake. If it lower, you let the contract lapse and lose your (hopefully) small stake.
Because the other party can just pay you out the excess profit on the shares if they are worth more than the contract price, rather than delivering the shares to you and obliging you to do the selling, the existence of such options in effect increases the number of transactions in those shares above the level of the real stock actually being traded
I can explain more, with examples, for any subscriber who wants a more comprehensive explanation, or you can take a look at Investopedia.
Heads they win, tails you lose
The reason for adding this educational note is to get you to think about the other side of the deal – the business that ‘writes’ the option. You might think that if you are buying a call option based on a share price rising and will profit if it rises a lot, the guy on the other side of the deal must be expecting it to fall and to be fleecing you for the premium when he is proved right.
That may be true, but actually, the other party may already own the share or index, or be capable of buying it and so has the risk of it rising covered.
If the share price goes up, they do only make the gain up to the option price because the excess goes to you, but that may be all they want in a rising market, bearing in mind that all the time they are collecting premiums (which might give them an income of 4% per annum, for example).
If we take a slightly deeper look at what happens when markets suddenly turn around, we shine a light on heightened market volatility. If your counter parts sees markets turning and a pretty high chance that you won’t make money on your contract, they are likely to sell the asset. They don’t need it to cover the risk of paying you out and they will look to bank any profit they have already accrued. They may even start ‘shorting’ the share.
So, without going into too much detail, we can say that the enthusiasm of a significant bunch of new investors for option contracts, which effectively multiplies up the trades in shares at market inflection points, is likely to also multiply volatility.
My balloon ran out of gas
Another well established influence on the markets is the ‘reversion to mean’ effect where the price of an asset will fall back sharply to its long term trend level when there is a relatively minor change in sentiment if it has moved a long way ahead of trend. Recent changes in the price of gold bullion can be seen doing exactly that if you take a look at a graph for the last few weeks
These influences on volatility are like weather effects: a chill in the air, a dark cloud, a few drops or rain, even a rumble of thunder. They may only be transient, but they might also mean the end of Summer. It is best to look out your umbrella and even check where you put your heavy coat.
This is a notoriously hazardous time of year for investors. If you are sitting on worthwhile profits, you need to consider the relative risk of missing out on more upside versus the consequences of a sharp correction.
If committing cash to the markets, prudent investors will always want to be sure that the current price is good value. That may be so in some cases be the highest price ever paid so far, but that will not often be true.
It is always easier to make money buying when everyone else is scared after a rout. You may have to wait years for such an opportunity but keeping some cash on hand will be well rewarded in time.
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