Back in September, soon after the credit crunch had caught Western markets in its vice, a stock market acquaintance made a comment about an experienced speculation we both knew well.
“He periodically exhibits psychological weakness is the face of rising losses,” my acquaintance declared. Both men had been trading the equity market furiously over the previous weeks, when extreme volatility saw share prices in London and New York plunge in late July and then recover towards the end of August. Both men had lost substantial amounts of money. But just one of them had withdrawn from the market – psychologically weak or otherwise, he had financial wounds to lick.
I was reminded of the conversation over the past week as share prices in Europe and the US set off again on a stomach-churning ride. Claiming to have strength through such periods of extreme price movements – being able to see through the financial chaos, to hold a speculative trading position in the face of painful short-term adverse movements until the trader’s original financial analysis is proved right – is the stuff of legendary market bravado.
Fame beckons for those who make the brilliantly timed contrarian call, who bet against the herd, hold their nerve in the face of mounting losses, and then eventually attain glorious financial success. But more often than not such tales of financial daring-do really are the stuff of legend – and that’s legend in the sense of an unverifiable story, handed down over the years as accepted fact.
What has struck me about recent market events is that there have been no tales of swashbuckling market victory – of calling the top and calling the bottom, or traders and speculators holding their nerve and snatching a fortune.What we have had, instead, is just lots and lots of people displaying public psychological weakness in the face of mounting losses. And now, rather than scoffing at the lack of market machismo, traders and speculators are simply feeling sorry for each other.
The most simple, accessible guide to stock market volatility is a derivative contract, traded in Chicago, called the Vix index. It reflects, quite literally, the rate and extent to which prices of S&P 500 constituent companies are going up and down – the higher the number, the greater the volatility.
The chart here shows how equity market volatility has been rising again since the new year, approaching the highs above 30 last seen in mid-August and early November. But this is American stock volatility – as measured by the S&P 500. Price moves in Europe recently have been much more volatile than this simple chart suggests. Over the past few days stock markets in London, Paris and Frankfurt have been exhibiting intra-day swings of four, five, six and even eight per cent. In the emerging, or frontier markets of Asia and the Middle East such swings are not uncommon.
But in the long-established, highly-liquid markets of the West the opposite is true. It is simply about conditioning. Those playing equity markets in Europe and the US do so with a certain expectation of risk. Even if it is subliminal, they are trading with certain pain barriers in mind. Specifically, while they might be ready to wear overall price swings of one or two per cent on any given day, the idea of prices moving by a magnitude of five-fold fills them with dread. Are they wimps? Are they psychologically unsuited to tough, modern financial markets? Not necessarily.
Since the expectation is for prices to move by a factor of X on any given day, with the chance of prices moving by Y on an occasional basis, professional speculators adjust their finances accordingly. Margin trading, leverage, and the use of derivatives are all calibrated for “normal” market conditions, along with a financial buffer for occasional bouts of “abnormal” price moves.
But when the movements become extraordinary, the models go out the window, and some speculators go bust. Simple as that. In absolute terms, the trader playing a one per cent average daily swing in London may be taking exactly the same financial risks as someone playing, say, an average daily swing of four per cent on the Shanghai stock market.
But a sudden five per cent move in Britain has the same terror as 20 per cent in China. So the next time you see the FTSE100 has moved 300 points, up or down, have a little sympathy. There will be real pain behind the numbers.
Macho traders may say they like volatility because it gives them a chance to make exceptional profits. But there is such a thing as too much volatility. And European markets reached the point last week.
(Paul Murphy is associate editor of the Financial Times)