Hedge Fund CIO: What You Really Want To Know As A Trader Is Where Big Stops Are
By Eric Peters, CIO of One River Asset Management
Peel back every great trade and you will discover a gigantic stop-loss. Some are more obvious than others of course. The $1bln that Soros made in 1992 by betting against the British pound required the Bank of England to trigger its own stop-loss. As humiliating as it was at the time, the BOE’s defeat unshackled the UK from an exchange rate mechanism (ERM) that was suffocating its economy for no good reason. And that is the beauty of free markets. They push us toward sensible policies that can withstand assault by those who dare bet against them.
Paulson’s trade in 2008 required the government to step aside and allow a cascade of stop-losses across the financial sector. The magnitude of leverage and corruption that fueled the housing bubble was so extraordinary that the cost of subsidizing a continuation of the status quo exceeded the price of picking up the pieces after its collapse. Whether the government could have better buffered the effects of the disorderly stop-loss or not is beside the point. The market did what it was built to do and cleansed the system to the extent that it was allowed.
Late on the afternoon in February 2018, the VIX index exploded higher for no particularly good reason other than the fact that a number of exchange-traded and structured financial products would suffer catastrophic losses if it did. Had the size of those products been far smaller, the market would have had insufficient energy to generate a move of the magnitude required to destroy them. But that is how markets work. They build energy as a major participant(s) grows weaker and stumbles. The dynamic is Darwinian.
Beijing triggered a stop-loss, ordering China’s energy companies to “do whatever it takes” to secure fuel supplies. Prices had been surging with natural gas up over 5x in a year. Efforts to reduce CO2 emissions, a shift away from coal, along with myriad complexities in global supply chains conspired to produce electricity shortages. This hampered Chinese industrial production. Winter is not yet upon us. And half a world away, Lebanon’s national grid completely stopped and is unlikely to restart for days. It has run out of fuel to run its generators.
“Always buy ahead of buy orders,” he said on my first day. I’d started my career in the corn pit because old-timers said I’d lose money less quickly there.
“Sell in front of sell orders,” he said. Made sense. If brokers held large orders to sell corn at $2.50 per bushel and a buy order entered the pit, I’d fight to sell at $2.50. If prices subsequently dropped, I’d make money, and if they pressed higher, I’d cover my short with the brokers and break even.
“But what you really want to know is where big stops are,” he said. When prices rose toward large buy-stops, you would get long knowing that if the stop triggered, brokers would be forced to pay any price. You’d sell your longs to them for a big profit. The same principles held true for sell-stops.
Naturally, investors defended their stops from being triggered. Shorts would sell even more as prices approached their buy-stop, hoping to pressure the market lower. Sometimes their defense succeeded, prices fell, and for those of us who had bought hoping prices would surge higher, we had to puke into a market without buyers.
In the most basic sense, that’s what pit trading (now called market making) has always been about. Through this mechanism, prices move up and down – triggering stops, inflicting pain on those who can least bear it, concentrating capital in those with the greatest skill – gravitating toward some underlying economic reality, which itself is always evolving.
But that is not simply how the pit works. This is how the world operates. It is how we come to terms with our mistakes, like Europe’s ERM in the 1990s and the housing fiasco in the 2000s.
Now we are grappling with how to mitigate climate change. The profound adjustments required will apportion historically unprecedented costs and benefits unequally across competing regions, nations, industries, individuals. Global markets will highlight systemic pressures, policy successes, failures. Helping us identify where to focus resources to enhance prosperity and forestall conflict. All of which is a pleasant way of saying that markets will do what they are built for – hunting the weak, ferociously, mercilessly, delivering to us prices that best reflect reality.