We all know that we can’t predict a price shock, at least not many of them, and not which direction prices will go. If we could, it wouldn’t be a shock and we’d all be rich. But there are different kinds of prices shocks and different opportunities. The British vote to leave the EC is a good example, and that’s not played out yet.
Predicting a Price Shock
Yes, if you know a major event is coming, then you can expect a jump in volatility, even if you don’t know if the news will be good or bad. We all knew the date of the British vote, so we could buy volatility using an index, say UVXY.
An even safer trade would be to wait for a volatility spike after the vote and sell volatility. However, you wouldn’t be the only one to think of that. In Chart 1 we see the actual volatility (VIX, which is not tradable) and the ETF UVXY. The ETF was slowly but steadily selling off as traders took every opportunity to sell volatility on any rally. They would have made a profit, but even on the day after the vote, selling was so strong that prices never peaked.
Chart 1. Volatility of VIX and UVXY anticipating the British vote.
Equity Index Markets
Most of us trade the equity index markets, and the Friday following the vote saw European prices open 7% to 8% lower, a nasty move for those holding long positions. Exiting by running for the door turns out is not to be a good strategy. most of the time. In this case, Chart 2 shows that the market sees this as good for the Brits and bad for the rest of Europe. The FTSE has rallied 10% from its lows while the European indices fell further and have rallied less. The US and Swiss indices are mostly neutral.
Chart 2. Major equity index markets reaction to the British vote.
The Effect on the British Pound, Deja Vu
Perhaps the rally in the FTSE is a reaction to a lower British pound, which fell from 1.50 to 1.30 basis the U.S. dollar, a sell-off of more than 13%. That helps British exports, even while it cost residents more for imports. If you think this is odd, let’s look at a similar event in the past.
On “Black Wednesday,” September 16, 1992, the U.K. government decided not change their currency to the euro due to extreme anticipatory speculation. Chart 3 shows the reaction of the currency market in 1992 on the left, and to the right is the current reaction to “Brexit.” Very similar.
Chart 3. Left is the reaction to the decision not to use the euro. On the right is the reaction to the decision to leave the EC.
And how did the equity market react during the same period?
Chart 4. FTSE reaction to “Black Wednesday” and the recent British vote.
As long as Britain continues on this road, we see this as a structural change. Unlike news articles that pass through the market as water runs through your fingers, this type of event has lasting consequences. If history is correct, and it appears to be a similar situation, we can expect the British pound to fall much further (perhaps to 1.20) and the FTSE to rally. Of course, if Scotland chooses to leave the U.K., we expect an even worse toll on the pound (this time to 1.00) and a negative reaction from the stock market.
Trading a Price Shock in the U.S.
Price shocks are not frequent but they are very important. Traders who are highly leverage, without reserves, may not survive. Let’s look at four of the biggest price shocks in the U.S. during the past ten years. We don’t include the financial crisis of 2008 because that was not a “shock,” but an evolving bear market.
- February 27,2007. A 9% decline in Shanghai and a bad durable goods report sent the S&P down 416 points.
- May 6, 2010. A “Flash Crash” on the NYSE caused the DOW to drop 998.5 points in 36 minutes.
- August 24, 2015. The DOW opened down over 1000 points following “Black Monday” in China, with the Shanghai index down 8.5% to indicate their downside wasn’t yet over. At the same time the DAX entered bear market territory, down over 20%, CBOE volatility peaked over 45%, and crude oil hit new lows.
- June 24, 2016. The British vote to exit the EC.
Chart 5. Four price shocks in the S&P 500.
In all cases there was an opportunity to recover some of the loss within a few days, and in most cases the equity markets were on their way to a long-term recovery. It is said that “weak hands” lose and “strong hands” win. Price shocks are hard on investors who are undercapitalized or fearful of any loss. Their effects are most often short-lived.
Of the four cases above, it is interesting that the one with the least economic significance, the “flash crash,” had the most sustained downside, so perhaps that event was coincidental with the end of the financial crisis. In two months, in July 2010, the stock market would start on of its most impressive bull market.
Some Rules for Trading Prices Shocks
Remembering that a price shock is triggered by a single unexpected event, or an expected event with an uncertain outcome, the best results come from:
- Not panicking by having enough reserves to make a rational decision.
- Assess whether this is a temporary or structural change. The British vote is structural to the economy while a weather forecast of a hurricane, or even an assassination, is temporary. Shocks that are not structural will recover faster.
- Wait for a rally to exit or, if you are a system trader, only if the price change generates a system exit.
- Prices are full of mini-shocks, on the day of the monthly employment report, on the Fed rate announcements, and on earnings reports. Sell volatility on a spike following the event. Volatility should decline for a few days.
- If you’re buying volatility in advance of an event, exit immediately upon the announcement. Volatility usually drops quickly.
You can test your ideas by finding historic price shocks. Put your price series into a spreadsheet, calculation the “true range” for each day, and the 20-day average true range. Then find the ratio of today’s true range divided by yesterday’s average true range. When that value is over 4 you should have a price shock. Look to see how prices moved after the shock.
Remember that price shocks involve more risk than most trading days, so be sure to start small. Look for opportunities on economic report days. Most moves will be small, but it will be good practice and your experience can save a great deal of future grief.
Copyright 2016, P. J. Kaufman. All rights reserved.