The Trades That Blew Up

Explaining the trades that blew up and contributed to our sell-off on Monday

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So, yesterday was one of the most risk-off days we’ve ever seen, with the Nikkei imploding and other risk assets following suit. I haven’t felt more glued to my screen since March 2020.

As the saying goes, “may you live in interesting times.”

After some exchanges on twitter I realized that not everyone here has a clear idea of what happened yesterday, or what’s been going on behind the scenes. The truth is, no one has a clear idea of what happened yet, because it’s just too recent to be that obvious.

But we can make some educated guesses.

I’m going to try to do that here, explaining what I see as the cause for the blow up, and then I’ll talk again about where I think we go from here.

Let’s get started.

The Yen Carry Trade

If you read finance newsletters (and you do, you’re here) then you’ve heard of the Yen carry trade. I’ll recap it quickly.

There has been a historically large spread between the BOJ’s interest rate policy and the Fed’s interest rate policy. Situations like that give rise to what’s known as a “carry trade” where you borrow cheaply to buy something that yields more than you’re paying to borrow, and you pocket the difference.

A simple and low-ish risk way to do that would be to borrow Yen at the insanely low rates being offered in Japan, and buy USTs, pocketing a few % difference.

A slightly more fun, exciting, and “profitable” thing to do would be to borrow Yen, and buy treasuries with leverage.

A MUCH more fun, exciting, and “profitable” thing to do would be to borrow the Yen and buy US risk assets. That trade worked really well all year, as the Yen fell against the dollar (lowering the real balance of what you owe) and risk assets rose against the dollar, so you profited on both ends of the trade.

Trades that work attract traders and so people piled in to the Yen carry trade to get in on the fun.

That all started to change in mid-July.

In mid-July the Yen started to reverse course against the dollar, and at the same time USD denominated risk assets started to “shit the bed” so to speak.

It began to look to traders like the Fed would imminently cut rates, and BOJ might even be raising them (a big surprise to markets), which would narrow the gap in the interest rate differentials and strengthen the Yen. As markets often do, they began to price this in, in earnest.

So traders executing the carry trade started to experience losses on both ends. Their Yen-denominated debts were going up in real terms while their collateral was going down in real terms.

You can see the reflexivity forming.

Traders taking losses started having to sell USD denominated assets to repay their yen, which drove them down more, which caused other traders to have to sell, etc.

That appears to have ended at its natural conclusion Sunday night/Monday morning Japan time: With someone big blowing up, and force liquidating a bunch of risk assets across global markets.

At the same time, the Nikkei was a bit antsy repricing for the BOJ’s policy pivot, and the combination of someone imploding and that repricing caused the Nikkei to extravagantly die.

The “Rotation” Trade

When US risk assets started to sell off in Mid-July, people talked about it as a rotation because small caps rallied.

There were a lot of theories about why this happened at the time. Lots of people were saying that the small caps were pricing in rate cuts and big tech was just overinflated.

That explanation didn’t make a ton of sense because markets had been aggressively and overoptimistically pricing in rate cuts all year, and this time was no different. No one had a better explanation though, so that’s what people went with.

In retrospect, it’s more likely to me that the Carry Traders had been heroically long the big names, and largely ignored the underperforming small caps all year. So at they started to blow up, the big names suffered more.

Then, the rotation trade became a meme and trades that work attract followers, and it became a thing.

This is a good reminder that when you see big moves that you don’t understand, even when the VIX is staying low, you should consider those moves a risk-off signal.

The Dispersion Trade

At the same time as all this has been happening, there has been another popular trade blooming in 2024 called the Dispersion Trade.

The Dispersion Trade is a volatility trade where you sell vol on individual stocks and buy vol on the index. The rationale is that individual stocks have higher volatility than the index, so you are collecting the differential. At the same time, the movements of the individual stocks will all more or less offset each other because your exposure there is diversified.

VIX had been really low all year, and a lot of people were making a lot of money selling volatility. It was becoming so widespread that I repeatedly saw people on twitter talking about how you can make a “salary” just by selling long out of the money options everyday.

They didn’t realize then (though they do now!) that the downside of that strategy is losing your entire account when the VIX suddenly spikes to unforeseen levels and correlations go to one like they did on Monday.

Go back to the Carry Trade for a minute. As the Carry Trade was slowly unwinding the VIX started to slowly creep up towards the end of July. Then, on August 5th, VIX went to 60, correlations went to 1, and everybody selling volatility blew up.

Picking Up The Pieces

It’s hard to overstate how dramatic of an event Monday was. The VIX spike was something we haven’t seen outside of March 2020 or the 2008 Financial crisis. To say people got carried out is an understatement.

To me, the size of the move implies that the quiet trades that were picking up steam all year have well and truly died.

Meanwhile, the Nikkei has pretty much fully retraced Monday’s death.

It’s still down a lot since July 10th, but far from where it was.

No one can tell you for sure what the fallout will be from the events of the last month. There could well be firms out there hanging on by a thread, ready to follow the ones that blew up on Monday at the next sign of volatility.

Also, there is the whole background of “Is the US heading into a recession?” to worry about. If you want to know more about my opinions on that, check out this post.

A Case For The Blood Being Over

VIX is likely to remain elevated for a while. Because many of the big players use VAR calcs that rely on the VIX to determine their permissible exposure to certain asset classes, that will slow the rate at which money can flow back into stocks.

Today’s price action was not as encouraging as I was hoping. QQQ and SPY pared their gains down quite a bit from the highs, and are continuing to sell off after hours.

I’m staying cautious, as I think you should too. If you want to keep on top of the markets going forward, subscribe below.

Good luck out there!

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Please remember that I’m not a financial professional and this isn’t financial advice. I’m quite literally a moron who is just doing his best. Please make your own educated decisions, DO NOT outsource your critical thinking to me.

Disclaimer: The information provided here is for general informational purposes only. It is not intended as financial advice. I am not a financial advisor, nor am I qualified to provide financial guidance. Please consult with a professional financial advisor before making any investment decisions. This content is shared from my personal perspective and experience only, and should not be considered professional financial investment advice. Make your own informed decisions and do not rely solely on the information presented here.