Friday, June 23, 2017

How Leveraging Crashes Markets

With leverage, a small action can cause a huge reaction, particularly when it comes to finances.
As I noted in an earlier post, one of these new crypto-currencies crashed the other night when somebody tried to withdraw millions of dollars all at once. The currency has since recovered somewhat, but it illustrates how these currencies can be very volatile, especially if they are not widely exchanged.  Volatility rarely works to the advantage of the small investor.

When the individual tried to cash in a huge chunk of this new crypto-currency, there weren't enough buyers interested in purchasing the currency and the price dropped precipitously.  The law of supply and demand kicks in.  However that alone doesn't explain why the price dropped so suddenly.

Many people had invested in this currency instead of using it as a trading or exchange medium.  And often these investments were leveraged, based on futures-type options.  Thus, if the price dropped below a certain level, their investment was set-up to automatically sell once it reached that price level. The same thing can happen with ordinary stocks and bonds, as people trade on their future value.  They are forced to cash-in to protect themselves, as they are investing using borrowed shares.

When the market crash of 2009 occurred, a very similar thing happened. Stocks across the board went down in value after repeated bad financial news was received. Once the stock prices reached certain threshold points, automatic trades were triggered which flooded the market with even more of these stocks.  As a result, supply exceeded demand which depressed price even further which triggered even more automated sell-offs.

I mentioned before that trading futures is sort of like trading the derivative of the stock price, and in fact these types of contracts are often called derivatives.  If you never took Calculus, I can try to explain it in very simple terms.  Think of three forms of physical measurement, distance, speed, and acceleration.

Speed or velocity is the first derivative of distance over time, dx/dt where x is distance and t is time. Acceleration is the change in velocity over time or dv/dt or the second derivative of distance.  In calculus, we can integrate these values to determine their underlying data values.  Thus, for example you can use an accelerometer to find your position by double integrating acceleration, although it is very tricky to do.  That's how an inertial navigation system works, although today we tend to use GPS more.

But as you can see, the more levels of derivation involved, the flakier the data can become, and the more wild the swings in value that can occur.  Let's say, for example if you're driving your car, the measured distance you travel and any given moment doesn't change very rapidly.  But your velocity can change very suddenly if you floor the gas pedal or slam on the brakes.  Similarly your rate of acceleration can change dramatically as well - even more so - in a matter of seconds, rather than minutes or hours.

The same is true for derivative investments, which is why most people say these should be left to experts and people with deep pockets.   Over a year, a stock price might not change too much.   But it may change in small amounts very rapidly in a short period of time.   These can trigger a sell-off in the market, if automated trades take over.   This in turn, could tank the stock price, or the crypto-currency price, for a very short period of time.  As the example from a few days ago illustrates, the price recovered very quickly, but not before a lot of these margin traders lost their shirts when their shares will sold off when certain trigger points were reached.

The problem for derivative traders is that you can lose more than you invested.   For you and me, the stock or bond investor (not "trader") the most we can lose is what we have in the game.   I put $5000 into GM stock and lost it all.

That's bad.   But suppose I spend $5000 betting on the price of GM stock?  I could lose my $5000 and end up owing $50,000 to make up for the shares I thought would go up in price, but instead went down (or vice-versa).   You can literally bankrupt yourself overnight this way.

It is, quite frankly, like borrowing money to invest, only worse.  At least with that half-assed scheme, the total amount you can lose is what you borrowed.   With derivatives, the sky can be the limit.

So not only are these a shitty investment - or at least a wildly risky one - for the small investor, they do on occasion bite us all on the ass when too many people are speculating on stock prices rather than investing in companies.   When a market moves from "investment" to "trading" too far, it can become wildly unstable.  And instability rarely benefits the small investor!