Article / 25 May 2016 at 13:00 GMT

Mind your fungibles and plan to sidestep falling knives

Hypothesis Testing
United Kingdom
  • Fungible stock prices can fall hard and fast, causing further panics
  • A stop can be placed, but not guaranteed without undue additional costs
  • Holding fungible stocks, consider a defence utilising a slower stock to act as a brake
  • Another aspect for traders to consider is elasticity

Tontine Coffee House

The Tontine Coffee House and Merchant's Coffee House on the corner of Wall Street, where it all began. Image: Oil on linen 1797 by Francis Guy, New York Historical Society, public domain

By fxtime*

The classic professional floor trader mantra is liquidity of product and ease of immediate exchange. It's known in trader parlance as ''fungability''. 

When you open a trade, you want to be sure that once you move to close it, it will be done immediately without undue spread affecting your hard-earned profits. But, as we have seen all too often, markets suffer crisis moments which economists describe as liquidity spirals. 

A market panic causes traders to cover their trades, but as there are no buyers on the other side of the trade, prices fall harder and faster, causing further panic and triggering yet more stop losses.

Such events are called "falling knives". Bargains can be found, but do you really want to catch that falling knife?

Certain equities fall for very valid reasons, dragging others with them, so you need to ask ''How are your fungibles?''

Classic defensive strategy

Equities are risky at the best of times, especially high alpha stocks and beta stocks as they accelerate faster than the index of which they are components.

A defensive measure is simple enough as a stop can be placed, but not guaranteed without undue additional costs.

 Trading the old way: the more traders present, the more liquid the stocks. Image: iStock

Alternative strategy

A better defensive measure perhaps is to seek a slower equity in the same marketplace, one that reacts in the same direction but slows the effect of the move.

In the UK, Barclays and Lloyds banks are fungibles — extremely liquid stocks with a market depth that ensures your trade order will be filled immediately. Rarely will you suffer the effect of needing to seek a requote.

But Barclays moves far faster than Lloyds Bank. If you are long Barclays, you could preset an order to trigger short Lloyds as a slowing stock value. Why would you do that? If you have Barclays as equity and believe it is a growth story for, say, the medium term, falling knife scenarios can be painful.

Equities that are dragged down through no fault of their own will recover, so rather than suffer the drawdown, you could use Lloyds as a brake. It will track Barclays downwards and earn a profit (albeit slower), but give you time to re-assess the situation.

Perhaps Barclays will become a bargain, and you could then use the proceeds of the Lloyds' short for future purchases.

Can we improve our defensive position safely?

Perhaps we should consider watching the VIX index? Never go long VIX, as it is an extremely corrosive theta option with large margin requirements and a sanguine VIX at 14 or below is often a warning of oncoming volatility.

Perhaps you should consider an options defensive play. The options guys here outline plenty of these strategies. In times of low VIX, puts are cheaper than the implied volatility rank (IVR).

You could also sell an out-of-the-money call option, which should also be cheap. At times like this, I would try to preset an alarm to short the VIX when above 28, with the assumption that sooner or later the falling knife will hit support/floor of some kind, and profits can be made.

Trading at a VIX extreme of market volatility is often safer. Falling knives don't have to be caught, but can be played defensively as long as you are trading fungibles only.

Yet another aspect for traders to consider is elasticity. Demand for some products is relatively constant regardless of price. We may dislike the price of oil and reduce demand slightly, but we all commute to work, heat our homes and use power regardless of the price.

In fact, we consume pretty much the same amount each year. We tend to cut frivolous expenditure before cutting core energy spending. It isn't just oil that has inelastic demand. Consider water, food and other consumer staples, and you can see why such sectors become defensive plays.

Furthermore, such sectors are big parts of indices and totally fungible. Equity portfolio managers should perceive when the commodity cycle is at a low for the establishment of long-term diversity and defensive stock positions.

Although I describe here a defensive approach for equities, forex, indices and bonds all can be managed defensively in much the same manner.

Last week I mentioned rates of change between three currency pairings traded as one large-scale trade, and previously the correlation between the Nasdaq and S&P 500 using their moving averages.

We are nearing a seasonal market adjustment, so perhaps now is the time to assess how liquid are our fungibles and what we can do to sidestep falling knives.

Next time you're in a coffee shop, ask your barista for the fungibles. The merchants of the original Manhattan coffee houses described theirs on their trade tickets as a menu.

Barista and coffee machine
 The coffee's good, but how are your fungibles? Photo: iStock

— Edited by Adam Courtenay

*fxtime is a pseudonym

goldfinger goldfinger
Really great piece. R u still long Lonmin?
fxtime fxtime
Funny enough yes I am ! It is a SIPP trade so medium term. If it drops below 150p I will halve my holdings as expect it to drop alongside gold (expect the latter to drop to around $1200) but overall I expect a further wave up this year ! VW et al need replacement exhaust systems and the most stringent emission exhausts are ones containing platinum :-)
fxtime fxtime
Lonmin chart fwiw for you...been a nice earner so far...hope you made too?
fxtime fxtime
I will buy gold at $1200 or below for a long term rally.
Michael O'Neill Michael O'Neill
Fx time. Another great story. The Barclay's /Lloyds trade was a neat idea
fxtime fxtime
Very small range markers expect a big move within 48hrs...sadly the ROC and rate of distribution do not give direction only imply a high vol move is imminent.
fxtime fxtime
The 48hr window of trading hours takes us to Tuesday as markets are shut for various public holidays so it should be a fun day :-)


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