Duncan Donald

Fri, Dec 7

Risk versus Reward in Volatile Markets

Over the past year, 2018 has been an extremely erratic and notably more volatile year across all asset classes than seen over recent years, having seen some major highs and lows across some of the more volatile asset classes as well as for major currency pairs. 

When looking for return on investments, it is always tempting for individual investors to look for the next big thing. In recent years we have seen the surge of the FAANG stocks, incorporating the global leaders of Facebook, Apple, Amazon, Netflix and Google (with Amazon and Apple both achieving the trillion Dollar status earlier this year). The final quarter of 2018 saw these companies report strong earnings, but the revenue and earnings forward guidance for Q4 2018 and beyond was less positive. This has encouraged a significant corrective selloff in many large, blue chip tech stocks, highlighted by a 25% fall in Apple’s price from the peak of the move. Understandably, the backdrop of a global trade war and the pace of US interest rates have also played a significant part in this downward movement.

AAPL Daily Chart (Jan17 - Nov18)

This highlights that even the most established companies such as Apple, with a product that has gone from being a luxury good to effectively an essential for many households, still has vulnerabilities.  In the same time period, we have seen heightened currency volatility for some of the major G7 countries, most notably the United Kingdom’s Pound given the Brexit backdrop. In addition, the currency markets have seen a strong US Dollar as the US economy goes from strength to strength, accompanied by an ongoing a rate hiking cycle as the strive to get back to a "normalised" interest rate. 

Despite the volatility across asset classes, liquidity across these markets remains healthy. All major currencies and stock markets have exhibited high trading volumes, both buyers and sellers providing depth to the market at any given moment during open trading sessions. 

Naturally, any seasoned investor and trader looks for volatility so if a market doesn’t move, how will you make money? But successful investing and trading is about finding the equilibrium between opportunity, volatility and liquidity. Traders and investors want a market to move to present an opportunity to grow capital.  More importantly, they'll need to know when the moment comes to trade, the market has the depth and liquidity to facilitate this. 

Throughout 2017, the growing emergence of Bitcoin and Crypto-currencies was very much eyed scornfully by the professional trading community. Whilst the non-professional market was getting excited about this potentially dynamic solution for a global currency which had grown from zero, and in the process created millionaires of those early believers. The temptation to join the party lead to a surge of investment, creating a snowball of perceived value in these products. Naturally at this time, I was being asked by friends and relatives who were looking to be involved if this was worth the investment and to their dismay, my answer was a firm no.  I based this on a few factors, the primary being the lack of regulation in the sector, meaning that many brokers and exchanges were not bound by the rules and regulations brought in to protect investors. The second factor was the lack of depth and liquidity in these markets. Unlike developed markets, the daily turnover in volume terms was relatively small, meaning any significant trade or investment could significantly move the market price.  The market overweight of buyers absorbed and pushed through the limited supply of sellers, to create daily record highs as Bitcoin surged towards the $20,000 mark.

BTCUSD Daily Chart (Jan17 – Nov18)

Obviously, this surge in price was of slight initial embarrassment to me for those who had asked my opinion when it was at lower levels.  But, as the rest of 2018 played out, the initial concerns I had identified proved justified. Crypto-currencies were naturally buoyant given the one-way, upwards demand, as market operated with a herd mentality. But a lack of a two-way market leaves any asset class vulnerable to a shift in sentiment.  In early 2018 the tipping point came as traders and investors started to unwind long positions, cashing in and selling as price action turned. There were fewer buyers, so it was not physically possible to find a buyer to match to a seller, meaning when the herd switched the tone, with many investors being unable or even unwilling to exit their positions when it reached their stop loss or line in the sand, leading to heavier than anticipated loses.  

I use the Bitcoin example not because I am anti crypto-currency technology, but I believe that until full regulation is established in these markets, institutional investment will be side-lined, leaving it just as vulnerable to these whipsaw moves.  These markets serve as great example of the vulnerabilities of less liquid markets, which is not exclusive to unregulated markets.

In the last year we have seen serious depreciation in the Emerging Markets, in particular Turkey and South Africa. Most pertinently, Turkey came under the greatest pressure from the Trump administration after the imprisonment of a US Pastor on Turkish soil.  In August, the markets saw an unforeseen move in the US Dollar/ Turkish Lira rate from 5.22 to 7.20, when the US both threatened and imposed serious trade sanctions. This move was again heightened by the low-level of liquidity in the currency. Emerging Markets are often revered for their volatility and the opportunity their-in to make a quick profit, but 2018 has certainly shown (as an esteemed financial markets mentor once taught me, "there is no such thing as a free lunch"). The greater the potential opportunity, the greater the risk.  

USD/TRY Daily Chart (July18 – Nov18)

We end 2018 with a somewhat fragile geopolitical landscape, given the backdrop of the US-Sino trade war, Brexit and the relationship between the Italy and the European Commission. This hints that 2019 could be just as volatile as 2018, and non-professional investors should look at the lessons learned in 2018, and we would encourage seeking professional advice when investing. Should you wish to make personal investments in any asset class, always consider these two key points: 

-  Define your maximum risk and stick to it: Before the inception of any trade, calculate where you will exit, not just on the profit side but most importantly the loss side. Once you have defined that level, be unwavering and stick to it.  Live to fight another day.

-  Calculate your Risk/ Reward Ratio: This means the amount you are looking to make versus what you are prepared to risk in order to do so. You should never be looking to risk a greater amount than you are looking to make. I have personally always aimed to make at least twice of what I am risking. No trader makes money on every trade (not even Warren Buffet or George Soros), but with the right Risk/ Reward Ratio and some good ideas, you can afford to get it wrong occasionally.

Whichever market you are looking to trade or invest in, the above principles would be consistent in any global trading institution and I am sure you will agree, they are common sense, although when in any trade or investment, emotion will often test your personal psychology. 

As always, discipline is key and if you cannot be assured in your ability to be disciplined, leave it to the experts.