In 1998 there was a hedge fund called Long Term Capital Management. Long Term Capital was rescued by the Federal Reserve and some large financial institutions. Long term capital's model broke when Russia defaulted on their debt. They were using MASSIVE leverage to profit from very small spreads in Russian Bonds and many other instruments. Long Term Capital used too much leverage. When their model broke due to the Russian debt default, all of their trades had to be unwound. Once the model was broken the leverage was so large that there was no way they could survive. When you use too much leverage, you hit a tipping point. Once that point is breached it is not IF you will fail, it is WHEN you will fail. People who understand leverage understand this very well. Unfortunately, there aren't many people that understand leverage. I have only read one story of someone understanding the risk that Long Term Capital posed. He was fired from his job at Lehman Brothers for speaking publicly about the risks. Click here for a more detailed description. I think his ultimate justice lies with the price of Lehman Brothers (LEH) here and now.
Why do I retell this story? Let's take a look at Volatilty during 1998 when the fed engineered the bailout of a 4.6 billion dollar hedge fund.
The risks posed today are far greater than they were in 1998. It is my opinnion that we are entering a time where we could see unprecedented volatility. I still think that downside insurance is undervalued here and now. Remember, when volatility expands, insurance becomes EXPONENTIALLY more expensive.
On June 4th, I wrote about the short setup in the ($SPX). All indexes have sold off significantly since then. However, the NASDAQ ($COMPQ) has underperformed to the downside. Therefore, I am positioned to take advantage of volatilty expansion in some of the NASDAQ names. Note to analysts and their endless upgrades of the big four letter names : This is not the time to be upgrading tech stocks. They are and will be affected by this. How do I know? Look at the technicals.
We are in a downtrend. Rallies are to be sold here. As traders, we often hear that tops are a process and bottoms are made in a V shape. I think that this time the bottom will be a process and it may be far longer of a process than what is priced in here.
The bounce we saw from the March lows, was just that. A bounce.
Joel Stahl
Thanks for the heads up. What stocks are you watching?
Posted by: Merrill Madsen | July 12, 2008 at 09:43 AM
GOOG and RIMM.
See prior posts here:
http://esl.typepad.com/tradingtechniques/2008/06/goog.html
http://esl.typepad.com/tradingtechniques/2008/06/rimm-aftermath.html
Posted by: Joel Stahl | July 13, 2008 at 11:21 AM