Isolated shocks and the increase in market volatility


In our meetings with clients the topics for conversation vary, but 99% of discussions include reference to at least two or three of the themes listed below.

  • Isolated shocks (e.g. recent events in Natural Gas)
  • ETFs
  • Emerging Markets FX and Bonds
  • Corporate Share Buybacks
  • Weak Oil
  • Volatile arbitrage and spread markets (LME/Comex copper arbitrage is a favourite of ours) 

What connects these things?

Let’s look first at the events in Nat Gas over the last few weeks:

A pretty shocking move even as cold weather hit the east coast. It soon emerged that the volatility was driven by two main factors (which are well covered in other articles):

  1. A leveraged ETF (DGAZ)
  2. A hedge fund known as had sold low delta natural gas options. When prices started to gap higher they were unable to manage their delta risk and ended up taking a catastrophic hit. This sort of ‘nickels in front of a steam roller’ mentality has been around for as long as options have existed and does not warrant much analysis. It is worth noting though, that the prices of very low delta options in other unrelated markets also rallied during the demise of this business as their clearer covered their risk (Z19 30.0 calls in silver for example).

The leveraged ETF also involved selling convexity, but in a way that many market participants still struggle to come to terms with. This is a subject unto itself and not suited to our little note. Suffice it to say it adds stop losses to the market and, in times of distress, those stop losses can get very large.

In combination these two effects put huge gap risk into a market already prone to shock events. What is really fascinating is how much this mirrors events we observed in February in the VIX, in the summer in Emerging Markets, and increasingly in some of the spreads and inter-market relationships we look at (see chart of Comex Cooper dec18/Mar19 spreads below - a huge move which none of our trading network has been able to explain).

Artemis speak about these inter-relationships at length in their article below:

Artemis Capital Management; Volatility and the Alchemy of Risk

This piece is quite comprehensive, and benefits from excellent analysis. However, its focus is chiefly on equities and credit markets and sees any future market event rooting itself in corporate debt markets.

At Arion we are mostly agnostic, but see three main drivers of uncertainty in current market conditions:

Strong Dollar / Fed Rate Cycle

Increased Political Uncertainty

Decline of discretionary risk capital across all markets (but especially in commodities)

The Artemis piece analyses the leverage at work in equities markets, but commodities futures are naturally leveraged, and lack smoothing mechanisms (OPEC and some specific market entities notwithstanding, commodities lack enough natural flow to smooth leveraged speculation, especially with the retrenchment of banking names from the space). It is our belief that commodities are naturally given to extreme movements, but that with markets as they are - more volatile moves are liable to be exacerbated by liquidity conditions. This view was recently echoed in a note put out by Goldman Sachs and repeats a view we have raised with clients repeatedly over the last 18 months.     

So what’s next?

A candidate for a highly illiquid/volatile commodities move would have some of these characteristics

  • Large amounts of leverage
  • One-sided positioning driven for logic such as roll yield (i.e. short in contango markets, long in backwardation)
  • Thin liquidity, with a high degree of financial positioning relative to fundamental positioning
  • Extreme Pricing
  • Historically low realised volatility (this drives leverage at CTA and risk parity style funds)

To our eye a prime example of this is Nickel. It ticks all of the above boxes and increasingly looks vulnerable to a correction.

Watch this space.

Author; Darius Tabatabai, Portfolio Manager at Arion Investment Management

Important information: This document is issued by Arion Investment Management Limited (“Arion”) which is authorised and regulated by the UK Financial Conduct Authority (the “FCA”). It is intended for the use of clients of Arion only. This document is intended for institutional investors and professional clients. It is not to be distributed to or relied upon by retail investors in any circumstances.

The information and opinions in this document are believed to be current and accurate in all material aspects as at the date of its release and to compiled or arrived at based upon information obtained from sources believed to be reliable and accurate. Arion makes no representation or warranty as to the accuracy or completeness of this document and accepts no liability for any inaccuracy or omission. Information obtained from third parties has not been independently verified by Arion.  Arion does not accept any responsibility to update this document or any opinions expressed in it based on any information obtained after the date of its release.

This document is for informational purposes only.  All comments, opinions and content contained in this document are of a general nature and do not take into account the personal investment aims, financial situation or requirements of any investor or potential investor. 

The information in this document does not constitute an offer to sell or the solicitation of an offer to purchase any investment product or service. The value of investments and the income derived from them can fall as well as rise. Investors may not get back the amount originally invested. Past performance is not an indicator of future returns or results. Before acting upon anything associated with this document Arion recommends that specific investment advice is taken.

This document is a marketing communication and has not been prepared in accordance with the requirements of any jurisdiction designed to promote the independence of investment research. It is not subject to any prohibition on dealing ahead of the dissemination of investment research.
About Arion: Arion is a commodity focused investment manager with offices in London. Arion is authorised and regulated by the FCA (registered no. 742037). It is registered with the Commodity Futures Trading Commission (CFTC) as a Commodity Pool Operator and Commodity Trading Advisor and is a member of the National Futures association (NFA).