What “forced deleveraging” is and why you should care

Last Friday’s selloff was run of the mill until right before the bell when it suddenly accelerated for no apparent reason leaving millions of investors shellshocked.

I tweeted the following that evening after thinking about the price action a bit and doing some closing bell analysis …

Several folks wanted to know what I meant by “forced deleveraging”

It’s an excellent question!

Leverage is an aspect of high-finance that very few investors even know exists and even fewer know how to “read” to their advantage. Frankly, it makes Dark Pools look like amateur hour.

Let me explain.

It’s not uncommon for large funds and big money players to be “levered” 3:1, 5:1 or even 10:1, meaning they’ve borrowed $3-$10 for every $1 of real money they have in the system.

Archegos which blew up $30 billion in just 48 hours last year and caused global ripples, for example, borrowed $85 for every $15 of real money it had in the game. Then, the fund’s managers used a specialized investment called total return swaps to hide that from other market participants and the regulators.

I wrote about how that works in this thread so I won’t repeat that here but please do take a look because it’ll help cement what I’m about to explain. (Read)

Imagine you’re the principal at Big Bucks Fund, Inc.

You’ve got $50,000,000 of your money to invest and$50,000,000 of money you’ve borrowed to buy more stock than you otherwise could using your money alone.

If you buy XYZ for $1,000 and it goes to $2,000 but have used just your $50 million, that’s a double. Definitely awesome.

But if you’ve used your $50 million plus the $50 million you’ve borrowed (margin), you’ve quadrupled it. Truly epic.

In other words, you can buy and sell stocks using borrowed money to increase your buying power beyond what you’d otherwise have and, inturn, magnify your profits.

Of course, the reverse is true too.

If the stock tanks, your fund will sell the stock at a loss then have to pay back the loan for a total loss that’s more than your initial investment because you must cover a) the loss plus b) principal, interest, and fees.

Practically speaking, this means you have every incentive to sell first and ask questions later as a means of avoiding that situation. And if you have to clobber other market participants to save your own asteroids, so what.

Here's where I’m going with all this.

Borrowed money (leverage) comes with a cost. Rising rates make that more expensive which, in turn, means the prospect of losses and the speed with which you could incur ‘em goes up.

That’s why funds that have borrowed a lot of money typically sell as hard and fast as they can to get back under the borrowing thresholds that will require a margin call if rates rise.

This pushes stock prices lower in a nanosecond because most of their order desks are highly computerized. What’s more, big money funds are closely linked to the Dark Pools which, of course, gives them ample fodder on the way out. Think HOOD here.

The selling usually starts with big tech because that’s where the big money can apply the most leverage, have the best liquidity, and deepest markets. It’s easiest to move quickly in a pinch, in other words.

The “inflation-sensitive” line you hear in the mainstream media every time rates rise is a convenient story, but that’s not what’s actually happening.

Which brings me back to this past Friday.

The US 10-Year Treasury is a benchmark rate, meaning the cost of borrowing is closely linked. It rose sharply into the close after being largely stable for much of the day.

My guts and experience tell me that some big funds had“levered up” (bought stocks) expecting to hold over the weekend but were then forced to reverse course and liquidate ahead of the close.

That may have been voluntary – meaning part of their tradingplans vis a vie rising rates - but the violence of the selloff makes me suspect that there may be a fund or funds that couldn’t meet margin requirements and got involuntarily liquidated (and shares sold as a part of that process).

In closing, this all sounds super scary.

It doesn’t have to be.

Learning to read the big money and knowing how they think is an edge savvy individual investors can exploit.

Why?

Simply because knowing what I’ve just explained gives you the behind-the-scenes knowledge needed to know where, when and why the big money is moving.

Then get ahead of it.

Hope this helps!

Keith

@fitz_keith

PS: I write about this stuff every day in the 5 with Fitz, my daily trading notes. People around the world read ‘em and seem to love ‘em. They’re FREE and always will be. (Signup)

PPS: I also take things (and knowledge like this) a step further in One Bar Ahead™, my digital investment journal. So, if you’re frustrated with Wall Street and tired of the bull-puckery, it could be just the ticket to becoming a more confident, more knowledgeable, and hopefully, a more profitable investor. (Learn more)

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