I would like to know your thoughts about liquidity driven selling.
You’ve mentioned it several times in the mastery course.
Now I’m at the Global Macro Foundations 2 lesson and the trigger for my request is that you have listed a few possible alternatives to shorting the EUR, and in the list there is “7. Short Gold (liquidity driven selling)”.
I’ve tried to read about this subject and while there are quite a few articles and little snippets about it, I only could manage to understand that it means that the seller needs cash for other purposes, and that the main cause of a crash is liquidity driven selling while there is a lack in willing buyers.
I would like to read a more elaborate description of this topic.
If you can refer me to some informative web sites, that would be great.
However, I would even more like to know your thoughts about this topic, e.g.
- in what assets is the most frequent the occurrence of liquidity driven selling
- when and why it occurs
- what are the causes and the characteristics of such a selling
and especially the
- potential applications of this phenomenon, how to take advantage of it.
Liquidity driven selling is similar to order flow generated by risk aversion. Liquidity driven selling is done by those market participants that have open positions, and they want to raise their liquidity of their holdings and of their fund. Liquidity driven selling can be done in many different markets.
For example, it can happen in the forex market, if let’s say the USD/JPY and other JPY pairs were in a big uptrend, and a lot of market players are holding big tens of billions of dollars of long positions, then if risk aversion comes, they can dump their positions. They “raise liquidity”, because they are squaring their positions and closing them out, taking whatever profit or loss they had open. They are converting the paper profit or loss into a realized profit or loss.
Let’s say a hedge fund is long $5 billion of USD/JPY. They decide to exit the position, due to their desire to boost liquidity. When they close out the trade, they have the cash in their account ready for use again. They have more liquidity as they have free cash that is not allocated to that huge USD/JPY long trade, etc. So if they want they can sit on the cash and hoard liquidity, or they can search for other market opportunities, trades and investments where they can allocate their cash to.
Now, the chances of USD/JPY dropping 50% or 70% in a single year is very low, but the chances of the stock market dropping 50% or 70% or so in a single year is much more likely and has happened in the past multiple times. So when a big fund holds a lot of equities it may want to raise liquidity and raise cash, if it believes a liquidity crisis is coming.
Liquidity driven selling can also be called “raising cash position.”
For example, if a large fund (or group of funds) is long $5 billion of gold, and they decide to sell gold, with the reason being that they want to raise cash and liquidity, that would be liquidity driven selling. There have been occasions in the past where if there is risk aversion, or financial crisis, or a liquidity crisis where market players are scrambling for cash, people holding gold can start selling it in order to raise cash and liquidity.
In the 2008 financial crisis, there were weeks where market players were selling gold violently, because they were trying to raise liquidity and raise cash. Similar situation with the equity market long positions during the 2008 crisis. There were many market players that perhaps they liked the trade from a fundamental view point, but the macro conditions were so rampant with risk aversion, and there was a liquidity crisis, that people sold gold and sold their equity positions in order to raise cash. If there is going to be a financial meltdown and implosion of the financial system, then some people want to move out of equity positions, commodities, and into some government bonds. They want to raise liquidity, raise cash, and keep that money in some short or long term government debt. (t-bill, t-notes, t-bonds.
Now, sometimes gold has a safe haven bid during a crisis, other times the safe haven bid is swamped by the macro players looking to sell gold in order to raise liquidity. It just depends on what type of risk aversion it is, how the market is positioned at that moment in time, etc.
There are a few different types of risk aversion out there. There can be risk aversion during a financial crisis such as 2008, where it was also a liquidity crisis. There can be risk aversion from a war that breaks out or geopolitical risks. If the risk aversion is from a war, then gold stands a better chance of rising on the safe haven bid, rather than if there is a financial/liquidity crisis, although gold can still fall during war periods and geopolitical events as there is some liquidity driven selling as well. I can’t say for certain and no one else can. It would depend on my daily habits and reading of the gold market and news impacts and information flow and market positioning at that moment in time.
It depends on how the market participants view the risk aversion.
1. If the market views it as a wealth destruction event and cataclysm, like 2008, then it can even start selling equities and commodities like gold in order to raise cash, because cash is king in a liquidity crisis. (government debt, especially short term maturities is considered like cash) There may be some gold bugs that keep saying that gold is the ultimate safe haven in a crisis, but they don’t really know what they are talking about. The world has never come to an end to such a drastic point where people are living in bunkers and canned goods and hoarding their gold. Gold and the financial system have never been tested to the point where people lose faith in the paper currency and resort to trading gold pieces, etc. Perhaps it occurred back in some war torn countries 100 years ago, but the financial system is very different today.
During 2008, the gold bugs were the fools that went long gold in order to survive the crisis. Gold went down 30% in 2008, before it bottomed in November of that year and started to rise on the QE expectations. The really smart people went long short term government bonds. There was a big safe haven bid in government debt as inflation was dropping after peaking in the summer of 2008, so bonds were more attractive, and interest rates were dropping making bonds more attractive, and if there was going to be a crisis, that activated the safe haven bid. So there were 3 converging macro themes that caused a big move in government bonds during the fall of 2008.
In the book Hedge Fund Market Wizards, the trader Michael Platt talks about how he was making $500 million per month by being long bonds “fixed income” as he calls it, during the crisis.
During a liquidity crisis, the people who have the cash are king. They have the cash that they can allocate to fresh trades, fresh investments, fresh opportunities. While the people who are already fully invested in stocks, or stuck in other illiquid assets, or real estate are seeing their asset values and accounts fall in value and are forced to try to find a way to sell them, in order to raise cash. But they are selling in a declining market and risk aversion market, where everyone else is looking to sell for liquidity reasons as well. Not everyone is a forced seller. Some people have no problem holding through the drawdown. Warren Buffett held on to a lot of his positions in 2008 instead of selling them, and they did rebound in the subsequent years. Not everyone holding real estate is going to sell. There are many players in the market that have sound properties and cash flow and were not leveraged and can easily handle any fluctuations, etc.
2. If there is a financial crisis, together with rampant expected inflation, then perhaps gold would go up, while bonds would not go up. If there is a financial crisis with low expected inflation, then perhaps gold might not go up and bonds will go up.
It just depends on the battle of various macro scenarios.
Liquidity driven selling is just another form of risk aversion order flow. You can sort of combine the three names together if you want: Liquidity driven selling / risk aversion / raising cash
Although a small distinction has to be made about the two groups of capital: The people who already have open positions, and the fresh capital sitting on the sidelines waiting to come into the market.
With liquidity driven selling, it is possible that the group of capital that is stuck long is trying to get out, while the fresh macro sitting on the sidelines is coming into the market and hammering it lower and establishing fresh positions that will benefit if there is further liquidity driven selling by other panicked players.
As for how do you use it, it is just another type of scenario / market environment / order flow generator. It has its time and place. There hasn’t been much risk aversion over the past few months so the liquidity driven selling has remained relatively dormant lately. Of course there will come a day when it will come back. And when it comes back, it can come in various forms. It doesn’t have to be a full blown 2008 crisis. It can be much smaller or medium in magnitude. Remember there are the 3 different types of movements – the ODVE, the MDMM, and the GM move. Liquidity driven selling can last for 1 day then fizzle out, or it can last for a few days or 1 week and fizzle out, or it can last for months, etc. It just depends on the situation and depends upon conditions as Jesse Livermore once said. That is why I think having the proper habits and principles is important, so you can “detect” when such a scenario and market environment is going to occur.