Profiting from bubbles: divergence trades and the problem of resonance
August 6, 2010
I’m now getting ready for the Academy of Management conference. Getting ready, that is, for the strange hotel existence of the conference attendant. Featuring: the continuous use of a name tag, the foraging for food in academic receptions, and the attempts not to doze off in the after-lunch PowerPoint presentations. But not all is lost. The Academy is inspiring at its best. And this year I am very hopeful for the session that Michael Jacobides has put together on the credit crisis.
If there is one message coming out of the crisis, it is that we live in a bubble economy. Bubbles are, as I see it, the central intellectual challenge of our time. And instead of telling the government to go and fix it for us, I’d rather devise strategies that allow actors to deal with bubbles on an individual basis. I am offering some ideas here, based on my research with David Stark. (This, by the way, is the second of a series started here).
Bubbles and the problem of resonance
My latest paper with David identifies a new problem in the capital markets, which we call resonance. Resonance, I would argue, is one of the ways in which bubbles come about. Understanding what resonance is, and how some traders exploit it, provides ideas for profiting from bubbles – and ameliorating them in the process.
What, then, is resonance? Our paper traces the case of a merger arbitrage desk, and a so-called “arbitrage disaster.” Merger arbitrageurs use models and databases to bet on the probability that two firms that announce their merger will indeed merge. But the traders, we found, not only relied on their own estimates; they also used models to find out what their rivals were collectively thinking about the trade. As we show, this typically works very well… except for situations in which everyone is similarly mistaken. In those cases, everyone is falsely reassured that they are correct, bet the house, and lose the shirt. This mechanism, which we call “resonance,” was at play in the case of the GE-Honeywell merger. See paper for details.
So what? The lesson we draw is that attending to the social context (“the market”) is only helpful in situations where that market context contains enough diversity. If not enough rivals hold a certain risk to be relevant, a trader that relies on a combination of his/ her own model and “the market” will dismiss the most damning evidence about it, down to press reports that write it on the front page.
The lack of diversity makes for a trading opportunity. A trader can actively look for situations in which there is a great measure of agreement among market participants, and consider whether the agreement is genuine or an artifact of the precautionary mechanism. If it is, a trader might hypothesize that most of its rivals are wrong, and profit from it.
For an example, return to the case of GE-Honeywell and consider how an entrepreneurial trader found a way to exploit disasters in merger arbitrage. According to the Financial Times, the renowned New York hedge fund Atticus Global developed a strategy to exploit arbitrage disasters such as the GE-Honeywell deal, before they happen. Atticus proceeded by betting on the reverse of the outcome that its rivals were anticipating. As we saw above, merger arbitrageurs bet on merger success and the subsequent convergence in the prices of GE and Honeywell. By contrast, Atticus bet on merger cancelation and a subsequent divergence in the prices of the two stocks. As the journalist described, “Most risk arbitrage managers followed their usual strategy of going long the target, Honeywell, and short the buyer, GE. Atticus shorted Honeywell and bought GE, making a 10 per cent return on its investment”. By assembling a trade that was the negative image of what its competitors did, Atticus managed to profit from their losses. Because the original trade is known as a convergence trade, Atticus strategy is known as a divergence trade. In general, “divergence trading” is a form of being contrarian.
Divergence trades such as performed by Atticus are unconventional and rare. While betting on convergence allows traders to rely on their rivals for reassurance, betting on divergence does not allow for that possibility. Divergence trades are therefore riskier and rarely put in practice — not even considered to be an integral part of the strategy. However, Atticus understood that there is one instance in which divergence trades might be profitable enough to be worth the risk – when something is not going happen and everyone else thinks it will. E.g., the more traders bet on convergence, the narrower the price difference, and the grater the returns from betting that the prices will widen.
In short, understanding the role that resonance and the lack of diversity plays in the market provides the basis for a trading strategy. Traders exploit cognitive diversity among their rivals. When this is missing, those same traders will be misleadingly reassured and potentially very wrong. This can be exploited with a convergence trade, by betting that the misled will lose out. As Gregory Zuckerman explains in his terrific book, this is exactly what John Paulson did in the credit crisis. And in a recent meeting with a hedge fund strategist in Paris this past May, I learnt that he was also focusing more and more on divergence trades. This should give us cause for optimism. If enough traders take on this approach, perhaps the next bubble will be less virulent as the last.