Home >Mint-lounge >Indulge >Trading lessons from the European crisis

History repeats itself, first as a tragedy, second as a farce. Investors would certainly agree with Karl Marx as they look towards the euro zone. Greece is again causing consternation in Brussels by threatening to reignite the crisis that engulfed Europe from the beginning of 2010 to the middle of 2012.

While the European crisis has enough amusing moments to keep future students of history entertained, it also offers insights to traders and investors. Success in markets requires marrying an understanding of finance with the ability to decipher complex politico-economic situations and to anticipate events. The European crisis with its twists and turns is a perfect case study and offers three lessons to further the market player’s understanding of this game.

The first lesson is as widely known as it is ignored. Most people know that events are inherently unpredictable and timing the market is a fool’s game, yet they continually attempt to pick market tops and bottoms. While logical analysis can provide a player with a list of potential trade ideas, it is almost impossible to know which ones will come to fruition and when. In the middle of 2009, a rational observer would have been justified in ignoring Greece and betting against Spain and Italy. Although Greece’s debt-GDP ratio had been above 100% since the beginning of 2007 and rose to about 120% in the first half of 2009 (according to Eurostat data), its small economic size (less than one-third of Spain and Italy) meant that it was less of a problem. In contrast, Italy had a debt-GDP ratio of above 100% (only marginally better than Greece), a slower historical growth rate and similar problems of corruption and political dysfunction. Spain was still reeling from the collapse of its property bubble with its banks sitting on massive losses. Despite these facts, it was Greece that first became the focal point for the market towards the end of 2009.

Instead of attempting to time the market, traders would be better served by handling unpredictability through portfolio diversification and expanding their time horizon. The former means putting money on a few well-researched ideas with potential for large upside (this should not be confused with theoretical finance’s blind diversification where investing in a broad range of assets/instruments is deemed sufficient). The latter allows time for the market to move in the trader’s favour. It also requires choosing the right asset class/instrument to express trade ideas. Shorting Spanish banks and Italian sovereign debt were good ideas in 2010 but its suboptimal implementation (e.g. through the high-cost route of shorting bonds) might have caused the trader to close out before realizing the full upside.

The second lesson is that when the market moves, it moves fast and more than anticipated. The euro tumbled roughly 20% in six months starting December 2009, making multi-year lows, while the Greek 10-year bond yields more than doubled rising five percentage points to levels never seen since Greece joined the euro (coincidentally, the moves in the last six months have been almost an exact repeat). Given these large and rapid moves, traders either need to quickly initiate new positions or get out of loss-making trades. The market has a saying—he who hesitates makes a loss.

The third lesson is the most difficult to follow as it counters the normal thought process of most market players. Rational analysis is the cornerstone for players and implicit in trade idea generation, execution and risk management. However, events seldom follow a rational course. When Greek troubles emerged in end-2009, a relatively small aid package along with a pledge of further support would have nipped the crisis in the bud. However, a convoluted political process led to an eminently avoidable conflagration. Simply being short based on the rational observation that debt loads were unsustainable across the periphery (Portugal, Italy, Ireland, Spain and Greece) would likely have been a money losing trade as seemingly irrational official interventions caused large mark-to-market losses. For example, Greek bailouts substantially transferred default risk from the private sector to the public sector and postponed the inevitable debt haircut until February 2012. A trader short a two-year bond since end-2009 in anticipation of default would have made a loss despite being “right".

Negotiating irrationality requires the ability to gauge the big picture, anticipate the actions of different participants and flexibility to quickly adjust to changed circumstances. It is akin to anticipating the next move in a game of chess where the players keep changing. Although the game itself is logical, some moves may seem illogical since each player differs in skills and strategy. Unexpected moves can prolong the game or even change its course. Knowledge of the game has to be supplemented by insight into the players. Success comes to those who can master this intellectual challenge.

Shashank Khare is an investment professional and writer. After studying engineering at IIT-D and business administration at IIM-A, he entered the world of credit derivatives before CDS became a four-letter word. Having successfully batted through the crises, he now indulges his passion for economics, finance and policy.


What is the Greek debt crisis

In 2010, Greek bond yields rose and the euro tumbled as investors took fright at the high levels of Greek sovereign debt. Bailout and tragedy followed as misguided policy, thrust upon Greece by its creditors and the International Monetary Fund (IMF), transformed the post-financial crisis recession into a depression. After two bailouts and a debt restructuring, Greek sovereign debt is now even higher than it was in 2010 (about 175% of GDP currently vs about 130% in 2010).

The current bout of volatility began after the previous Greek government failed to elect its candidate as president. In the snap elections that followed, Syriza, a radical left-leaning party was ushered in largely on its pledge to overturn fiscal austerity imposed by euro-zone governments, ECB and IMF (the “troika"). However, after a lot of grandstanding, Syriza meekly surrendered. It allowed the troika to continue to dictate terms in return for the concession to rename itself as “the institutions". However, like last time, the saga doesn’t seem to be over with an agreement. The Greek government remains defiant and both sides are hardening stances. Moreover, the crisis risks descending into farce as political considerations and frayed tempers lead national leaders to behave as schoolboys (the latest twist has Yanis Varoufakis, the Greek finance minister, allegedly caught on tape showing the middle finger to Germany and advocating a unilateral default).

Subscribe to Mint Newsletters
* Enter a valid email
* Thank you for subscribing to our newsletter.

Click here to read the Mint ePaperMint is now on Telegram. Join Mint channel in your Telegram and stay updated with the latest business news.

Edit Profile
My ReadsRedeem a Gift CardLogout