Crowded trades - what to do?

Markets are nearly efficient in using all information and reflecting equilibrium prices, but not completely. The lack of completeness exists because all of the capital needed to make the market efficient may not be immediately available. Flows in reaction to news matter and occur over time. The speed of capital and trade flow will have an impact on behavior of price, and this adjustment to equilibrium prices will often take time.

These adjustments in prices are usually not immediate and are the cause of trends.  In simple terms, as flows increase, market prices will rise if there is not the same amount of dollars on the opposite side of the trade. If there is too much or too little flow, there can be a liquidity problem of either under or overreaction in price.

At the extreme, too much flow and positioning leads to crowded trades especially if here is not offsetting views to provide liquidity. The crowded trade may be too much flow or positioning too large in a given idea, strategy, or market.  This is one of the risk problems that have often not been given enough attention. A single hedge fund strategy may be small relative to the total market volume of trading or the open interest in a futures market, but if many funds are doing the same thing, there can be a shortage of liquidity. The aggregate risk can feed back and effect the actions of the individual. 

Crowded trades are a problem especially with global macro managers because there are fewer macro opportunities. For example, if one believes in a deflation story, there are a limited number of trades that can be structured. If everyone thinks the yen is going lower, the amount of capital on one side of the market from one type of trader can be quite large. If the traders are all of the same type and watch the same news and data, there is a greater likelihood that they will move together. This movement together can cause market cascades of one-sided trading. For macro traders, the hope is that the total size of the market is much greater than the marginal behavior of himself and similar traders.

 A stock investor who has a broader set of names to trade can avoid crowded trades because there are just a wider set of opportunities. Of course, each market may be smaller so crowded trades can still exist, but the chance for diversification is greater. The issue is always the balance between the size of the speculative traders who may be acting on an expected information advantage and the objectives of other traders.

Crowded trades are dangerous because of the potential for what we will call negative cascades. Demand may build over time as money flows into a trade only to see it quickly reverse. 

What causes or identifies crowded trades:

• Similar thinking which places on one side of the market;
• Limited liquidity or declining liquidity relative to flow;
• The potential for quick reversals based on some catalyst event.

What can be done about it:

Focus on finding the market tilt from a crowded trade.

• Using the commitment of traders as a crowded trade tool. If the commitment of traders is at an extreme, there is a crowded trade.
• Matching news stories with crowded trades. If there are more headlines on particular trade, the trade is crowded. Contrary news will reverse crowded trades
• Matching analyst views with crowded trades. If all of Wall Street is talking about specific trades, these trades will be crowded.
• Extended trend trades become crowded and will likely reverse.
• Low volatility trades will become crowded and be subject to reversal if there is a volatility increase.
• Low interest rates and high liquidity will create potential for crowded trades through leverage. A change in leverage will reduce the crowd for any set of levered trades. 

Some generic crowded trades for 2015:

• The dollar increase;
• The bond rally and then reversal;
• The corn and wheat market decline;
• The deflation story.

More will come and lead to fats reversal, so managers should be prepared for crowded trade risk.