Volatility Favors Few
An economic downturn steering the global economy into a recession has littered the news, and rightfully so. Federal Reserve Chair Jerome Powell’s comments have left investors with an even greater knot in their stomachs, after commenting on the future economic outlook as ‘“highly uncertain and subject to significant downside risks… There is a growing sense that the recovery may come more slowly than we would like… and that may mean that it’s necessary for us to do more”’ (1). These statements lead the charge for a 2% decrease within the S&P 500 index. It is clear that the overwhelming majority of companies are suffering tremendous losses. However, one division within the Financials sector is cheering on these wild swings. While mergers and acquisitions teams are finding themselves with far fewer deals, sales and trading divisions have yielded astonishing profits.
Mergers and acquisitions, as well as advisory teams have followed global macroeconomic trends, in the sense that activity is frozen. FitchRatings reported, “M&A activity virtually stopped and advisory revenues shrank 13%” (3). It appears that noble ethics, a sharp decrease in liquidity, and a hostile environment where companies are protecting themselves have prevented larger companies from acquiring smaller divisions and enterprises at enormous discounts, leaving M&A teams with their hands empty. Some analysts have even been furloughed or fired- all while their colleagues in sales and trading enjoy large paydays. Similarly, advisory and capital markets have decelerated. Many companies are forced to cut unnecessary expenditures, such as advisors, to help compensate for massive losses in revenue. Few private companies have any urge to IPO in this economy. Finding management willing to go public when their stock is guaranteed to trade below fair value is quite scarce.
Through most of Q1, investment banks predicted trading profits to be in the 4-7% range. This dramatically changed after the first few weeks of March, as word spread of an impending national lockdown and global pandemic. This quickly changed as an article by the Financial Times’ best explains the magnitude large banks faced, “One big US bank said it was regularly putting through twice its usual daily volumes in its cash equity trading division. ‘Equity volumes have been ‘off the charts’ and the trading firms’ equity trading revenues will reflect the strength,’ said Gerard Cassidy, analyst at RBC…” (2). Uncertainty in pandemic response caused upheaval in financial markets, churning up volatility on which traders both thrive and profit. Volatility within trading is such a substantial force that many intraday traders place a greater focus on the market open and market close, due to the increased volume of shares traded relative to the rest of the day. Volatility is defined as the distance from one point within the data set (one trade) to the next, usually measured with variance or standard deviation. As information about COVID-19 accelerated round the globe, the volume of trades greatly magnified with many investors racing to sell their positions and others buying at fire sale prices. This spike in uncertainty leads to investors becoming extremely active, selling their positions to realize the gains accumulated in recent years. A huge increase in trading volume typically causes higher spreads between data points. A fixed supply of each asset followed by a plummet in demand caused prices to fall.
According to FitchRatings, “Goldman Sachs had its strongest FICC trading revenues in five years, growing 33% to $3 billion. Bank of America notched its best-ever equities trading results, surging 39% to $1.7 billion, while equities revenues for the group grew 28%” (3). Fitch’s statistics shed a positive light on something: growing revenues, a topic nearly unheard of in recent weeks. Skilled traders across these large institutions have capitalized on drastic price swings and increased bid-ask spreads. More broadly, portfolio managers, options traders, and hedge funds are reaping enormous rewards from this volatility. One publication relates option values to volatility, stating how they become more valuable in volatile climates, due to the increased likelihood of drastic prices surpassing the given strike price (4). While price exposure allows traders to benefit from once out-of-the-money contracts to deeply in-the-money and profit off of soaring premiums, the same principle can be applied to equities: dramatic price swings lead to increased profits.
The wide range of performance statistics across divisions in the financial sector and investment banks is both attention grabbing and remarkable. Such drastic performances beg to be examined due to the fact that divisions within one company produce performances on such opposite ends of the spectrum. Concluding that sales and trading is incredibly sensitive to the element of volatility, skilled professionals are able to use this to their advantage. Large sell orders are triggered by most institutional money managers. Asset managers for both individuals and institutions wish to eliminate their positions after recording record setting gains of a 27% increase in the S&P 500 last year in hopes of preserving their gains in clients’ 401k’s and portfolios. Proprietary and intraday traders on the other hand, are able to short these trends within the market and reap massive benefits. M&A certainly has a brighter future than S&T due to the necessary human nature required for deals and increasing computerization of S&T. That being said, sales and trading has the ability to consistently produce revenue, even in economic downturns, as currently demonstrated. It is fair to say when mergers start to accelerate again, this will be an indicator of a much stronger economy. Only time will tell how these trends continue to unfold as the exogenous correction continues.
Works Cited
1. https://www.wsj.com/articles/global-stock-markets-dow-update-05-13-2020-1158934281 (Stocks Fall as Fed’s Powell Says Outlook ‘Highly Uncertain’)
2. https://www.ft.com/content/5ec64072-6e1e-11ea-89df-41bea055720b
3. https://www.fitchratings.com/research/banks/us-banks-trading-revenue-surges-on-coronavirus-volatility-future-results-uncertain-20-04-2020 (US Banks Trading Revenue Surges on Coronavirus Volatility; Future Results Uncertain)
4. Carr, Peter, and Dilip Madan. "Towards a theory of volatility trading." Option Pricing, Interest Rates and Risk Management, Handbooks in Mathematical Finance (2001): 458-476.
