What Every Trader Needs to Learn From August 5’s Volatility

The massive sell-off on August 5 caught the markets by surprise. It even gave some market veterans a scare…

All day, I was getting phone calls from old trading pals and other folks. They worried that we were watching a crash unfold right before our eyes like back in 1987.

As a young trader in my 20s, I saw the 1987 crash firsthand. And it’s remained etched in my mind ever since.

Standing there on the trading floor, it felt like I was witnessing the whole world collapsing.

So rest assured, August 5 was way different than 1987. (For a start, the markets recovered by the end of last week.)

But it reinforced something that the 1987 crash and other market downturns have taught me.

And I want to share that with you today…

Out of Nowhere

Up until August 5, most folks didn’t know much about the “carry trade.”

In a nutshell, it’s when big investors borrow money at a low rate and invest it in an asset that generates a higher yield.

And the recent meltdown was due to the carry trade between the Japanese yen and the U.S. dollar unwinding.

Institutional investors borrowed yen due to low interest rates in Japan. Remember that when the Bank of Japan raised rates in March, it was the last major economy to abandon negative rates.

Those investors then swapped their yen for U.S. dollars to invest in assets like stocks and bonds.

But recently, the Bank of Japan raised rates for the second time in about 17 years. That upset the relationship between the yen and the dollar.

So those highly leveraged investors had to unwind their positions… and fast.

Adding to the turmoil, weak jobs data put the prospect of multiple U.S. rate cuts back on the table.

Higher Japanese rates coupled with likely rate cuts in the U.S. caused the yen to rally against the U.S. dollar.

That’s why markets tanked and volatility spiked. Investors rushed to dump their positions so that they could close out their yen loans.

It was a double whammy that nobody foresaw…

It’s Always About Risk

When you see massive volatility like this, it’s not only institutions feeling the pain…

The dust has mostly settled now. (Although I’m expecting plenty of volatility through the end of the year.)

The markets have recouped their August 5 losses and then some.

But it makes little difference to those who blew up their accounts on August 5.

In this instance, the dramatic unwinding of the yen carry trade caused the chaos.

But throughout my 40-year career, I’ve seen countless events rock the markets…

Think of the Russian debt default, the Greek debt crisis, and COVID.

Plus there have been plenty of other geopolitical events along the way…

There’s always something coming around the corner that we can’t see.

And when a shakeup hits, you can be sure that those who have poor risk management will come undone in a big way.

Important Lessons

In many ways, the crash of 1987 early in my career still defines me…

It taught me to be cautious and bank profits when I see them. That’s worked very well for me over the decades.

The crash also taught me the most important lesson of all…

Your capital is all you have as a trader.

You have to protect it zealously with strict risk management.

Otherwise, you can be sure that an unexpected event will eventually come along and put you out of the game.

Happy Trading,

Larry Benedict
Editor, Trading With Larry Benedict