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It’s always misleading to say “Stocks are rising” or “Stocks are falling.” Stocks may have risen or fallen in the past, and they may rise or fall in the future, but there is no current rate of change. Which means we cannot learn the future by looking at the past, not even past milliseconds.

The “carry trade” is a good example. Interest rates in Japan have been very low, with short-term interest rates near zero. In the United States, short-term rates have been over five percent. So traders would put up collateral to borrow yen, then sell the yen for dollars, which were then invested at much higher interest rates. The traders earn higher interest than they pay, booking large profits. What could go wrong?

The foreign exchange rate is what could go wrong. For most of 2024, the dollar was becoming more valuable relative to the yen. That is, when it was time to unwind the trade and pay off the loan of yen, one dollar would buy even more yen than previously. In dollar terms, the amount owed to the Japanese lender was declining. That made the trade doubly profitable. But traders learned over the past few days that what has been happening regularly for six months can change very quickly. The dollar has dropped over ten percent against the yen in less than thirty days (as of this writing, on August 6, 2024). So the principal amount of the loan in terms of dollars has increased by ten percent. That wipes out the benefit of earning five percentage points higher interest.

A volatility trade also offers profit potential if things go well. For example, a trader who expects the S&P 500 index to be stable might sell options to people who want to hedge their portfolios. The trader could collect a payment today by guaranteeing to sell the stock index if the price goes up a certain amount. The trader would also collect a payment by guaranteeing to buy the stock index if the price falls a certain amount. If the trader is right that the index price won’t change much, the payments are pocketed with no unfortunate trades being made. But there’s huge risk if the market either rises or falls a lot. This is a particularly vivid example of how “present tense” thinking can fool someone. The trader says, “The market is stable, so I’ll find a way to profit from it.” The trader should have thought, “The market has been stable in the past; do I want to gamble on it being stable in the future?”

A variety of other trades are described in Matt Levine’s excellent Money Stuff newsletter, including basis trades, index rebalancing trades, and dispersion trades.

Truly risk-free profit opportunities occasionally pop up, but there are sophisticated market participants watching for them. If the S&P 500 futures contract is trading at different prices in London and New York, someone will very quickly buy cheap and sell dear. It may take less than one second for the prices to equalize.

People who watch financial markets may see trades that would have worked well in January, and again in February, and once again in March. They will be tempted to say, “This trade is working.” But that sentence uses the present tense. And there is no present tense in financial markets. The trade did make profits in the past. It may make profits in the future.

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