- Archegos built large equity stakes in secret through derivatives like total return swaps.
- An options expert explains to Insider how total return swaps and contracts-for-difference work.
- He shares a trade that investors can make to take advantage of the stocks impacted by the blow-up.
In the aftermath of the implosion of “Tiger Cub” Bill Hwang’s family office, major Wall Street banks could be facing anywhere between $5 billion to $10 billion in losses, according to a new JP Morgan note written by analysts led by Kian Abouhossein.
The debacle, which has now implicated banks including Goldman Sachs, Morgan Stanley, UBS, Deutsche Bank, Credit Suisse, Nomura, Wells Fargo, and Mitsubishi UFJ Financial, has reminded investors of the near-collapse of Long-Term Capital Management in 1998 and the GameStop-induced market upheaval just two months ago.
But how was Archegos, which managed about $5 billion to $10 billion of Hwang’s family money, able to build up such large stakes in major US-listed companies without having to publicly disclose his bets?
The answer lies in the secretive derivative instruments including total return swaps and contracts-for-difference.
Breaking down the derivatives
In its simplest form, a total return swap is a two-party agreement where one party pays the other to gain exposure to the total return of an asset without actually owning it.
"If I'm the bank and you're the customer, and you want to buy a million shares of a stock but you don't want to actually put the capital up, you'd rather borrow money, then essentially we have an agreement between the two of us," said Felix Frey, who founded OptionsGeek after a 20-year derivatives trading career on Wall Street.
In this scenario, the bank will then buy a million shares of the stock on behalf of the customer and the customer will bear the responsibility for whatever happens to the stock.
"If I bought at $100 and the stock goes to $110, then you make the $10. If it goes down $10, then you're going have to pay me the $10," Frey said in an interview. "If the stock issues a dividend, then I pass through those dividends as part of the returns to you. Essentially, I'm just holding the stock for you."
While the client bears all risks related to the stock, the bank assumes the credit risk if the client defaults. Such was the case for Archegos, which defaulted on a string of margin calls from a slew of banks that racked up $50 billion of credit exposure to the firm's stock bets.
One of the key factors that made this massive exposure possible was that total return swaps are usually done with leverage, which amplifies the gains and losses. For example, some banks were lending to Archegos eight times levered, meaning that for every stock it bought, the bank would lend it seven more, according to the Financial Times.
Similarly, contracts-for-difference or CFDs represent an agreement between two parties where one party will pay the other party the difference between the value of an asset when the contract opens and its value when the contract closes.
CFDs are commonly used by European retail investors but inaccessible to their US counterparts. They allow investors to gain exposure to a single stock, a portfolio of stocks, or an index without actually owning them, according to the Commodity Futures Trading Commission.
The highly risky and opaque nature of total return swaps and CFDs has made them a popular tool for activist investors who prefer to hide their outsized stakes in companies until they are ready to announce at the most opportune moment.
In the case of Archegos, these derivative instruments have enabled the family office to amass large and highly leveraged stakes in stocks without ever making their transactions public.
A 'Warren Buffett trade' to exploit the selling spree
So far, investors have not seen the type of contagion that Lehman Brothers' collapse triggered in 2008, but the extent of losses from banks, other hedge funds, and investors is still not crystal clear.
Instead of buying the stocks that were pummeled by the $30 billion forced liquidations, Frey shares an options strategy that capitalizes on the potential volatility in many of these names including Baidu, Tencent Music Entertainment, Vipshop Holdings, FarFetch, iQIYI, ViacomCBS, Discovery, and GSX Techedu.
The anatomy of the trade is to essentially sell a downside put and buy a call spread in a beaten-down stock like Viacom, which would allow investors to take advantage of the implied volatility and the large values of the far out-of-the-money puts and calls.
"People are nervous about the puts, so they want to pay higher for those puts," he said. "People are also trying to bet on a bounce back by buying the out-of-the-money calls, so this strategy takes advantage of that."
Instead of holding the stock, investors can sell maybe a 20% to 30% out-of-the-money put, buy a near-at-the-money call, and then sell an out-of-the-money call, Frey said, adding that investors can execute the strategy at a decent price and take out a lot of downside risk.
To be sure, options trading is extremely risky and investors should still conduct due diligence on the stocks to make sure that they were battered due to technical factors instead of fundamental impairment.
"In this type of environment when something drops precipitously, and you like the name or you realize that it's dropped because of supply and demand, then maybe this is a time to do that type of trick," Frey said. "It's almost like a Warren Buffett trade where he comes in when a stock goes down significantly and sharply, he'll come in to sell puts."
He continued: "That's one strategy. This is another strategy to try to make a little bit on a bounce-back."