Big Funds Are 'Degrossing' to Manage This Ugly Market: What That Means for You

Markets Open Tuesday Morning Following Dow's 350 Point Drop

After the ugly action on Wednesday that caused significant technical damage, the market is mildly lower on Thursday. There is a faint aroma of fear in the air, but also some signs of support, a little dip buying and breadth that is improved over Wednesday, with about 37% of stocks advancing.

One reason the action is relatively contained is a phenomenon known as "degrossing."

Degrossing is the process by which institutional investors, primarily hedge funds, reduce their overall market exposure by simultaneously cutting both their long and short positions. Earlier this week, I discussed Goldman Sachs' view that hedge funds were carrying near-record gross exposure, meaning the combined value of their long and short positions had reached unusually high levels. The funds were heavily long individual stocks but also heavily hedged through short positions in ETFs and index futures.

The problem with carrying that much gross exposure is that even with large hedges in place, the risk remains substantial. Volatility alone can trigger margin calls. A black swan event can overwhelm the hedges before they can be adjusted. The solution is to degross by covering the shorts and selling the longs at the same time, reducing the overall size of the book without making a directional bet.

That is what is happening on Thursday. Big funds are simultaneously buying back their shorts and selling their longs. The result is a market that moves in a more muted and choppy fashion rather than a sharp directional one. It is not a signal of confidence. It is a signal of risk reduction.

Know Your Time Frame

While the funds work through their degrossing, the most important thing you can do in this environment is be very clear about your investment style and your time frame.

If you are a long-term investor, there is no reason to do anything right now. The indices and most stocks have no clear support and can easily fall further. The serial bottom callers will keep trying to time the perfect entry and will rack up substantial losses before they finally get lucky.

There is elevated volatility and that does create opportunities for very short-term traders. Catching bounces in a badly oversold market can produce some quick gains but it is not easy to execute consistently. What typically happens is that a trader nails a few good trades and then gives it all back on a dozen that do not work. Success in that approach requires genuine selectivity and patience. Too many traders are action junkies who need to be doing something and that impulse is expensive in a market like this one.

My best advice is to watch some basketball rather than trying to catch a day trade.

I do not trust the market at all right now but I am extremely optimistic about the opportunities that are developing in the wreckage. When this cycle turns we are going to have some fantastic trading. The most important preparation you can do right now is making sure you have plenty of capital available when that moment arrives.

At the time of publication, DePorre had no positions in any securities mentioned.