Convergence Trade Blowups

A convergence trade bets that two prices which are theoretically linked — an on-the-run and off-the-run Treasury bond, two share classes of the same company, a stock and its convertible bond — will move back together after temporarily diverging. The trade is usually structured to be close to market-neutral: long the cheap one, short the expensive one, profiting purely from the gap closing regardless of which way the broader market moves.

The blowup risk is that "the gap will close eventually" and "the gap won't widen first" are very different claims, and convergence trades are almost always leveraged precisely because the expected gap is small. If the spread widens further before it converges — which it can do for reasons entirely unrelated to whether the original thesis was correct, like a liquidity shock making it harder to hold either leg — a leveraged trader can face margin calls forcing them to close the position at the worst possible moment, locking in the loss right before the spread would have closed on its own. The trade can be "right" in the sense that the two prices do eventually converge, and still destroy the fund that held it, because the fund was liquidated before that happened.

The canonical example is Long-Term Capital Management in 1998: many of its convergence positions closed profitably in the years after the fund collapsed, but by then the fund itself no longer existed to collect the gains, because it ran out of capital and time first.