Tag Archives: events

Who Are The Market Makers? What Do They Do? WHY?

Summary We constantly talk about the market makers [MMs] and their activities. It is apparent from their comments, that many readers have varied, limited views about the function of MMs, their status, regulation, objectives, and their compensations. A late-August irregularity in securities markets functioning created knowledgeable analysis and comment discussing all that, much of which may help our perspective and understanding. The August 24 th Market Opening Problem The casual, intermittent user of US equities markets may not even be aware that there was a problem or the seriousness of its condition. By 10:30 am NYC time that Monday, things were pretty much back to near normal, and trading the rest of the day was being conducted about as usual. But the previous hour or two nearly shut down the ability of investors and speculators to carry out their planned transactions. Many unpublicized DK (don’t know) trades complicated the end of day settlement processes. Here is how one deeply involved observer firm described what happened: Recent Volatility in the US Equity Market In late August 2015, the US equity market experienced a rapid spike in volatility as global market sentiment weighed bearishly on stocks. During that period, the VIX volatility index doubled and equity-trading volumes surged as investors reassessed global growth prospects and inflation expectations. Market activity on August 24 was particularly extreme. Before the market opened, global equity markets were down 3% to 5% and the e-mini S&P 500 future was limit down 5% in pre-market trading before wider price curbs went into effect at 9:30 am. Due to these pre-opening factors, the morning began under selling pressure with substantial order imbalances at the open as investors reacting to global macro concerns flooded the marketplace with aggressive orders to sell (that is, orders to sell without any restrictions as to price or time frame such as market and stop-loss sell orders). According to the New York Stock Exchange (NYSE), the volume of market orders on August 24 was four times the number of market orders observed on an average trading day. Extensive use of market and stop-loss orders overwhelmed the immediate supply of liquidity, leading to severe price gaps that triggered numerous LULD (limit-up, limit-down) trading halts. The confluence of these factors contributed to aberrant price swings and volatility across the US equity market. For example, the S&P 500 index was at a low, down 5.3%, within the first five minutes of trading, then rallied 4.7% off the lows before selling off again late in the session to close down 3.9%. Bellwether stocks such as JPMorgan (NYSE: JPM ), Ford (NYSE: F ), and General Electric (NYSE: GE ) saw temporary price declines in excess of 20%. Individual stocks as well as ETPs (exchange traded products) and CEFs (closed end funds) experienced significant dislocations after the opening followed by unusual volatility. Transparency and Information Flow Price transparency and information flow in the US equity market were curtailed from the start, forming one of the key contributors to the day’s events. Anticipating widespread volatility, NYSE invoked Rule 48 prior to the open. NYSE Rule 48 suspends the requirements to make indications regarding a stock’s opening price and to seek approval from exchange floor officials prior to opening a stock. By suspending time-consuming manual procedures, this action should have permitted Designated Market Makers (DMMs) to open stocks more quickly and effectively. However, this rule had the unintended effect of limiting pre-open pricing information in securities, especially for any stocks experiencing delayed opens. Although DMMs actively worked to facilitate a prompt open for all securities, the opening auction was considerably delayed for an extensive number of stocks. At 9:40 am, nearly half of NYSE-listed equities had yet to begin normal trading. These delays, along with the absence of pre-open indications, impeded the normal flow of information, which market makers and other participants rely upon to perform their customary activities with respect to the market open. Without this information, and with many securities experiencing delayed openings, correlations snapped between prices for securities in the same industry or ETPs tracking identical benchmarks deviating significantly from one another. In financials, for example, JPMorgan experienced a sharp decline, while Morgan Stanley (NYSE: MS ) did not. The basis between futures and cash prices for the S&P 500 index also widened considerably – futures traded at a 1.66% discount to the corresponding equity basket. These dislocations heightened uncertainty in the market because the validity of automated pricing models becomes challenged when there are meaningful disparities between the prices of normally correlated securities. Additionally, since many of the computerized processes, which support market making, rely on futures as a reference asset, the ability of market makers to efficiently allocate capital and price risk was inhibited. Market makers faced further uncertainty on the cancellation of potentially “erroneous trades,” adding to their reluctance to trade. The lack of price transparency impaired the ETP “arbitrage mechanism” because market makers were unable to rely upon price information for individual stocks to determine when arbitrage opportunities exist between the ETP and its underlying basket, and to hedge their positions. In the absence of the necessary data, many market makers ceased arbitraging US equity ETPs. Exchange-Traded Products The market forces discussed above led to a temporary breakdown in the arbitrage mechanism of many ETPs. 327 ETPs experienced LULD halts on August 24. Many ETPs also experienced brief periods where they traded at significant discounts to the value of their underlying portfolio holdings. As a result, the events of August 24 left many investors dissatisfied with the prices at which trades were executed and raised concerns about the functioning of markets and ETPs. Further, like individual stocks, the confluence of order imbalances, lack of information flow, and opening issues contributed to differing experiences, even for comparable ETPs. Retail investors who had standing stop-loss orders were especially impacted – once the stop price was reached, the orders were converted into market orders, which were often executed at prices that were markedly lower than the stop price. As stop-loss orders are typically intended to be used to mitigate losses, investor education about the risks of stop-loss orders should be significantly increased. To that end, Figure 1 may be helpful. Figure 1 (click to enlarge) Now You Probably Know More Than You Want And there is even more complexity involved. But the necessary message is that in a trillion dollar a day market complex, lots of actions need to be coordinated. Computer programs that expedite actions have rigidities that need to be softened in some circumstances by human judgment. Often that is where market makers [MMs] get involved. Several of the key MM functions and responsibilities are outlined in Figure 2 Figure 2 (click to enlarge) Source: BlackRock Capital Management Figure 3 identifies the principal roles of MMs as providers of liquidity, the usual MM function thought of when the subject of market makers comes up. Figure 3 (click to enlarge) Source: BlackRock Capital Management Key to understanding these roles are the impact they have on prices and price trends. The size of capital involved in typical transactions is a principal determinant. That makes the first listed category of Liquidity Provider, the block trade facilitating broker-dealer, the most significant stock price impactors of MMs by far. These are irregular but frequently occurring, multimillion-dollar trades. Each one typically has the price impact potential to step away from the posted last trade and the current bid~offer quote by a full percent or more. Skillful execution may prevent such a change, or encourage it. Trade and market savvy are important resources, along with arbitrage experience. Firms engaging in the block trade business are often vertically integrated or diversified in their MM activities into several other or all of the roles listed. Exchange-registered market makers tend to be the traffic cops of the current day exchange world and have procedural influence that affords stature in the internal community. Their exposure to the public is usually quite limited, but their day-in, day-out functions may be essential. The remains of the exchange floor specialist system are here. Wholesale MMs serving regional brokers are essentially an internal function of the MM community and are among the least influential as to procedure or securities prices. Technology dominates the electronic MMs, earning them frequency and pervasiveness of presence in number of trades. The billions of shares regularly traded could not be exchanged without this support. But the typical price changes involved from last trade tends to be tiny and highly mechanistic. Their principal contribution is immediacy of executions at low cost. The high-frequency arbitrageurs or HFT players are the intellectual and market savvy step-outs of the electronic MM organizations. Their influence is in the bid~offer realm more than in the trade volume arena. They are constantly sniffing quotes to find risk-free arb opportunities, and individual investors rarely are aware of their presence. But their reach is extensive and they are a liquidity-providing influence. Competition hones their honesty, as a group. Their accomplishments financially tend to be a basis point at a time, just a million times over. They are expert exploiters of the leverage of time. For those interested in the full complexities of the market making process here is the complete BlackRock discussion and their recommendations for market operating revisions. Some of the underlying problems go back to the 1987 “portfolio insurance” market failure debacle. Conclusion Market makers come in a variety of flavors and perform many functions essential to the power and value of today’s equity markets. Where their influence to the advantage of individual investors is the greatest is in their service to those investment organizations that must trade in market-disrupting units because of their size. That limitation of size is unavoidable since the economic basis for their investing businesses is in the amount of capital under their management. They are active investors in order to utilize their info-gathering intelligence resources. But the advantage for us is that they use the arbitrage skills of trusted market making firms to provide the other side of those big trades and the temporary financial liquidity to acquire or dispose of the thousands of shares regularly involved. In the process of MMs hedging the risk to their capital, what is revealed is the extent of the risk believed to be present. Those self-protective actions and the implicit price-range forecasts prove to be useful guides as to future specific price moves, on a very comparable base among equity investments of wide diversity.

Muddling Through Works For Me

The global economy, including the United States, is muddling through with growth well below potential, but better than a year ago. The global consumer is the winner while the global producer is suffering from excess capacity, excess inventory and much lower prices. Lower prices for the producer means higher disposable income for the consumer as long as his income is at least constant and hopefully, rising. There are clear winners and losers out there due to this conundrum. It’s not so hard really to construct a long/short portfolio in this environment if you use common sense and in-depth research. It is most interesting to see how managements are reacting to this environment. If they bite the bullet and make the right strategic changes, they will come out stronger and their stock price will reflect it but if they keep their head down and maintain the status quo, their business and stock price will erode over time. The portfolio manager who uses historical analysis and doesn’t listen to or see what is happening out there won’t see the change. But the one with an analytical proclivity, an open mind and who puts in the hard work will see the change or lack thereof and construct a winning portfolio accordingly. This is an analyst’s delight. My strength! This is a worldwide phenomenon so you need a global perspective and knowledge. That’s what we at Paix et Prospérité are all about. The financial markets continued to move up last week on the “wall of worry” that we have been discussing in previous blogs. Our view was, and remains, that the Fed is out of the way until at least December, and most likely next March, and this has become the prevailing wisdom on Wall Street. You could hear the sigh of relief around the world. The global financial markets acted accordingly: stock markets for the most part rose, led by China and the emerging markets; bond yields remained ridiculously low as fears of deflation override fears of inflation; commodity prices, including oil, fell for the week; the dollar held constant after falling over the last two weeks; a huge deal was announced in the beer industry; Dell bid over $67 billion for EMC which was under attack from an activist; and corporate earnings season began. Quite a busy week! Our portfolio continues to outperform by a wide margin. I have spent a lot of time over the last year declaring that this is a market of stocks, not a stock market. Step back and think about this for a moment. Historically, investors rotated industry sectors based on where you were in the economic cycle. For instance, you would want to have the stable growers like food and drug stocks when the economy turns down and parenthetically you would want to own the economically sensitive stocks late in a cycle as capacity utilization increases to the point that prices increase accelerate and stick. Not now! What’s different today? Globalization. The lowest common denominator, for the most part, sets prices. For example, Chinese steel imports have forced tremendous pricing pressure here and in Europe. Some nations don’t have the same profit motive as we do and may be nationalized. It could all be about jobs over profits. Currencies play a major role here too. It used to be that our high-energy costs penalized our chemical industry in competing globally. Not anymore as our feedstock costs are as low as any country, including the Middle East. Products move globally and if you don’t have a competitive advantage either in price or technology, you’ll lose out over time. It’s our job to find them. We’re pretty good at that. Change can take many forms. Take a look at Amazon (NASDAQ: AMZN ), Netflix (NASDAQ: NFLX ), and Uber as three examples whose business models turned their respective industries upside down. Just ask Wal-Mart (NYSE: WMT ) and the networks. We will discuss all of this in more depth later but you can guess where I am going with this. Do the work; don’t follow the chart, as that is history; and find the future winners as your longs and the losers as your shorts. I waited over a year for Nelson Peltz to wake up the analysts and investors in GE . Be patient and let the thesis play out. Don’t forget to maintain your liquidity and control risk too. Let’s quickly take a look at the events of the week by region, see if there any changes in core beliefs and then turn to asset allocation and specific recommendations. 1. As I mentioned last week, the U.S consumer is in great shape and continues to support the economic expansion more than offsetting industrial weakness most prevalent in weak export numbers. Specifically, consumer confidence rose to 92.1 in October from 87.2 in September; consumer expectations out six months rose to 82.7 from 78.2 in September; the consumer view of their personal finances rose to 106.8 from 101.2 last month; consumer comfort index rose to 45.2 and is up 5 points in a month and retail sales rose a mere 80.1% in September from August. The surprise for the week was that the Consumer Price Index fell a seasonally adjusted 0.2% in September and was unchanged year over year. Excluding food and energy, the core CPI actually rose 0.2% in September and 1.9% year over year. Social security recipients, over 56 million strong, will not get an increase in the cost of living index in 2016. Tell them there is no inflation in the country. Relative strength by the consumer is being partially offset by continued weakness in factory output, which declined 0.1% last month. Manufacturing comprises only 12% of the economy and will remain a drag for quite some time. By the way, capacity utilization declined to a three month low of 77.5. Finally the Beige Book came out and supported only a “modest expansion” at the end of the third quarter. Many of the districts blamed the strong dollar saying it was hurting exports and tourism. Clearly the Fed is on hold for now and maybe longer than we think despite several world central bankers asking for the Fed to end the drama and to finally lift rates. Waiting has been unsettling to the global economies, as we have mentioned many times too. Since estimates of future global growth are still falling, the Fed is on HOLD. 2. The big news out of Europe is that Switzerland is set to impose 5% leverage ratios on its largest banks which include Credit Suisse and UBS up from around 3.7% as mandated by Basel III. The Swiss authorities are following the lead of U.S. regulators who set the same levels for our biggest banks. It’s quite simple: higher capital ratios means less lending. Dodd Frank and Basel III have certainly reduced financial risk in the economy at the expense of growth. While growth in Europe has clearly bottomed, it won’t reach earlier estimates due to weakness in foreign economies impacting exports. But the European consumer is clearly doing better which bodes well for 2016. 3. China reported its third quarter GNP on Monday and had the weakest quarter in 6 years. China Premier Li has been vocal, recently committing to moving forward on market oriented reforms to open up the country more to foreigners, ongoing urbanization, more transparency and increased infrastructure spending. Services and consumer spending are supporting growth while manufacturing and exports are relatively weak. A familiar story. By the way, credit growth has accelerated recently as monetary easing has spurred loans. The CPI increased 1.6% in September from a year earlier while the PPI fell 5.9%. There is more room for further monetary and regulatory initiatives to stimulate growth as has occurred elsewhere. 4. Japan’s government recently lowered its targets for growth this year as output/industrial production is weaker than anticipated due to slower growth overseas. Here again, consumer spending is holding up as employment and wages are slowly increasing and lower energy costs are boosting disposable personal income. Catch a theme here? The global consumer is holding up well while the global producer is weaker than anticipated. So why does muddling through work for me? Let’s get back to our core beliefs: the global economy, including the U.S., will continue to grow, albeit slowly, and there will be lower highs and higher lows as imbalances are contained and a conservative bias permeates at every level from government to business to the individual; interest rates will remain surprisingly low as global competition will keep a lid on inflation along with lower energy prices; the dollar will remain the currency of choice as this country’s global competitive situation continues to improve and energy independence remains a possibility down the road; earnings, excluding commodity related industries, will surprise on the upside despite relatively sluggish global growth; speculation is limited to real estate, art and private equity; the stock markets are undervalued as 10 year bonds are around 2.1%, the risk factor should be around 3 as leverage ratios keep falling; and S&P earnings are slightly higher in the aggregate and much higher in energy and commodity companies. It’s hard to imagine M & A getting any stronger. Another of our core beliefs. Finally this is all about asset allocation, stock selection and risk controls. I listened to or read the transcripts of at least a dozen companies last week starting with Alcoa (NYSE: AA ) and ending Friday with GE and Honeywell (NYSE: HON ). I really suggest that you take the time to read some of these transcripts as managements are really doing some amazing things. Alcoa is splitting into two companies; GE is selling most of its financial assets and reinvesting in its higher margin, higher return industrial businesses; Honeywell is churning out 10%+ growth and generating 110% free cash flow; Citi (NYSE: C ), Bank America (NYSE: BAC ), JP Morgan (NYSE: JPM ), PNC etc., are all making great strides not relying on a rising yield curve to make money; Intel (NASDAQ: INTC ) is upgrading its mix. I could go on and on. My portfolio is comprised of being long companies going through positive changes, short those with their heads in the ground, a few Larry Tisch value plays and there is no industry concentration. It really is stock specific. I remain around 93% net long, no bonds and no dollar currency trading position. Take the time to understand the strategic goals of the management of each company in your portfolio, step back and reflect hard and long on it, pause once again and consider all that could go wrong and also right, control your risk by maintaining ample liquidity and be patient as change doesn’t occur over night. There are clear winners and losers out there. Perfect for a hedge fund like ours. Change is a global phenomenon.

A Fork In The Road For XIV

Summary Investors are currently torn between fear mongering pundits and semi-positive economics. An update on the contango and backwardation strategy. The longest period of backwardation in over four years has ended, for now. It has been a very interesting couple of weeks in regards to contango and backwardation. Unlike most of my readers, I don’t get the real time view of the market since I am in the classroom all day. I get a few minutes to check at lunch and that sums up my daily view of the market until around 8pm. My preferred strategy here to profit from the increased volatility has been the contango and backwardation strategy. You can find a detailed description of that strategy, with back testing, here . I always find it fun to go back and read my past writings. When I first started writing for Seeking Alpha, I really wasn’t that great. I believe I had to edit my first article around five times before they agreed to publish it. That is life. Pick yourself up and try again. When I first introduced this strategy on Seeking Alpha, I pointed out that it would not win 100% of the time. Because we are using contango and backwardation as entry and exit points, the strategy becomes difficult when you have futures that consistently bouncing into and out of backwardation. There are two basic options to overcome this problem: Continue on with the strategy. Remember that this strategy will historically protect you from severe losses. Move away from the strategy by holding your position. If you have a long-term positive view for the market and the economy, then you may want to buy and hold a short position in volatility rather than continuing to trade into and out of positions. Before entering these trades you should be fully aware of your potential risks verses the reward. Moving Forward I have stated this previously and it is now being confirmed in the markets. The VIX Index and VIX Futures have moved away from their historically low range. In the short-term I would expect futures to begin trading more towards the historical mean. Take a look at the chart below: (click to enlarge) The VIX will move through cycles of higher and lower ranges of volatility. Historically when the VIX trades in the 10-13 range for an extended period of time, it is followed by a prolonged period where the median VIX will move to a 17-25 range. In periods of economic distress or turmoil that range can be much higher. Let’s look at the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ: XIV ) as a basis for discussion here. We know that XIV is driven by the first and second month’s contract within the VIX futures. If the front month’s contract were to fall to 13 from here, that would represent a theoretical gain of around 30% considering all factors. However, if the front month contract were to fall to 17 than XIV would experience a theoretical gain of around 12%. In both cases you would have the added benefit of contango to compound your gains over time. This would make your actual gain larger than what I am reporting for illustration purposes. Over the long-term XIV needs healthy levels of contango to build value and cannot just depend on falling futures contracts. When assessing risk and reward you need to factor in a potential sea change in the median level of the VIX futures. As you can see below XIV is only off about 17% from six months ago despite experiencing a severe haircut. All of this is can be attributed to the wealth built from contango. See below: We have just experienced the longest period of backwardation in over four years: (click to enlarge) Other events that could affect XIV and volatility The Senate and House are currently debating the next potential government shutdown which is scheduled for the end of this month. This would provide a healthy dose of volatility and negatively impact XIV. The larger question here is, is this now how the United States government operates now? I have written past articles, which have been mainly brushed to the side, on government debt levels. I believe our debt is unsustainable with current levels of economic growth. Ultra low rates have helped our interest payments. I would be more optimistic about our government debt if we had respectable politicians who could put their personal agendas aside and come together to actually solve problems. Much of what I see is theater and kicking the can down the road. For example, the current solution to the government shutdown is to pass a measure to get us to December. Slow growth is now the new normal. This has been confirmed by The Fed and recently several CEOs have come on record as stating the same. The concern with slow economic growth and low inflation is that it doesn’t take much to turn the tide the other way. These are larger economic problems that require us to come together and create solutions that last longer than two months. Conclusion For now, the days of ultra-low volatility are gone but not forgotten. Like the business cycle it will always come back around. Whether that will be in a couple months or several years remains to be seen. I remain optimistic on the U.S. economy and hope that Washington has the will power to create long-term optimism through compromise. We need to help foster genuine sustainable growth. Bubbles create great opportunities for us volatility traders, but hurt real people. We may get into a longer period of contango this week that would again align your trading with the contango and backwardation strategy. However, if the market remains choppy we could be moving between the two often. You will have to make a personal decision on how you want to proceed with your investments. Follow me here on Seeking Alpha for regular volatility updates and news you can use. As always, feel free to leave your professional comments below. We always create some great discussions. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in XIV over the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: The author reserves the right to trade into and out of any products mentioned here and generally will not post exact positions or trades in real time. The author does not give individual buy/sell advice.