Tuesday, June 12, 2012

Coiled Spring

[Update: 6/12/2012] Literally, the same day I posted this, I heard about the new book "Broken Markets"  It describes how High Frequency Trading has taken over the stock market.  I am only about half way through, but what I have read so far is cause for serious concern.  Suffice to say, when the SHTF (any time now), the outcome will make the 'Flash Crash' seem like a picnic...

The book describes how following the privatization of the exchanges in the past decade, they embraced a model called "colocation".  Colocation is an IT term meaning to rent data center space (ping, power and pipe) for a service fee.  The key difference is that in this instance colocation means colocating a trader's servers in the same data center where the Exchange has its servers.  The key reason being 'latency' i.e. the amount of time it takes to propagate data over a network.  As an IT guy myself, I can tell you that the latency AND bandwidth you get via physical colocation v.s. having servers in another state or a thousand miles away, is orders of magnitude higher.  This new model therefore opened up all types of 'scalping' opportunities based on the ability to have data milliseconds before the competition and therefore to front-run all types of trades.  In the meantime, the traditional retail investor has generally abandoned the market in disgust while traditional market makers were forced out of business by the intense price competition.  Therefore 'natural' buying and selling was replaced by this manic high turnover-based volume with up to 70% of it performed by HFT machines.  The difference however, is that these new HFT firms masquerade as market makers but they do not take on any of the traditional obligations of true market maker - i.e. buyer of last resort and seller of last resort.  Hence, the Flash Crash of May 2010, when all of these HFTs pulled back from the market at the same time...

[Original Post: 6/8/2012]
Market risk is coiling quietly under the surface as policy-makers are forced to generate a constant stream of hopium-based 'ideas' just to keep the markets from exploding apart, on a daily basis.

Hopium Floats (for a while):
Essentially, HFTs (High Frequency Traders) in conjunction with HFBs (High Frequency Bureaucrats) are the only ones keeping this market afloat.  HFTs are specialized hedge funds (some of) which short options volatility to take advantage of publicized market events.  For example if the Fed, ECB or the China Central Bank has a policy announcement, the HFTs will short volatility into the event and then cover after the event, raking in relatively large (when annualized) profits.  That's because the rest of the investing world is buying volatility (put options) into these events, causing volality premia to rise into these events and fall immediately after.  That makes these HFT arbitrageurs essentially the net marginal buyers of the market.  Their 'payment' for taking on this risk is embedded in the options premia, which when annualized can be substantial.

In a world therefore, where you have HFBs running around making announcements every other day - various meetings, policy changes, elections, conference calls - you get the idea, it essentially creates an endless stream of 'events' for the HFTs.  However, as always there is no free lunch, because the rest of the investing world is dying by a thousand cuts, by having to pay these pumped up options (hedging) premia which fall straight to the bottom line of the HFT/Vol sellers.  In other words the market is artificially buoyed by the transfer of wealth from mainstream investment funds to these highly leveraged volatility sellers.  

Rearranging Deck Chairs on the Titanic
My point is therefore is this: all of this highly leveraged derivatives 'action' is obscuring the primary trend of the market (aka. down), in two ways:

1) because it is inserting options arbitrageurs (volatility sellers) as a new marginal buyer of risk (and is concentrating market risk in these funds, similar to how subprime risk was concentrated in AIG four years ago, right before the SHTF).  After all, hedge funds are call options - heads they win, tails you lose... 

2) because, as I have shown many times, it is causing market-based options volatility (VIX) to be artificially depressed, leading investors to have an unwarranted sense of complacency  

I am by no means saying that these HFTs can support the market longer-term, only to say that as long as policy-makers continue to invent new schemes to inject hopium into the markets then these distortions can continue.  As we all know, at this juncture it is literally impossible to keep track of all of the various schemes and ideas floating around for saving the 'Euro'.  Suffice to say any real change of substance is many months and many parliamentary sessions down the road...if ever...

Computers Don't Remember 2008
Therefore, Deja Vu of 2008 when we were told 'subprime' was priced in, once again the talking heads are telling us (based on market levitation) that the macro risks (Europe etc.), are priced in to the market i.e. fully ignoring the incentives that are in place to ensure that those risks are not priced into the market.  And suffice to say that if all of these risks were priced in, the market would be a lot lower and put options would be a lot more expensive...which is just another way of saying that markets are highly unprepared for the inevitable day when 'Extend and Pretend' comes to an end.

BTFD-Friday Night Edition
Speaking of BTFD, here in a picture is exactly what I have been explaining, despite all of the 'contrarian' discussion about the 'oversold' market, every dip is getting bought.  Now we see the McClellan Oscillator (black line) is already as overbought as it was at the May high, despite only a few day's rally.