The Deipnosophist

Where the science of investing becomes an art of living

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Location: Summerlin, Nevada, United States

A private investor for 20+ years, I manage private portfolios and write about investing. You can read my market musings on three different sites: 1) The Deipnosophist, dedicated to teaching the market's processes and mechanics; 2) Investment Poetry, a subscription site dedicated to real time investment recommendations; and 3) Seeking Alpha, a combination of the other two sites with a mix of reprints from this site and all-original content. See you here, there, or the other site!

24 October 2008

Who buys, if everyone sells?

When all investors attempt seemingly to squeeze through the same exit door at the same time, then who takes the other side of their sell orders; in particular, an ugly market opening such as today's indicates?

The NYSE specialists and NASDAQ market-makers, that's who. It is the stated responsibility for the former group and implied responsibility for the latter to do just that -- in the attempt to maintain orderly markets, "When everyone sells, you (Mr Specialist) must buy, and when everyone buys, you must sell."

But that does not mean they should lose money in the transaction. In such an environment, they will repeatedly lower bids (their bid) until the sell (stop) orders stop their inflow, at which point the markets open, stocks gap lower, much lower -- and the moment they buy from you, me, us. While we panic, they keep their collective head about them. But they will not carry a position overnight, so sometime soon thereafter, typically within the opening ~45 minutes, the markets will up-tick -- they will create the up-ticks -- and they will sell into the price rise. Voilà, a seemingly stupid purchase becomes profitable almost immediately.

But how does an ugly opening become a reversal and a rally to a possible positive close? Short sellers follow the specialists and market-makers, and cover their short term short positions, which creates additional buying pressure. And then the (intra-) day traders purchase, seeking a profitable quick long-side trade. Swing traders purchase next, and then, position traders, and finally long term investors. Which explains, rather simply, how a market gets its legs... and has legs (new trend endures).

This process, simplified though I have made it, is not a prediction, merely an explanation into the markets' mechanics. It is why professional investors seek gap openings in either direction as an opportunity to fade - invest opposite the prevailing direction -- for however fleetingly they hold the positions.
-- David M Gordon / The Deipnosophist


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