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!

01 November 2009

Market Volatility, Liquidity, and You

Electronic Communication Networks (ECNs) now account for approximately one-third of all NASDAQ trading, especially with the advent many years ago of deep-discount commissions via on-line transactions. A battle back then began to brew between the buy-side (pension and mutual funds) and the sell-side (old-line wirehouses such as Merrill Lynch). When the buy-side began demanding drastically reduced commissions on executions and the sell-side tired of caving in, the sell-side began to whisper to those who might listen, “Hey lesser commissions are great; but really, just how good is the quality of your execution?” Terms such as slippage, the concession over the current market quote to buy or sell the investment, gained greater currency. In time, both sides commissioned academic studies to support their argument. Ultimately, a consensus was reached that was perceived as elegant, but which, in practice, is anything but.

The theory now widely accepted is a default strategy wherein a variety of techniques will be employed to average the acquisition or disposition of assets, thereby ensuring there would be no bad executions. Of course, the Law of Unintended Consequences dictates the inverse: no bad executions means no good executions. The most commonly utilized of these strategies is VWAP, or Volume Weighted Average Price.

To determine whether the sell-side did, in fact, provide fair executions, the academics decreed that at the end of a trading day, the stock in question should have its price range averaged, and weighted. Then the claimant could state: 

“If you executed my order at a price worse than the VWAP — well, consider yourself and your firm as fired!"

This means the buyers or sellers have become interested in getting average prices, only. When coupled with the desire to make transactions only with the herd, one begins to understand the difficult position each side found itself in. These strategies are counter-intuitive in that they remove the decision from a decision-making process. The buyers pass up bargains because they cannot buy when alone. The result? Their indecisiveness makes the market less efficient.

Akin to VWAP is the participate order, which means: “I want to buy/sell XYZ at $50 -- but only if someone else is buying or selling at that level. I know I am not good enough to decide on my own to buy XYZ, but if someone else as credible as me buys as well, then I cannot be criticized for my decision.”

Compare how Wall Street actuates its buy/sell decisions with how you transact your own.

Market makers and specialists

Though we, as retail investors,  might believe we enjoy a pleasant and profitable relationship with NASDAQ market makers and NYSE specialists, we do not. Unfortunately, since the Crash of 1987, market makers have been issued a mandate to be less a service provided and more of a profit center. The result is an adversarial relationship between the needs of market makers and specialists, and our own.

There is a very clear difference in responsibilities between market makers and specialists. Yes, market makers are there to execute your trade but that is not their sole job responsibility. They do have a decree from the Securities and Exchange Commission (SEC) and the National Association of Securities Dealers (NASD) to maintain orderly and continuous markets. To the degree that the market makers are required to take the other side of a one-sided market, they risk their own capital by doing so. Their position obviously is not risk-free. However, NASDAQ market makers buy on the bid and sell on the offer; you and I, on the other hand, must buy the offer or sell the bid. That is one way market makers make their profit — by trading the spread between the bid and ask. When working with the retail investor, the market maker will always get their vigorish — the extra money from the spread or other arcana — usually via the retail investor’s misunderstanding of the following: 

1) The mechanics of market and limit orders;
2 ) "Fast” markets; 

3) Rotation (churn of the order book); and
4) The dynamics of the market’s opening and closing hour.


A market order is one in which a trade execution is guaranteed, but not a price.
A limit order is one in which a price is guaranteed, but not a trade execution.

This major difference is not as startling as these orders’ similarity; each allows the market makers discretion as to when (time) your trade execution is reported, which in turn grants the market maker the opportunity to report the worst execution to the customer, retaining the best executions for himself.

This can happen to you. Next time you place an order during a busy market day and your broker says: “ACORN!” (Advise Customer, Our Responsibility None); or fast marketfast tape, orders ahead, and assorted variants, you will understand your order’s importance, the bottom of the pecking order.

During “fast markets”, the market’s opening rotation can be especially hectic. Due to an order imbalance, the NYSE specialist will delay opening the security for trading until a clearing price can be found; NASDAQ market makers simply raise the bids or lower the offers till a trade occurs. This is one reason for the changing pre-opening prices one sees on NASDAQ.

The market’s closing rotation is commonly referred to as being for professionals. Why? Because market professionals know why they buy a security and so are comfortable holding that position overnight. Too, the market professionals trust themselves to do the right thing, should their position be working against them. This is one reason a strong market or stock might open down but close higher. Of course, it follows that a weak market or stock is one that opens higher but closes down.

Remember, three parties participate in any transaction: 

1) Your broker, who gets commissions;
2) The brokerage that executes your trade, and which profits from the spread between bid/ask; and 

3) You, who hopes to profit from the trend.

Far and away, you have the most potential for profit -- or loss.

It once was true that buyers and sellers would place orders with their brokers who would route those orders to market makers for execution, matching the orders one-by-one, by hand. Today, orders are matched by computers; however, market makers can and do trade for their own accounts based on this critical information. Market makers know how high the bidders will bid, and so can profit from that knowledge by trading against us, their clients. Imagine knowing how many orders exist at any given price level. With this knowledge, market makers know the stock's short-term trend.

Consider the profit centers known as payment for order flow and internalization. Each is a means of making more money for the brokers at the expense of the individual investor.

Payment for order flow is the practice whereby ECNs and some market makers pay brokers to route your order their way – it does not necessarily follow that your order will receive the best prevailing price. For example, imagine XYZ currently trading at $50 bid by $50 ¼ offer when you enter your market order to sell. To you, market order means $50/share or better; but to your broker, the best bid might be a market maker or ECN with whom he does not have an existing payment for order flow scheme. What will he do? He will route your order to the market maker with whom he does have an existing relationship, even though your market order has now been executed at $49 ¾/share. Though he makes only $.25/share, these hidden charges do add up. For example, Knight Securities paid, in prior years, $.005/share for American Stock Exchange orders and $.0225/share for orders on the S&P 100. These seemingly insignificant pennies aggregated to $139 million in order flow payments during a recent year.

is another practice whereby your broker matches your order against his inventory, in effect acting as a principal to the transaction, rather than as your agent.

Neither of these schemes has your interests at heart. You can halt them by issuing specific instructions with your broker.

The cost of liquidity
Market makers will argue that payment for order flow and internalization are the payback they (market makers) deserve for providing necessary liquidity to the markets. But remember, as mandated by the SEC and NASD, the market makers must risk their capital to ensure continuous pricing and continuous markets; however, ECNs need not guarantee liquidity because their raison d’être is simply to match existing limit orders.

Liquidity is a coward

Ray DeVoe said this many years ago and it is as true now as it ever was: Money will flow to where it is best treated. If the markets should be declining, then the potential buyers can step aside, allowing the markets to fall into a vacuum created by their absence. This process becomes self-actualizing as lower prices generate margin calls, which begets forced selling, more impatient (and frightened) sellers, and ever-lower prices.

This process can result in market (price) discontinuities, wherein prices gap from trade to trade, sometimes on very few shares actually being traded — an opportunity for the astute, patient investor who has time and cash on hand. The markets’ price trends are not something that happen to us; rather we are the market. Since we are the market, we can regard these discontinuities as times to act, rather than sitting passively. In other words, you are in charge of the market. The market is not in charge of you.

are in essence a function of The Law of the Marginal Buyer/Seller. This Law states that when an order is paired — say, 10,000 shares to buy, 10,000 shares to sell — it is the marginal (additional) shares that tilt the clearing price to a specific price level. In the example above, the 10,000 shares might be paired at $50 but an additional 100 shares to sell might cause the entire block to trade at $49 ¾, which impacts the quality of execution for the larger lot size.

Impatience affects both buyers and sellers, but for different reasons. Sellers grow impatient because they are time sensitive: there are margin calls to be met, Rule 144 and 145 Sales, etc. However, buyers can become impatient because they are price sensitive. The stock's rising price trend often manifests as incaution on the part of many buyers.

So where are we now?
Due to their flexibility, the institutions have bollixed themselves; they have taken a subset of price momentum theory and refined it, now unable to act decisively and in a timely manner. Previously, buy orders would be placed in stages below the market so as to be executed as the decline progressed, if a tradable were declining in price. This was helpful, as it smoothed volatility (and the intra-day charts), and lessened the opportunity for extreme market moves.

Today, however, when a stock is declining in price, most institutional buyers simply step aside without entering any orders to purchase. The result is a vacuum, a black hole down which prices plummet in gaps from one trade to the next. These institutions will not re-enter the fray with buy orders until the intraday chart shows a clear bottom, and the price now rises. For the markets, this means declining prices becomes one-sided, as buyers step away and the market is left to the sellers. When, instead, it rises, the buyers then, and only then, step in to buy, causing the price to move higher in gaps as the sellers now step aside. (The sellers are sold out anyway.) Though popularly termed volatility, in fact it is the market’s mechanisms and dynamics at work.

In their desire for better executions, lesser commissions, and lessened volatility these strategies which the institutions have deployed have had the diametrically opposite effect from what was originally intended: the markets now suffer from more volatility, less efficient markets, and worse executions.

So what’s an investor to do?

In brief, during each trading day, one is presented with the following possible actions:
1) The opportunity to buy;
2) The opportunity to sell;
3) The opportunity to do nothing at all;
4) The opportunity to panic.

The market does not control us and we cannot control the market, but by knowing ourselves as investors, and as individuals, we can take advantage of the occasional mess the markets become. Accept the fact that no matter what you do, you will be wrong. Remember that both sell-side and buy-side institutions are captive to a cage of their own design. We, you and I, can profit from their misguided notions. We can learn how to read these opportunities, and to seize them as they occur. As such, we remove ourselves from being the victim of the market’s vagaries.

There are some other things you can do to become an investor who embraces the uncertainties of the market. 

1) Stop watching CNBC. Stop scanning for news. Moreno’s Law states, “You will always be the last to hear the news/rumor,” so why insist upon confirming that fact?
2) Remember that the markets’ pricing mechanisms are a reflection of what we do not know, not what we do know. We invest today based upon our perception of tomorrow —for the company, its product, the sector, and the economy. Price itself is merely the memorialization of what occurs underneath the surface. There are market constituents who do the necessary investigative work to determine true value. Price itself is not value; it is risk. 

3) When you assess your investment opportunities, remember that profiting from the market’s trends is only one road to wealth, as it offers the opportunity to sail with the wind at your back. 
4) Begin to determine exactly why it is you purchase stocks. If your answer is because “they go up,” then consider what you will do when go down. Discern who you are so you can better invest your money/savings. As Warren Buffet asked, “Why should I risk what I have and what I need for what I don’t have and don’t need?”
5) Remember, too, why you are here. Incredible as it seems, not everyone invests or trades for the purpose of making money. Some prefer to spell profit as prophet.

Determine who you are. When you know who you are, the pain of being on the wrong side of the market will dissipate. You then can view all trends and Wall Street’s various schemes as opportunities that provide you with better executions than their elegant (but ineffectual strategies and solutions) ever could.

PS: For specific investment opportunities, price and timing included, please visit Investment Poetry.
-- David M Gordon / The Deipnosophist

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