Tagged: CBOE

The Mock

Does it matter where stock-trades occur, investors and public companies?

It does to the stock exchanges.  The explosion in passive investing has driven trades toward the last price of the day, found in stock-exchanges’ closing auctions.

Why?

Index and Exchange-Traded Funds need to track a benchmark in most cases. The bane of passive investing is skewing from the mean, called a tracking-error. The last price of the day is the reference price, the official one.  Money pegging a benchmark wants it.

It’s been profitable business for the big exchanges because they charge the same price to buy or sell into the close. Often at other times there’s a fee to buy but a credit to sell (they say “adding and removing” but don’t get lost in the jargon).

Orders to buy or sell may be “market-on-close,” (we’ll call it “the mock”) meaning at the best bid to buy or offer to sell as determined by matching up supply and demand, or “limit-on-close,” orders buying or selling at a specific price or better to end the day.

If you’re nodding off now or looking for the latest news on who might’ve won the Iowa Caucus, stay with me. There’s an important market-structure lesson coming.

Cboe (the erstwhile Chicago Board Options Exchange) operates four stock markets and just received SEC approval to be part of the closing auction, formerly controlled by the NYSE for stocks listed there, and the Nasdaq for stocks listed there.

The auction will occur at Cboe’s BZX market, likely at a set fee per share. It’s important to know that BZX encourages orders to sell, paying $0.30 per hundred shares, or even $0.32 if the shares first came from retail traders.  That means firms like Two Sigma might buy trades for $0.15 from Schwab and sell them at BZX for $0.32.

Why would an exchange pay so much for a trade?  Because it sets the price – and that’s valuable data to sell, worth more than the cost of paying for the trade.

But I digress.

So the Cboe will now use prices from the NYSE and the Nasdaq to match trades market-on-close for reference purposes.  No short trades, no limit orders. Only what the market giveth or taketh away.

Naturally, the NYSE and the Nasdaq opposed the Cboe plan. We wrote about it all the way back in Aug 2017, describing the cash at stake then.  The biggies argued expanding access to the closing auction would fragment liquidity.

Anyone can use order types from all the exchanges to fill trades. What difference does it make where trades occur if the rules from the SEC say the behavior must be uniform?

It’s like those heist movies where the robbers huddle beforehand and say “synchronize watches.” The market is a collection of synchronized watches at the close.

But overlooked amid the market mumbo-jumbo are the effects on trading the rest of the time – and we need to understand, investors and public companies.

Phil Mackintosh, now chief economist at the Nasdaq and always an interesting read, says, “The data show there are a lot of other investors, traders and hedgers who are also using the close because it’s a cheap way to get sizable liquidity with minimal market impact.”

True enough, it’s not all passive. By the way, MSCI indexes rebalance for the quarter today. The issue to us is the way that much of the trading throughout the rest of the day is an effort to change the prices of big measures into the close.

Traders know money chases reference prices.  So they change prices the rest of the day by running stocks up or down, and trading index futures, options, options on futures, or baskets of ETFs, creating divergences to exploit.

This becomes the market’s chief purpose – skewing prices and bringing them back to the mean (the hubris here is a story for next time).  Everyone thinks it’s fundamentals when the behavioral data show how pervasive this short-term pursuit has become.

How to solve it? Disconnect markets. That alone would halve the arbitrage opportunity.

Since that won’t happen, the best defense is a good offense. Know what all the money is doing, all the time (we can help), and you won’t be fooled. Or mocked.

The Vital Day

Which is the most important trading day of the month?

“The one when my company reports results,” you say.

Good guess, and you’re usually right. Not this time. It’s the last day.  Yesterday was it, the vital day of April, the benchmark for monthly fund-performance.

All funds want to clock results, punch the timer when the sprinter hits the tape. But it’s most true for money tracking a measure like the S&P 500.

CBOE, the giant derivatives and equities market operator, began in 2014 offering an options contract to “allow asset managers to more precisely match SPX option expirations to end-of-month fund cycles and fund performance periods.” SPX is the S&P 500. CBOE offers many ways for investors to improve tracking or profit on variances.

CBOE describes SPX securities as “flexible tools that allow investors to synthetically adjust their positions to a 500-stock portfolio.”

All three big exchange groups (NYSE, Nasdaq, CBOE) operate equity and derivatives markets, and all promote pricing advantages for firms trading equities and derivatives simultaneously.

That means, public companies and investors, these exchanges are encouraging traders to speculate. How often are prices of stocks affected by the prices of derivatives ranging from options on individual stocks to futures on indexes and ETFs?  (Heck, there are options on futures.)

Answer: Behavioral analytics ModernIR developed show that about 19% of volume marketwide the last five days ties to derivatives. By sector, Communication Services was highest at 20.6%; Industrials the lowest, 17.7%.

Active Investment by comparison was 11.2% of volume in Communication Services stocks, and 12.6% in Industrials (sellers, however).

AAPL, trading today on results, had 23% of volume on Apr 29 – $1.03 billion! – driven by derivatives-related trades. About 150 S&P 500 components, and hundreds of others, release this week.

Derivatives are bigger than investment. Do stocks then reflect fundamentals?

BK plunged Apr 17 – index options expired that day – and the biggest behavioral change was in Risk Mgmt, reflecting derivatives. Shorting peaked Apr 17. Bets preceding results were quantitative, and big. Math.  Active money then bought the dip.

SIRI dropped on results like a diver off a cliff, and over 23% of its trading volume beforehand traced to counterparties for derivatives bets.

TWTR exploded from about $34 to over $40 intraday on long (not short) derivatives bets made with new options that traded Apr 22, driving more than 20% of TWTR volume. Active money played no price-setting role and was a profit-taker on the move.

INTC rag-dolled down Apr 26 with results, on volumes approaching 80 million shares, and the biggest behavior was Risk Mgmt – counterparties to derivatives bets.

CHRW was 70% short and 25% of its trading volume tied to derivatives – a resounding bear bet – before shares blinked out this week to December levels.

Imagine the value you’d add – what’s your name, IR professional? Portfolio manager? – if you knew the behaviors behind price and volume BEFORE stocks went wild.

A lesson: 

Fast Traders arbitrage the tick. That is, computerized trades profit by churning many securities long and short fleetingly, netting gains. The more money seeks a measure – indexes, ETFs, closet indexers, money trying to beat a benchmark – the more machines change prices. Fast Trading is 42% of volume the past five days.

Passive investment must track the benchmark. ETFs need variance versus the index to price shares. That combination is 27% of volume.

Active money chasing superior stories defined by fundamentals is 12% of market volume the five days ended Apr 29. So, during earnings season stocks had a 1-of-8 chance of being priced by story.

Derivatives (Risk Mgmt to us at ModernIR) used by indexes to true up tracking and traders to profit on volatility are 19% of volume.

Got bad news to dump, companies? Do it the last three trading days of the month. You’ll get hammered. But then it’s done. Money will return in the new month. Investors, in the new month the stuff hammered to finish the last month could win.

There’s a vital day: The last trading day each month. It trumps story. You should understand it. We can help you.

Three Acts

Spain rocks.

We’re back from pedaling the Pyrenees and cruising the rollers of the Costa Brava on bikes, where the people, the food, the wine, the scenes, the art, the land and the sea were embracing and enriching.

To wit, we traversed 200 miles, thousands of feet of climbing and even walked some 40 miles around Barcelona and Girona and I still gained weight. But I wouldn’t trade a bite of Jamon Iberico or sip of rich red Priorat (I’ll let you look those up!).

After a night home we’re now in Chicago where I’ll speak today to the Investor Relations council for MAPI, the manufacturers’ association, on market structure, and tomorrow we’re in Austin for the NIRI Southwest Regional Conference where we sponsor and I’ll aim to rivet attendees with how IR should navigate modern markets.

Speaking of which, a perspective as September concludes this week that’s shaped by two weeks away and abroad might best work as journal entries:

Journal Entry #1:  CBOE to buy Bats Global Inc.

Years ago I sat in front of Joe Ratterman’s desk in the unassuming Lenexa, KS, BATS offices and talked about things ranging from market structure to Joe’s fondness for aircraft.  Joe is now chairman and should be able to afford a bigger plane.

But the thing to understand here is how the combination is a statement on markets. Derivatives and equities are interwoven with other asset classes. It’s what the money is doing. The market is a Rubik’s Cube where moving one square impacts others and strategies for traders and investors alike manifest in complex combinations (you clients see this all the time in our Patterns view in your Market Structure Reports).

The IR job is about building relationships with long-term money, sure. The challenge is to understand the process and method through which money moves into and out of shares. Without knowledge of the process and method, comprehension wanes – and it’s incumbent on IR to know the market. Investors and traders are not mere buyers or sellers now. Profit and protection often lie in a third dimension: Derivatives.

Journal Entry #2: The Tick Size Study. 

We reflected back to 2014 last week and revisited our comments from December that year. The exchanges at the behest of the SEC are at last embarking next month on a study of bigger spreads for buying and selling small-cap stocks to boost trading activity.

It’s a fundamentally correct idea except for one problem. And you’d think, by the way, that the Federal Reserve could grasp this pedestrian concept. Where spreads are narrow, products and services commoditize and activity moves to the path of least resistance. You understand? Low interest rates shift focus from long-term capital investment to short-term arbitrage.  Low market spreads do the same to stocks.

But the problem is the National Market System. It’s an oxymoron. Something cannot simultaneously be a market – organic commercial interaction – and a system – a process or method.  There’s either a market, or a process and method. The SEC wants to tweak the process and method to revitalize organic commercial interaction. Well, if organic commercial interaction is better, why not just eliminate the system?  The Tick Size Study is a good idea trapped within a process and method that will likely desiccate it of benefit.

Journal Entry #3:  The Market.

It too is matriculating in a process and method.  We had the Great Recession, as those who take credit for halting say.  The process and method for constraining it (for now) could be called the Great Intervention.  The third step is the Great Risk Asset Revaluation, currently underway.

In August 2014 the Fed’s balance sheet stopped expanding as the Great Intervention that followed the Great Recession halted.  In latter 2014 the stock market stopped rising. So long as the Fed’s balance sheet increased, the supply of money via credit did too, and that money chased a decreasing supply of product – stocks (because public companies are buying back more shares than they issue, collectively).  There are today fewer public companies than in 2008.  Stocks are trading roughly where they did in December 2014.

Something to ponder:  Generally when growth stocks experience slowing revenues (see Twitter for instance) or earnings, shares fall. The stock market has been in a year-long recession for both. Never in modern history has the economy not also been in recession when that occurred, nor has the market failed to retreat. That it hasn’t is testament to the inertia – a tendency to remain in a uniform state of motion – created by Intervention.

It’ll stop. And stop it must.  We’ll never have a “normal” market until then, so see it cheerfully and not with fear (inertia can last a long time too). Catch you in October.