Tagged: Counterparty Tuesday

Form Follows Function

We’re told that on Friday Jan 18, the Dow Jones Industrial Average soared on optimism about US-China trade, then abruptly yesterday “global growth fears” sparked a selloff.

Directional changes in a day don’t reflect buy-and-hold behavior, so why do headline writers insist on trying to jam that square peg every day into the market’s round hole?

So to speak.

It’s not how the market works. I saw not a single story (if you did, send it!) saying options expired Jan 16-18 when the market surged or that yesterday marked rare confluence of new options trading and what we call Counterparty Tuesday when banks true up gains or losses on bets.

Both events coincided thanks to the market holiday, so effects may last Wed-Fri.

The point for public companies and investors is to understand how the market works. It’s priced, as it always has been, by its purposes. When a long-term focus on fundamentals prevailed, long-term fundamentals priced stocks.

That market disappeared in 2001, with decimalization, which changed property rights on market data and forced intermediaries to become part of volume. Under Regulation National Market System, the entire market was reshaped around price and speed.

Now add in demographics.  There are four competing forces behind prices. Active money is focused on the long-term. Passive money is focused on short-term central tendencies, or characteristics. Fast Traders focus on fleeting price-changes. Risk Management focuses on calculated uncertainties.

Three of these depend for success on arbitrage, or different prices for the same thing. Are we saying Passive money is arbitrage?  Read on. We’ll address it.

Friday, leverage expired. That is, winning bets could cashier for stock, as one would with the simplest bet, an in-the-money call option. The parties on the other side were obliged to cover – so the market soared as they bought to fulfill obligations.

Active money bought too, but it did so ignorantly, unaware of what other factors were affecting the market at that moment.  The Bank for International Settlements tracks nearly $600 trillion of derivatives ranging from currency and interest-rate swaps to equity-linked instruments. Those pegged to the monthly calendar lapsed or reset Friday.

Behavioral volatility exploded Friday to 19%. Behavioral volatility is a sudden demographic change behind price and volume, much like being overrun at your fast-food joint by youngsters buying dollar tacos, or whatever. You run out of dollar tacos.

That happened Friday like it did in late September. The Dow yesterday was down over 400 points before pulling back to a milder decline.

And there may be more. But it’s not rational thought. It’s short-term behaviors.

So is Passive money arbitrage?  Just part of it. Exchange-Traded Funds (ETFs) were given regulatory imprimatur to exist only because of a built-in “arbitrage mechanism” meant to keep the prices of ETFs, which are valueless, claimless substitutes for stocks and index funds, aligned with actual assets.

Regulators required ETFs to rely on arbitrage – which is speculative exploitation of price-differences. It’s the craziest thing, objectively considered. The great bulk of market participants do not comprehend that ETFs have exploded in popularity because of their appeal to short-term speculators.

Blackrock and other sponsors bake a tiny management fee into most shares – and yet ETFs manage nobody’s money but the ETF sponsor’s. They are charging ETF buyers a fee for nothing so their motivation is to create ETF shares, a short-term event.

Those trading them are motivated by how ETFs, index futures and options and stocks (and options on futures, and options on ETFs) may all have fleetingly different prices.

The data validate it.  We see it. How often do data say the same about your stock?  Investors, how often is your portfolio riven with Overbought, heavily shorted stocks driven by arbitrage bets?

What’s ahead? I think we may have another rough day, then maybe a slow slide into month-end window-dressing where Passive money will reweight away from equities again.  Sentiment and behavioral volatility will tell us, one way or the other.

Ask me tomorrow if behavioral volatility was up today. It’s not minds changing every day that moves the market. It’s arbitrage.