Tagged: Expirations

Substitutes

Substitutes were responsible for yesterday’s market selloff.

Remember back in school when you had substitute teachers? They were standing in for the real deal, no offense to substitutes.  But did you maybe take them a little less seriously than the home room teacher?

The market is saturated with substitutes. The difference between stocks and the home room back in grammar school is nobody knows the difference.

If shares are borrowed they look the same to the market as shares that are not borrowed.  If you use a credit card, the money is the same to the merchant from whom you just bought dinner or a summer outfit. But it’s a substitute for cash you may or may not have (a key statistic on consumption trends).

Apply to borrowed stock. The average Russell 1000 stock trades $235 million of stock daily, and in the past 50 trading days 46%, or $108 million, came from borrowed shares. The Russell 1000 represents over 90% of market capitalization and volume. Almost half of it is a substitute.

Why does it matter?  Suppose half the fans in the stands at an athletic event were proxies, cardboard cutouts that bought an option to attend a game but were there only in the form of a Fathead, a simulacrum.

The stadium would appear to be full but think of the distortions in player salaries, costs of advertisement, ticket prices.  If all the stand-ins vanished and we saw the bleachers were half-empty, what effect would it have on market behavior?

Shorting is the biggest substitute in the stock market but hardly the only one.  Options – rights to buy shares – are substitutes. When you buy call options you pay a fee for the right to become future demand for shares of stock.  Your demand becomes part of the audience, part of the way the market is priced.

But your demand is a Fathead, a representation that may not take on greater dimension. Picture this:  Suppose you were able to buy a chit – a coupon – that would increase in value if kitchen remodels were on the rise.

Your Kitchen Chit would appreciate if people were buying stoves, fridges, countertops, custom cabinets.  Now imagine that so many people wanted to invest in the growth of kitchen remodels that Kitchen Chits were created in exchange for other things, such as cash or stocks.

What’s the problem here?  People believe Kitchen Chits reflect growth in kitchen remodels. If they’re backed instead by something else, there’s distortion.  And buying and selling Kitchen Chits becomes an end unto itself as investors lose sight of what’s real and focus on the substitute.

It happens with stocks. Every month options expire that reflect substitutes. This kitchen-chit business is so big that by our measures it was over 19% of market volume in the Russell 1000 the past five days during April options-expirations.

It distorts the market.  Take CAT.  Caterpillar had big earnings. The stock was way up pre-market, the whole market too, trading up on futures – SUBSTITUTES – 150 points as measured by the Dow Jones Industrial Average.

But yesterday was Counterparty Tuesday, the day each month when those underwriting substitutes like options, futures, swaps, balance their books.  Suppose they had CAT shares to back new options on CAT, and they bid up rights in the premarket in anticipation of strong demand.

The market opened and nobody showed up at the cash register. All the parties expecting to square books in CAT by selling future rights to shares at a profit instead cut prices on substitutes and then dumped what real product they had.  CAT plunged.

Extrapolate across stocks. It’s the problem with a market stuffed full of substitutes. Yesterday the substitutes didn’t show up to teach the class. The market discovered on a single day that when substitutes are backed out, there’s not nearly so much real demand as substitutes imply.

Substitution distorts realistic expectations about risk and reward. It’s too late to change the calculus. The next best thing is measuring substitutes so as not to confuse the fans of stocks with the Fatheads.

Side Deals

Yesterday on what we call Counterparty Tuesday, stocks plunged.

Every month options, futures and swaps expire and these instruments represent trillions of notional-value dollars. Using an analogy, suppose you had to renew your homeowners insurance each month because the value of your house fluctuated continually.  Say there’s a secondary market where you can trade policies till they expire. That’s like the stock market and its relationship to these hedging derivatives.

As with insurance, somebody has to supply the coverage and take the payout risk. These “insurers” are counterparties, jargon meaning “the folks on the other side of the deal.”  They’re banks like Deutsche Bank, HSBC, Morgan Stanley, Citi.

Each month the folks on the other side of the deal offer signals of demand for insurance, a leading indicator of investor-commitment. We can measure counterparty impact on market volume and prices because we have an algorithm for it.  Last week (Feb 17-19) options and futures for February expired and the folks on the other side of the deal dominated price-setting, telling us that trading in insurance, not the assets themselves, was what made the market percolate. That’s profoundly important to understand or you’ll misinterpret what the market is doing.

On Monday Feb 22, a new series of derivatives began trading. Markets jumped again. Yesterday on Counterparty Tuesday, the folks on the other side of the deal told us they overshot demand for options and futures or lost on last week’s trades.  And that’s why stocks declined.

The mechanics can be complicated but here’s a way to understand. Say in early February investors were selling stocks because the market was bearish. They also then cut insurance, for why pay to protect an asset you’re selling (yes, we see that too)?

Around Feb 11, hedge funds calculating declines in markets and the value of insurance and the distance to expirations scooped up call options and bought stocks, especially ones that had gone down, like energy and technology shares and futures.

Markets rose sharply on demand for both stocks and options. When these hedge funds had succeeded in chasing shares and futures up sharply in short order, they turned to the folks on the other side of the deal and said, “Hi. We’d like to cash these in, please.”

Unless banks are holding those stocks, they’re forced to buy in the market, which drives price even higher. Pundits say, “This rally has got legs!” But as soon as the new options and futures for March began trading Monday, hedge funds dumped shares and bought puts – and the next day the folks on the other side of the deal, who were holding the bag (so to speak), told us so. Energy stocks and futures cratered, the market swooned.

It’s a mathematical impossibility for a market to sustainably rise in which bets produce a loser for every winner. If hedge funds are wrong, they lose capacity to invest.  If it’s counterparties – the folks on the other side of the deal – the cost of insurance increases and coverage shrinks, which discourages investment.  In both cases, markets flag.

Derivatives are not side deals anymore but a dominant theme. Weekly options and futures now abound, more short-term betting. Exchange-Traded Funds (ETFs), derivatives of underlying assets, routinely populate lists of most active stocks. Both are proof that the tail is wagging the dog, and yet financial news continues casting about by the moment for rational explanations.

Every day we’re tracking price-setting data (if you don’t know what sets your price the problem is the tools you’re using, because it’s just math and rules).  Right now, it’s the counterparties. Short volume remains extreme versus long-term norms, telling us horizons are short. Active investment is down over $3 billion daily versus the long-term.

You can and should know these things. Stop doing what you’ve always done and start setting your board and your executives apart. Knowledge is power – and investor-relations has it, right at our fingertips.

Options Expirations and Earnings Reports

If you want a belly laugh and a breath of fresh air, read John Cochrane’s oped on the treasury secretary in today’s Wall Street Journal.

Speaking of news, a common headline in web news strings for clients is: “Preparing for (fillintheblank’s) Earnings Announcement with an Option Straddle.”

Seen that? Traders wait for companies to say when they’ll report results. They prefer if you do it a few weeks ahead so they can get cheap puts and calls. Just days between your announcement and earnings, and options may be in high demand and limited supply. It’s a lesson, IR professionals, about modern markets. (more…)

Goldman Sachs or Expirations?

We hope none of you are marooned in Europe by volcanic ash. If you are, we’ll try to keep your minds off the extra money you’re spending with the shocking suggestion that markets writhed last week not for Goldman Sachs but for expirations.

The SEC last week sued Goldman Sachs for misleading investors about certain collateralized debt obligations during the subprime mortgage meltdown. (more…)

The derivative we need is a weather swap. The Winter Olympics would pay a premium for that spare snow lying around unused on the east coast.

Speaking of derivatives, the dollar retreated today, and US equities rebounded. We all want it to be about investing. Commentary everywhere today polished bullishness to an economic sheen. But that won’t make it reflect reality. Money keeps buying short-term love because the direction of the dollar is like a blacksmith’s bellows on equities. (more…)