Tagged: Options

Counterparty Tuesday

Anybody hear yesterday’s volatility blamed on Counterparty Tuesday?

Most pointed to earnings fears for why blue chips fell 500 points before clawing back.  Yet last week the Dow Jones Industrial Average zoomed 540 points on earnings, we were told.  We wrote about it.

Counterparty Tuesday is the day each month following expiration of the previous month’s derivatives contracts like puts, calls, swaps, forwards (usually the preceding Friday), and the start of new marketwide derivatives contracts the following Monday.

When grocery stores overstock the shelves, things go on sale.  When counterparties expect a volume of business that doesn’t materialize, they shed the inventory held to back contracts, which can be equities.

Counterparty Tuesday is a gauge indicating whether the massive derivatives market – the Bank for International Settlements tracks over $530 trillion, ten times the global economy – is overstocked or understocked. It’s much larger than the underlying volume of Active Investment behavior in the US stock market.

Let me use a sports analogy. Suppose your favorite NFL team is beating everyone (like the LA Rams are).  “They are killing everybody through the air,” crow the pundits.

You look at the data. The quarterback is averaging five passes per game and zero touchdowns.  But on the ground, the team is carrying 40 times per game and averaging four rushing touchdowns.

These statistics to my knowledge are fake and apply to no NFL team right now. The point is the data don’t support the proffered explanation. The team is winning on the ground, not through the air.

In the same vein, what if market volatility in October ties back to causes having no direct link to corporate earnings?

What difference does it make if the stock market is down on earnings fears or something else?  Because investor-relations professionals message in support of fundamental performance, including earnings.  Boards and management teams are incentivized via performance. Active stock-picking investors key off financial performance.

If the market isn’t swooning over performance, that’s important to know!

Returning to our football analogy, what data would help us understand what’s hurting markets?  Follow the money.

We wrote last week about the colossal shift from active to passive funds in equities the past decade.  That trend has pushed Exchange-Traded Funds toward 50% of market volume. When passive money rebalanced all over the market to end September, the impact tipped equities over.

Now step forward to options expirations, which occurred last week, new ones trading Monday, and Counterparty Tuesday for truing up books yesterday. Money leveraged into equities had to mark derivatives to market. Counterparties sold associated inventory.

Collateral has likely devalued, so the swaps market gets hit. Counterparties were shedding collateral. The cost of insuring portfolios has likely risen because counterparties may have taken blows to their own balance sheets. As costs rise, demand falters.

Because Counterparty Tuesday in October falls during quarterly reporting, it’s convenient to blame earnings. But it doesn’t match measurable statistics, including the size of the derivatives market, the size and movement of collateral for ETFs (a topic we will return to until it makes sense), or the way prices are set in stocks today.

The good news?  Counterparty Tuesday is a one-day event. Once it’s done, it’s done. And our Market Structure Sentiment index bottomed Oct 22. We won’t be surprised if the market surges – on earnings enthusiasm? – for a few days.

The capital markets have yet to broadly adapt to the age of machines, derivatives and substitutes for stocks, like ETFs, where earnings may pale next to Counterparty Tuesday, which can rock the globe.

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.

Looking Back: Dec 2015

In New York City, it’s beginning to look a lot like Christmas around Rockefeller Center and it feels more like it here than in Denver where we hear yesterday it was 66 degrees (on Dec 12!).

In the weather forecast today is a probable Federal Reserve rate hike, followed by index-options expirations Thursday, quad-witching Friday along with quarterly index rebalances, and volatility expirations next Wednesday.

The market’s Teflon character the past year means we have to go back to Dec 2015 to recall risk. Remember when the Fed lifted rates for the first time since 2006?  We went to sea to avoid the fallout. Read on. -TQ

 

Dec 9, 2015: The Vacuum

Looking around at the market, we decided the only thing to do is go to St. Maarten.  Safely at sea, we’ll wait out options-expirations and the Fed meeting next week and return Dec 21 to tell you what we saw from afar.

What’s up close is volatility. Monday in US equities 100 stocks were down 10% or more. And NYSE Arca, the largest marketplace for ETFs, announced that it would expand the ranges in which securities can trade following a halt.  Where previous bands were 1-5% depending on the security’s price, new rules to take effect soon double these ranges.

Energy, commodity and biotech stocks led Monday decliners and we had clients in all three sectors down double digits. Yet just 15 ETFs swooned 10% or more. How can ETFs holding the same stocks falling double digits drop less? The simplest explanation is that the ETFs do not, in fact, own the underlying stocks.

We return to these themes because they’re why markets are not rational. Your management teams, investor-relations professionals, should understand what’s made them this way.

Suppose ETFs substitute cash for securities. How does net asset value in the ETF adjust downward to reflect pressure on the indexes ETF track if the ETFs hold dollars instead?  This would seem good.  But it enriches ETF authorized participants, brokers ordained to maintain supply and demand in ETFs, who the next day will sell ETF shares and buy the underlying stocks (just 12 stocks were down double-digits yesterday).

What we hear from clients is, “The action in my shares seems irrational. I don’t understand how we could drop 15% on a 5% decline in oil.” It’s bad enough that oil dropped 5% in a day.  And lest you think your sector is immune, what’s afflicting energy could shift any time to other sectors. How? Four factors:

Arbitrage. The stock market today appears to be packed with more arbitrage – by which we mean pursuing profits in short-term divergences – than any other market in history. There’s index arbitrage, ETF arbitrage, sector arbitrage, derivatives arbitrage, multi-asset-class arbitrage, currency arbitrage, latency arbitrage, market-making arbitrage, long-short arbitrage and rebate arbitrage. A breathtaking amount of price-activity in the market can disappear the moment gaps present too great a risk for short-term traders.

Risk-transfer. There is insurance for everything, and that includes equity-exposure. Rules against risk-taking have sharply reduced the number of parties capable of providing insurance. When these big counterparties begin to experience losses, they dump assets to prevent further loss, exacerbating price-pressure. And what if they quit entirely?

Derivatives. Any instrument that substitutes for ownership is credit, and that’s what derivatives are. ETFs do it.  Options and futures do.  Swaps.  Currencies.  What things trade more than all the rest?  These.  The market is astonishingly reliant on credit.

Illiquidity.  There may be no harder-edged jargon than the word “liquidity.” It means ready supply of something. If you need it right now, can you get it, and how much, and at what cost? The stock market with $25 trillion of value is extraordinarily short on the product that this value seems to reflect, because of the three other items above.

Who’s to blame? In Bell, CA, the municipal government became profligate because the people it served stopped paying attention. The market is yours, public companies. That it’s stuffed with arbitrage is partly our fault. Companies spend millions on enterprise-resource planning software to track every detail. Yet the backbone of the balance sheet is public equity and an alarming number have no idea how they’re priced or by what. To that end, read our IEX exchange-application letter.

The IR profession can correct this problem by leading the effort to end the information vacuum. It starts with understanding what in the world is going on out there, and it continues through insisting that management learn something about market structure.  A task: Follow the cash. When your listing exchange next reports results, read them and see how it makes money.

Core Reality

“Our stock dropped because Citi downgraded us today.”

So said the investor-relations chief for a technology firm last week during options-expirations.

For thirty years, this has been the intonation of IR. “We’re moving on the Goldman upgrade.”  “UBS lifted its target price, and shares are surging.” “We’re down on the sector cut at Credit Suisse.”

But analyst actions don’t buy or sell stocks.  People and machines do. Thirty years ago you could be sure it was people, not machines.  Now, machines read news and make directional bets. And why is a sellside firm changing its rating on your stock smack in the middle of expirations?

We’ll get to that. Think about this. Investors meet with you privately to learn something about your business or prospects somebody else might overlook.  Analyst actions are known to all. You see it on CNBC, in new strings, from any subscription feed.

How could it be uniquely valuable information proffering investment opportunity?

Let me phrase it this way. Why would a sellside firm advertise its views if those are meant to differentiate?  If you’re covered by 50 analysts with the same view, how is that valuable to anyone?

Indexes and exchange-traded funds track benchmarks. Call them averages.  Brokers must give customers prices that meet averages, what’s called “Best Execution.” If most prices are average, how are we supposed to stand out?

Now we get to why banks change ratings during expirations. Citi knows (Citi folks, I’m not picking on you. Bear with me because public companies need to learn stuff you already know.) when options expire. They’re huge counterparties for derivatives like options, swaps, forwards, reverse repurchases.

In fact, yesterday’s market surge came on what we call “Counterparty Tuesday,” the day each month following expirations when the parties on the other side of hedged or leveraged trades involving derivatives buy or sell to balance exposure. They were underweight versus bets (our Sentiment Index bottomed Monday, signaling upside).

Sellside research is a dying industry. Over 40% of assets now are in passive-investment instruments like index and exchange-traded funds that don’t buy research with trading commissions as in the old days.

How to generate business?  Well, all trades must pass through brokers.  What about, say, nudging some price-separation to help trading customers?

How?  One way is right before the options on stocks are set to lapse you change ratings and tell everyone.  No matter who responds, from retail trader, to high-speed firm, to machine-reading algorithm, to counterparty backing calls, it ripples through pricing in multiple classes (derivatives and stocks).  Cha-ching. Brokers profit (like exchanges) when traders chase spreads or bet on outcomes versus expectations.

We’re linear in the IR chair. We think investors buy shares because they might rise, and sell them when they think they’re fully valued. But a part of what drives price and volume is divergences from averages because that’s how money is made.

In this market of small divergences, your shares become less an investment and more an asset to leverage. Say I’m a big holder but your price won’t diverge from the sector. I get a securities-lending broker and make your shares available on the cheap.

I loan shares for trading daily and earn interest. I “write” puts or calls others will buy or trade or sell, and if I can keep the proceeds I boost yield.

I could swap my shares for a fee to the brokers for indexes and ETFs needing to true up assets for a short time.  I could sell the value of my portfolio position through a reverse repurchase agreement to someone needing them to match a model.

Here’s why traders rent. Say shares have intraday volatility – spread between daily highest and lowest prices – of 2%, the same as the broad market. A high-speed algorithm can buy when the price is 20 basis points below intraday average and sell when it’s 20 basis points over (rinse, repeat).

If the stock starts and finishes the month at $30, the buy-and-hold investor made zero but the trader capturing 20% of average intraday price volatility could generate $4.80 over the month, before rental fees of say half that (which the owner and broker share).  That’s an 8% return in a month from owning nothing and incurring no risk!

Let’s bring it back to the IR chair.  We’d like to think these things are on the fringe. Interesting but not vital. Across the market the past twenty days, Asset Allocation was 34% of daily volume. Fast Trading – what I just described – was 37%. Risk Management (driving big moves yesterday) was almost 14% of volume.

That’s 85%. The core reality. Make it part of your job to inform management (consistently) about core realities. They deserve to know! We have metrics to make it easy, but if nothing else, send them an article each week about market-function.

Verve and Sand

The whole market is behaving as though it’s got an Activist shareholder.

In a sense it does.  More on that in a minute.

We track the effects of Activism on trading and investment behaviors both before it’s widely known and afterward. A hallmark of these event-driven scenarios is behavioral volatility. That is, one or more of the big four reasons investors and traders buy and sell stocks routinely fluctuates day-over-day by more than 10% in target companies.

(Aside: Traders and investors buy and sell stocks for their unique characteristics, when they have characteristics shared by others, to profit on price-differences, and to leverage or protect trades and portfolios. The market at root is just these four simple purposes.)

Event-driven stocks can override normal constraints such as Overbought conditions, high short volume, or bearish fundamentals.  In fact, short volume tends to fall for catalyst stocks because the cost of borrowing shares rises as more want to own rather than rent, and unpredictability of outcomes makes borrowing shares for trading riskier.

Currently in the broad market, shorting trails the 200-day average marketwide. The market has manifested both negative and overbought sentiment and has still risen.

And behavioral volatility is off the charts.

Almost never does the broad market show double-digit fluctuations in behavior because it’s a giant index smoothing out lumps. With quad-witching and quarterly index rebalances Dec 16, Asset Allocation ballooned 16.3% marketwide, signaling that indexes and ETFs are out of step with assets (and may be substituting).

Also on Dec 16, what we call Risk Management (protecting or leveraging trades and portfolios) jumped 12%. It’s expected because leverage with derivatives has been pandemic in markets, with Active Investment and Risk Management – a combination pointing to hedge funds – currently leading.

Here’s the thing. The combined increase for the two behaviors last Friday was an astonishing 28%.  Then on Dec 19 as the new series of marketwide derivatives issued, Fast Trading – profiting on price-differences – exploded, jumping 25%.

A 25% change for a stock trading $100 million of dollar-volume daily is a big deal. The stock market is about $300 billion of daily dollar-volume.

Picture a skyscraper beginning to sway.

Looking back, Risk Management jumped 16% with July expirations, the first after searing Brexit gains. The market fell from there to September expirations when again behavioral volatility exploded. The market recovered briefly before falling all the way to the election. With expirations Nov 18, Risk Management shot up 11.2%.

Behavioral volatility precedes price-volatility. We have it now, monumentally.

What’s happened in the broad market is a honeymoon before the wedding. The incoming Trump administration has sparked an investing surge betting on a catalyst – exactly the way Activist investors affect individual stocks.  Fundamentals cease to matter.  Supply and demand constraints go out the window. A fervor takes hold.

The one thing our long bull market has lacked is fervor. It’s the most hated – and now second longest ever – bull market for US stocks because so many have loathed the monetary intervention behind ballooning asset prices.

That’s all been forgotten and a sort of irrational exuberance has set in.

Those who know me know I embrace in libertarian fashion broad individual liberty and limited government because it’s the environment that promotes prosperity best for all. I favor a future with more of it.

We should get the foundation right though. I’ll use a metaphor.  Suppose a giant storm lashes a coast, burying it in sand. Some return to the beach to rebuild homes and establishments but much lies listlessly beneath a great grainy coat.

Then a champion arrives and urges people to build. The leader’s verve lights a fire in the breasts of the people, who commence building a vast structure.

Right on the sand.  Which lies there still unmoved, a shifting layer beneath the mighty edifice rising upon it.

It’s better to remove the sand – all the central-bank buildup from artificial prices, the manufactured money, the warped credit markets.  Otherwise when the next wave comes the damage will be that much greater.

So call me wary of this surge.

A Year Ago

In Luckenbach, Texas, ain’t nobody feeling no pain. We were just there and I think the reason is the bar out the back of the post office.

A country song by that name about this place released in 1977 by Waylon Jennings begins by asserting that only two things make life worth living, one of which is strumming guitars.

In equities, what makes life worth living is certainty.  TABB Forum, the traders’ community, had a piece out yesterday on the big decline in listed options volume, off 19% from last July to a 14-month low. TABB attributed the drop to falling demand for hedges since the Brexit, the June event wherein the UK voted to leave the European Union and exactly nothing happened.

The folks at Hedgeye, responding to a question about whether volume matters anymore since it’s dried up as stocks have risen to records said, paraphrasing, big volume on the way down, low volume on the way up, is as valid as it ever was for investors wary of uncertain markets and means what you think it does. You should be selling on the way up so you don’t have to join those people distress-dumping on the way down.

I got a kick out of that. Sure enough, checking I found that SPY, the world’s most active stock (an ETF) traditionally trading $25 billion daily is down to $11 billion.  Whether it’s August is less relevant than volume.

On August 24 a year ago, the market nearly disintegrated on a wildly delirious day.  August options-trading set a near-period record.

Now what’s that mean to investor-relations folks trying to understand stock-valuation and trading? We’ve long said that behavioral volatility precedes price-volatility. You can apply it anything. As an example, if housing starts plunge, that’s behavioral volatility.  If a movie starts strong and viewership implodes the second week, that’s behavioral volatility.  Both point to future outcomes.

We track market behaviors. They tend to turbulence anyway around options-expirations, which occurred in the past week, and August 2016 was no exception.  On Aug 19, triple-witching, Asset Allocation (investment tracking a model such as indexes and ETFs) surged nearly 11%, Risk Management – counterparties for derivatives – by 3%.

It’s the double-digit move that got our attention.  Double-digit behavioral change is a key indicator of event-driven activity, or trading and investing following a catalyst such as Activism or deal-arbitrage.  It’s very rare in the whole market.

We also tracked a whopping jump since Aug 15 in Rational Prices, or buying by fundamental money.  When it’s coupled with hedging, it implies hedge-fund behavior.  In effect, the entire market was event-driven under the skin yet not by news. Nor did it manifest in prices or volume (Activism also routinely does not).

We’ve got one more data point for this puzzle. Volatility halts in energy, metals and emerging-markets securities have returned after vanishing in June and July.  Remember, market operators have implemented “limit-up, limit-down” controls to stop prices from moving too much in a short period.

So though the VIX is dead calm other things are moving.  Short volume marketwide is nearly identical (44%) to where it was in latter November preceding December volatility and the January swoon.

We conclude that currency volatility may surge, explaining volatility halts in commodities.  Hedge funds are shifting tactics. The dearth of options trading may rather than mean a lack of hedging instead signal the absence of certainty.

Pricing options accurately requires knowing prices of the underlying securities, plus volatility, plus time.  Volatility isn’t the faulty variable. It’s got to be either the prices of the underlying or the uncertainty of time.

Now it may be nothing. But our job here is to help you understand the market’s contemporary form and function. If behavioral volatility precedes change, then we best be ready for some.  We may all want to pull on the boots and faded jeans and go away.

But hang onto your diamond rings (and that’s all the obscure country-music humor I’ve got for today!).

Rational Signals

The market message appears to be: If you want to know the rest, buy the rights.

While rival Nintendo is banking on Pokemon Go, Sony bought the rights to Michael Jackson’s music catalog for an eye-popping $750 million. This may explain the sudden evaporation of Jackson family discord. Cash cures ills.

In the equity market, everybody buys the rights to indexes and exchange-traded funds. TABB Group says indexes and ETFs drove 57% of June options volume, with ETFs over 45% of that and indexes the balance. TABB credits money “rushing into broad-market portfolio protection” around the Brexit.

Could be.  But that view supposes options are insurance only.  They’re also ways to extend reach to assets, tools for improving how portfolios track underlying measures and substitutes for stock positions. I’ve wondered about the Russell rebalances occurring June 24 as the Brexit swooned everything, and whether indexers were outsized options buyers in place of equity rebalancing – which then aided sharp recovery as calls were used.

We can see which behaviors set price every day.  On June 24, the day of the dive, Asset Allocation – indexes and ETFs primarily – dominated.  On June 27 Fast Traders led but right behind them was Risk Management, or counterparties for options and futures.

The tail can wag the dog. The Bank for International Settlements tracks exchange-traded options and futures notional values. Globally, it’s $73 trillion (equaling all equity markets) and what’s traded publicly is about half the total options and futures market.

Sifma, the lobbying arm of the US financial industry, pegs interest-rate derivatives, another form of rights, at more than $500 trillion. You’d think with interest rates groveling globally (and about 30% of all government bonds actually digging holes) that transferring risk would be a yawn.  Apparently not.  You can add another $100 trillion in foreign-exchange, equity and credit-default swaps tracked by Sifma and the BIS.

Today VIX derivatives expire. The CBOE gauge measures volatility in the S&P 500.  Yesterday VXX and UVXY, exchanged traded products (themselves derivatives), traded a combined 90 million shares, among the most actively traded stocks. Yet the VIX is unstirred, closing below 12. Why are people buying volatility when there’s none? For perspective, it peaked last August over 40 and traded between 25-30 in January and February this year and again with the Brexit in late June.

The answer is if the VIX is the hot potato of risk, the idea here isn’t to hedge it but to trade the hot potato. And for a fear gauge the VIX is a lousy leading indicator.  It seems only to point backward at risk, jumping when it’s too late to move. Maybe that’s why everybody buys rights?  One thing is sure: If you’re watching options for rational signals, you’ll be more than half wrong.  Might as well flip a coin.

We learned long ago that rational signs come only from rational behavior. In the past week right through options-expirations starting Thursday the 14th, Active Investment was in a dead heat with Risk Management, the counterparties for rights. That means hedge funds were everywhere trying to make up ground by pairing equities and options.

But options have expired.  Do hedge funds double down or is the trade over?  Short volume has ebbed to levels last seen in November, which one might think is bullish – yet it was the opposite then.

Lesson: The staggering size of rights to things tells us focus has shifted from investment to arbitrage. With indexes and ETFs dominating, the arbitrage opportunity is between the mean, the average, and the things that diverge from it – such as rights.

Don’t expect the VIX to tell you when risk looms. Far better to see when investors stop pairing shares and rights, signaling that the trade is over.

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.

Volatility

You’ve heard the saying that’s it all in your perspective. It applies to volatility.

Volatility is up 150% since the post-financial-crisis nadir of 10.32 for VIX Volatility in mid-2014. The “Fear Index” closed yesterday over 26, the highest since August 2015 when it topped 28 (way below 43 in 2011 and nearly 80 in 2008). VIX expirations are hitting today.

I’ve been seeing Mohamed El-Erian, whom I admire, chief economic advisor to Allianz and former right hand to Bill Gross at PIMCO, also now gone from the bond giant, on the business TV circuit saying central banks are ending programs designed to dampen financial volatility.

I think he’s got a point, and he means they’re starting to broaden trading ranges in everything from interest rates to currencies (as if we want them setting prices). But volatility is price-uncertainty reflecting evolving valuation.  Conventional measures often fail to reveal change because behaviors in markets morph while the metrics used to understand them don’t.

Figure 1

Figure 1

I can prove it.  In the first chart here (Figure 1), a small-capitalization technology stock on the Nasdaq hasn’t moved much in the year ended Dec 16, 2015 (I’ll explain that date shortly) but the stock rose from a 200-day average price of $20.67 to a five-day mean of $21.05, up 1.8%.  Not too great – but the Russell 2000 Index was off 1.3% in the year ended Dec 16, 2015. Perspective matters.

Now notice:  Daily volatility, or the difference between highest and lowest prices each day, is greater than the change in average price in all four periods.  Think about that. The price changes more every day than it does in moving averages for months and quarters.

Now see Figure 2 showing short volume Dec 1, 2015-Jan 15, 2016 for the same stock. The upper half is long volume (owned shares), the bottom short volume, or rented stock. The blue line is closing price. The data further back show short volume over the trailing 200 days averaged 60.2% daily.

Figure 2

Figure 2

Combine the charts. The stock moved less than 2% on average over the entire period but 60% of the shares trading every day were borrowed, and the spread between high and low prices was nearly 3% every single day.

Do you understand? On the surface this stock is not volatile. But up close it’s torrid – on rented shares. For a solid year, traders have kept this stock in stasis by borrowing and trading, borrowing and trading, because the cost of borrowing was substantially lower than daily price-movement. That’s market-neutral arbitrage.

Everything changed recently. Short volume in Figure 2 plunged Dec 22, 2015.  On Dec 16 (here’s that date now) the Federal Reserve bumped short-term rates to 0.25-0.50%. On Dec 17-18 vast swaths of interest-rate swaps tied to options-expirations lapsed. On Dec 21, the new series of options and futures (and interest-rate swaps) began trading. And on Dec 22, our small-cap’s short volume imploded, finally landing at 33% Jan 11, down from 71% Dec 10, a decline of 54%.

We’ve slung numbers here, I know. But the conclusion is simple. Whatever traders were doing in this small-cap, the Fed’s rate-hike ended it.  We think that’s good. But markets have been addicted for years to cheap credit, which includes borrowing shares for next to nothing, which shifts attention from long-term owning to short-term renting. That changed when the Fed bumped rates. And equites corrected.

There’s another lesson by extension.  What sets your stock’s price may be radically different than you think.  We’ve offered one example that shows short-term borrowing fueled persistent volatility trading masked by apparent long-term placidity. When interest rates crept up minutely, the strategy stopped working.

What’s your stock show?  Price-performance isn’t story alone, perhaps even over the long run, as we’ve just shown. There’s so much to see when measurements reflect current behavior (as ours do). Volatility is price-uncertainty that thanks to policies promoting short-term behavior is now concentrated intraday.  Sorting this out will take time. We won’t change seven fat years with a lean month. The good news is it’s all measurable.

Weighing Options

There’s no denying the connection between tulips and derivatives in 1636.

The Dutch Tulip Mania is often cited as the archetype for asset bubbles and the madness of crowds. It might better serve to inform our understanding of derivatives risk. In 1636, according to some accounts, tulip bulbs became the fourth largest Dutch export behind gin, herring and cheese. But there were not enough tulips to meet demand so rights were optioned and prices mushroomed through futures contracts. People made and lost fortunes without ever seeing a tulip.

While facts are fuzzy about this 17th century floral fervor, there’s a lesson for 2016 equities. Grasping the impact of derivatives in modern equities is essential but options are an unreliable surveillance device for your stock.

I’ll explain. ModernIR quantifies derivatives-impact by tracking counterparty trade-executions in the percentage of equity volume tracing to what we call Risk Management. We can then see why this implied derivatives-use is occurring.

For instance, when Risk Management and Active Investment are up simultaneously, hedge funds are likely behind buying or selling, coupling trades with calls or puts. If Risk Management is up with Fast Trading, that’s arbitrage between equities and derivatives like index options or futures, suggesting rapidly shifting supply and demand (and therefore impending change in your share-price). Options won’t give you this linkage.

Dollar-volumes in options top a whopping $110 billion daily. But 70% of it is in ETFs.  And almost 48% ties to options for a single ETF, the giant SPY from State Street tracking the S&P 500.

As Bloomberg reported January 8, SPY is a leviathan instrument. Its net asset value would rank it among the 25 largest US equities, ahead of Disney and Home Depot. It trades over 68 million shares daily, outpacing Apple. It’s about 14% of all market volume.  Yet trading in its options are 48% of all options volume – three times its equity market-share.

Why? Bloomberg’s Eric Balchunas thinks traders and investors are shifting from individual equity options where demand has been falling (further reason to question options for surveillance) into index options. SPY is large, liquid and tied to the primary market benchmark.

Bigger still is that size (pun intended) begets size, says Mr. Balchunas. Money has rushed – well, like a Tulip Mania – into ETFs. Everyone is doing the same thing. And just a handful of firms are managing it.  Bloomberg notes that Blackrock, Citigroup, Goldman Sachs and Citadel are the biggest holders of SPY options. Three of these are probably authorized participants for ETFs and the fourth is the world’s largest money manager and an ETF sponsor.

Mr. Balchunas concludes: “The question is how much more liquidity can ETFs drain from other markets—be they stocks, commodities, or bonds—before they become the only market?”

SPY options are an inexpensive way to achieve exposure to the broad market, which is generally starved for liquidity in the underlying assets. As we’ve written, ETFs are themselves a substitute for these assets.

The problem with looking at options to understand sentiment, volatility and risk is that it fails to account for why options are being used – which manifests in the equity data (which can only be seen in trade-executions, which is the data we’ve studied for over ten years).  If Asset-allocation is up, and Risk Management is up, ETFs and indexes are driving the use of derivatives. These two behaviors led equity-market price-setting in 2015. If you were reporting changes in options to management as indications of evolving rational sentiment, it was probably incorrect.

In the Tulip Mania, people used futures because there was insufficient tulip-bulb liquidity. The implied demand in derivatives drove extreme price-appreciation. But nobody had to sell a bulb to pop the bubble. It burst because implied future demand evaporated (costing a great lost fortune).

Options expire tomorrow and Friday, and next Wednesday are VIX expirations (two inverse VIX ETNs, XIV and TVIX, traded a combined 100 million shares Tuesday). Vast money in the market is moving uniformly, using ETFs and options to gain exposure to the same stocks. This is why broad measures don’t yet reflect the underlying deterioration in the breadth of the market (the Russell 2000 this week was briefly down 20% from June 2015 highs).

And now you know why. People tend to frolic in rather than tiptoe through the tulips. Be wary when everybody is buying rights.