Tagged: futures

Troubling Signs

Ahoy!

As you read, we are stopping in Charlotte en route to a 2pm arrival in Sint Maarten in the Caribbean.

Illustration 91269233 © Dharshani Gk Arts | Dreamstime.com

We saw the inflation print at 8.5%, plunging consumer confidence, rising credit risk, the supply-chain morass, and said, “Let’s flee to the sea.”

Okay, not really. We reset this sailing trip that vanished into the Pandemic.  Weirdly, we need no Covid test to see the sand and sea but for us citizens of the Land of the Free, we can’t get back in our OWN COUNTRY without one.

After being shot, boosted and afflicted with Covid in roughly that order.

We the People need to put the little despots in their places, power-seekers lording it over others without respect to math, science or common sense.  Untenable.  Unacceptable.

Back to market structure.  And monetary policy. 

Options expire this Good Friday short week, today and tomorrow. Trading is a tug of war between parties to expiring options and futures on Treasuries, currencies, interest rates, commodities, equities and bonds, and the counterparties with risk and exposure on the other side.

Don’t expect the market to be a barometer on investor-sentiment right now.

And new options trade Monday. Then counterparties square books Tuesday. Volatility derivatives expire Wednesday.

What will be apparent is if risk-taking is resuming.  I think Mon-Tue next week (Apr 18-19) are key.  Look, you can’t peg the day. Could be before, could be after.  But the market will either turn because investors and traders reset swaths of options and futures or we could get clocked.

No middle ground?

Broad Sentiment signals risk.  Might be a couple months away, or not.  Data going back the past decade that we track show that Broad Sentiment with a 90-day rolling read near 5.0 precedes a steep decline.

That’s about where it is.  History warns us.

What about the risk of recession?  Well, of course there’s risk.  Central banks globally exploded the supply of currency and shut down output. Nothing could be more damaging to economies.  Trying to remedy that catastrophe will take a toll.

And the Federal Reserve knows it and knows it must get interest rates back to a level that leaves room to chop them to zero to try to forestall an economic collapse. 

The Fed is motivated to stock up some ammo, not to “normalize rates.” The quickest way to do that is to lift overnight rates and start selling off bonds. If demand for bonds falls, interest rates rise.

That simple. And the Fed is wholly willing to put everything and everyone in jeopardy in order to give itself policy tools. 

I’m not opposed to raising rates. I’m opposed to low rates that devalue savings and purchasing power and encourage debt and consumption.

Impact on equities?  I think we’re seeing it already.  Passive Investment marketwide has fallen from 20.4% of trading volume over the trailing 200 days, to 18.8% now.

Doesn’t seem like much. But a sustained recession in demand from indexes, ETFs and quants will reduce stock prices.  Derivatives demand is down too, from 18% to 17.2%.

Mathematically, that’s an 8% long-term decline in Passive Investment, 4% drop in derivatives demand. Is a 12% reduction in real and implied demand meaningful?  

Absolutely.

So, it’s a matter of the degree of effect, and if or when that trend reverses.  A trend-change across the whole market is unlikely here at April options-expirations. 

How about earnings season?  Only if it’s a barnburner, which is improbable.

I think the best chance is June options-expirations, the next time big money can make meaningful changes to asset-allocations.  In between are Russell rebalances in May.

I’m neither bull nor bear. We’re data analysts. We track the trends.  There are troubling signs here.  Yes, they could dissolve again under the inexorable repetition of There Is No Alternative.

But if not, there’s a rough ride ahead.  So.  You will find us on a boat.  See you Apr 27.

Predicting Moves

One hundred seventy-eight companies reported earnings yesterday. Could one predict which would rise or fall?

There are 148 on deck today, 149 tomorrow.  The high point here in the Q4 2021 cycle was Feb 2 with 330.

Back in early 2016, Goldman Sachs found that stocks underperforming the market in the two weeks before results tended to outperform on the news.  Goldman recommended buying calls on those stocks and found that it returned an average of 18% (that is, buying and selling the calls).

They didn’t say how the stocks themselves fared.

Illustration 35557373 / Earnings © Iqoncept | Dreamstime.com

And there’s no indication the strategy continues to work as it did then.  But you’ll recall that Jan 2016 was pretty volatile.

Not as bad as Jan 2022. 

Bloomberg wrote Jan 31 (thank you, Alert EDGE user John C for the tip) that the market’s capacity to handle trades tumbled during volatility in January. The trouble was so bad that the spread between bids to buy and sell S&P 500 futures contracts widened to levels seen during the Pandemic crash of March 2020.

Nowhere does the article say, as we told all clients, that this same set of futures contracts expired the last trading day of January (and every last trading day of each month), and to prepare for tumult because volatility would make derivatives settlements a hot mess.

Index funds use futures contracts on the S&P 500 to get performance back in line with the benchmark at month-end. They’re an excellent proxy for nearly any basket and “40 Act” funds are permitted by rules to use up to 10% of assets on substitutes.

Tim, I thought you were going to tell us how to know if stocks will surge or swoon on results?

Hang on, I’ll get to that.  There’s an important point here, first.  Futures and options both depend on the value of underlying assets but routinely separate from them.  In fact, stocks in the S&P 500 last week were up 50% more than the derivatives that are supposed to track them.

Stocks comprising the SPX were up 2.3% on average last week, while the SPX, the futures contract, rose 1.5%. That’s a spread of 50% — a crazy divergence. 

Meanwhile, Short Volume hit a record 49% of trading volume in the S&P 500.

It’s all related.

Indexes need to get square. Banks absorb the task, for a fee. Massive volatility ensues. Banks trade like crazy to transfer the risk – they’re not front-running customers but mitigating derivatives risk – from giant gaps and maws in the data to the stock market.

Stocks gyrate. Short volume soars, spreads explode.

And it’s all about derivatives. Not much to do with investor sentiment at all.

Now, can we predict these effects in your stock at results?  Yes.  Not perfectly, but well. Derivatives play a colossal role at earnings, and it can be seen, measured, predicted.

Every public company should measure and observe what the money is doing ahead of results.  Measure what Active money is doing. Check Short Volume. Meter derivatives (we do all of that with machines).

We use that and Supply/Demand data to forecast volatility and direction and to understand the reasons WHY.

For instance, SNAP traded near $24, down from over $83 back in September, before results.  It then skyrocketed after reporting its first quarterly profit to near $40.  That’s terrific, but it’s also crazy.  What kind of market behaves that way?

A story for another day.

Anyway, SNAP showed big LONG bets during January options expirations. The stock price didn’t show it.  But the data sure did.  Short Volume set a six-month low and correlated to a big surge in derivatives (that’s measurable too).

Long bets on SNAP’s earnings.

That didn’t guarantee a big jump. SNAP Short Volume was back to 50% ahead of earnings – a straddle – and currently sits at 61%. But the bets were there.  It was possible to know just about everything that might happen.

If you can know all that, why wouldn’t you? 

If your CEO or CFO knew you could see which way the bets were going, and what was responsible for it, they’d probably appreciate learning about it from the investor-relations officer.  And they’d want to know if money focused on the Story played a role.

Measurable. We can help. Press of a button for us.

I’ll leave you with a tidbit. Statistically, stocks did better reporting AFTER options expirations, regardless of results. Bets cost more.

Public companies, report after expirations. Beware month-end futures expirations. Traders, predictability is better outside options-expirations.

Big lesson? Derivatives are running the stock market.  And data will help you understand the effects.  Don’t go through another earnings cycle guessing at what might happen.

Electric Jellyfish

There are four Pinthouse locations in Austin and Round Rock, TX.

We’ve not been to any of them but we’ve had their scrumptious hazy IPA beer, Electric Jellyfish.  It may be the world’s best.

And the stock market has been an electric jellyfish.

Illustration 234002321 / Electric Jellyfish © Rul Stration | Dreamstime.com

Let me explain, on this Groundhog Day (it’s 2/2/22!).  Jellyfish float on the currents.  They don’t propel themselves with purpose around the sea.  But an electric one probably would, except you’d never know where it was headed.

Substituting, the stock market floats on the currents, and if it was electric, it would propel itself around and you’d never know where it was headed.

Look, I’m joking to some degree!  We all make our living in the stock market.  And as Joe Walsh said, life’s been good to me.  Remember, the name of that album was “But Seriously, Folks….”

And the stock market has measurably predictive characteristics. So do jellyfish from the standpoint that ocean currents will tell you where they’ll go.  Currents drive both.

And it’s hard to fight the current.  Friday Jan 28 and Monday Jan 31 reflected the explosive role of futures contracts in the stock market, which in turn effectuate the epochal role of Passive money in stocks.

One thing leads to another (a good song by The Fixx but maybe the better version of one thing leading to the next is the great country tune by Hardy called “One Beer”).

Passive money follows a model. Fast Traders set the prices. 

Suppose investors are biased toward GROWTH. Those stocks get an outsized allocation in models tracking otherwise statistically predictable benchmarks like the S&P 500.

That in turn drives up the value of associated options contracts.  The notional value of traded put and call options exceeded the value of trading in the underlying stocks in 2021.

And that’s a further input into the value of futures contracts used by index and exchange-traded funds to match benchmarks.  They can transfer the risk of buying or selling stocks to banks through baskets of futures expiring the last monthly trading day.

All of that stuff compounds, driving values artificially high. If that current changes, markets can lose value at stunning speeds.

Jan 28 was the day before options contracts expired. Right before the close, stocks surged – as an electric jellyfish might.  Happened again Jan 31 as Dec-Jan futures contracts true-ups hit, and money reset to contracts lapsing the last day of February.

Last week, trading data we track showed investment declined about 12% in the S&P 500, while trading tied to derivatives that we call Risk Mgmt rose over 3%, Fast Trading 2%.

That’s the effect of futures contracts used by Passives – transferred to banks – and machines sifting the prices of stocks and derivatives and rapidly repricing both.

There’s another electric jellyfish datapoint here.  Short Volume, daily trading on borrowed or created stock, hit 49% of total market volume Monday Jan 31, the highest level we believe we’ve ever recorded in the S&P 500.

In a sense, the stock market went beyond electric jellyfish into the metaverse.  Banks tasked with truing up indexes had to buy gobs of stuff to make index clients whole after a tumultuous January.

That’s the implication.

And because there was very little stock for sale, Short Volume – the supply chain of the stock market – surged to accommodate it.

Market-makers can manufacture stock. They are required to make bids and offers even when no one is buying and selling. They’re exempt from rules requiring others to first locate shares.

We might say that banks prestidigitated stock to fill orders for derivatives.  Just made up shares to back instruments that might not get used.

I’m sure it’ll all work out.  Cough, cough.

And look, it might.  Weird things can occur, without apparent consequences.  But it all compounds.

At some point, all the screwy stuff we humans are doing to escape reality is going to bring us crashing back to earth. So to speak.  Monetary policy is artificial. The stock market is artificial. And now people are spending hundreds of millions of dollars on dirt that doesn’t exist, in the metaverse.

It was a terrific January 2022 for ModernIR as companies of all sizes sought us out for a grounding in the reality of data, a way to track the electric jellyfish.

And we can track it.  We can’t predict when it’ll stop working. We can predict that if you like IPAs, you’ll love Electric Jellyfish.

Sailing Away

Sailing takes me away to where I’ve always heard it could be just a dream and the wind to carry me.

Christopher Cross said it (youngsters look it up). In this pandemic we said, “That boy might have it figured out.”

TQ and KQ sailing

So, with two negative Covid tests in hand, we’re currently near 17 degrees North, 62 degrees West readying our 70-foot catamaran for a float with friends.  Chef, bar, crew, trade winds blowing our hair around, azure waters, sunrise, sunset. We’ll catch you after, Feb 8.

And in between, let’s have a look at the market.  The big buzz is GME, Reddit now dominating chatter with WallStreetBets (y’all can look that up too), the stock streaking, a push-pull among longs and shorts, and Andrew Left from Citron cannonballing into the discourse and an pool empty.

It may be a sideshow.  GME is up because Fast Trading, the parties changing bids and offers – shill bids, I call it – and buying retail volume surged from 38% of GME trading to over 57%.

At the same time, Short Volume, daily trading that’s borrowed, plunged from 47% to 34%. The funny thing is it happened AFTER the news, not before it.

The Reddit WSB crew has the sort of solidarity I wish we’d direct at being free. Nobody says to them the words “allow,” or “mandate,” and I love that.

But.

In a free stock market, your actions as traders are known before you make them.

That is, plow millions of limit orders into the market from retail brokerage accounts, and the firms like Citadel Securities buying them know before they hit the market.  They will feed the fire, blowing on the conflagration until it runs out of fuel.

And BBBY is up 50% in two weeks.  But it’s not the same, looking at market structure (the behavior of money behind price and volume in context of rules). Quantitative money plowing into BBBY to begin the year ignited the surge.

Could the actions of machines be misunderstood by humans?  Of course. Already the pattern powering GME has reverted to the mean.  In BBBY, Short Volume is up already on surging Fast Trading, the same machines we just talked about.

All but impossible is beating trading machines. They know more, move faster.

However, they are, paradoxically, unaware of market structure beyond fractions of seconds into the future.

Humans have the advantage of knowing what’s days out.  And on Fri Jan 29, the largest futures contract in the market comes due.  It’s designed to erase tracking errors. This is a much bigger deal than GME and BBBY but not as much fun.

Tracking errors are the trouble for Passive investors, not whether they’re “beating the benchmark,” the goal for Active stock-pickers.

A tracking error occurs when the performance of a fund veers from its benchmark.  The aim is generally less than 2%.  Yet S&P 500 components are 2.5% volatile daily, the difference between highest and lowest average daily prices. For those counting, daily average exceeds monthly target).

It’s why Passives try to get the reference price at market-close. But the market would destabilize if all the money wanting that last price jammed into so fleeting a time.  It would be like all the fans in Raymond James Stadium pre-pandemic – capacity 65,618 – trying to exit at the same time.

Congrats, Tom Brady. We old folks relish your indomitable way.

Like Brady’s achievements, everybody leaving RJ Stadium at once is impossible in the real world.

So funds use accounting entries in the form of baskets of futures and options.  ModernIR sees the effects.  The standard deviation between stocks and ETFs in 2019 was about 31%.  The difference reflects the BASKET used by the ETF versus ALL the stocks. To track that ETF, investors need the same mix.

Well, it’s not possible for everyone in the market to have the same quantity of shares of the components. So investors pay banks for options and futures to compensate for those tracking errors.  The more errors, the higher the demand for true-up derivatives.

In 2020, the average weekly spread rose to 71%, effectively doubling.  In the last eight weeks since the election it’s up to 126%.

The paradoxical consequence is that increasing volatility in benchmark-tracking is creating the illusion of higher demand for stocks, because options and futures are implied DEMAND. 

And so we’re

sailing away. You guys hold the fort. Keep your heads down.  We’ll catch you after the last Antigua sunset.

Mini Me

Minis abound.

You can trade fractions of shares.  Heck, the average trade-size is barely 100 shares, and 50% of trades are less than that.  Minis, as it were.

There are e-mini futures contracts on the S&P 500 index, and the newer micro e-mini futures product is the CME’s most successful, says the derivatives market operator.

Starting Aug 31 there will be micro options on e-mini futures for the S&P 500 and the Nasdaq 100. As of Aug 10, there are mini CBOE VIX volatility futures too, with a 10th of the face value of the conventional contract (expiring Aug 19).

One can spend less to have exposure to stocks and market-moves. The same notion animated a push toward decimalization before 2001 when it was implemented.

Decimals didn’t kill the stock market but they gutted analyst-coverage. Spreads – that is, the difference between the cost to buy and sell – funded research. In the 1990s there were on average 60 underwriters per IPO, and there were hundreds of those.

Today, there are five underwriters on average, the data show, and IPOs don’t keep pace with companies leaving markets through deals.  The Wilshire 5000, which in 1998 had 7,200 components, today has 2,495, factoring out micro-caps comprising just basis points of total market-capitalization.

Half the companies in the Wilshire 5000 have no analysts writing, while the top few hundred where trading supports it are festooned with quills – pens – like porcupines.

I think the inverse correlation between markets and the proliferation of minis bears some connection. It’s not the only thing, or perhaps even the biggest. But there’s a pattern.

And you should understand the market so you know what to expect from it. After all, who thought the March bear turn for stocks would be the shortest in history?

No one.  Including us.  Market structure, the way the ecosystem functions, explains it far better than fundamentals. But read to the end. We’ll say more.

Are the minis playing a role?

Look I’m not knocking fractional shares or tiny derivatives.  Rather, let’s think about the ramifications of growing layers separating trading from underlying assets.  Consider:

  • You can trade the stocks of the Nasdaq 100, the largest hundred at the exchange.
  • You can trade them in fractions without paying a commission.
  • You can trade the QQQ, the popular Exchange Traded Fund (ETF) that tracks the performance of the 100. ETFs as we’ve explained repeatedly are substitutes for stocks, not pooled interest in owning them.
  • You can trade e-mini futures contracts on the Nasdaq 100.
  • And now you can trade micro options on the e-mini Nasdaq 100 futures.
  • And you can trade options on the QQQ, and every component of the Nasdaq 100.
  • And you can trade the S&P 500 with exactly the same kinds of instruments, and SPY, the ETF.

It’s ingenious product-creation, and we’re not criticizing the innovators behind them.  It’s that I don’t think many people ask what effect the pursuit of mini increments of investment will have on market-behavior and prices, things that matter particularly to public companies depending on the market as a rational barometer.

And investors join public companies in caring how markets work.  Derivatives are becoming an ever-larger part of market volume. They’re layers of separation from underlying assets that become ends unto themselves, especially as increments shrink.

Why trade the stocks? Trade the rights on how they may behave – in tiny slices.

It disguises real supply and demand, which drives markets up relentlessly. Until that stops. Then markets collapse violently. These are chronic conditions in markets with too many derivatives.

Just saying.

Speaking of the market, it did as we wrote last week, with Market Structure Sentiment™ bottoming Aug 7, presaging gains a week out. Now options are expiring (including the VIX today), and Sentiment is topping, and behavioral volatility is massive, larger than we’ve measured at any point in the pandemic.

Maybe it’s nothing. Sometimes those data pass without a ripple. The FAANGs look good (low shorting, bottomed Sentiment). But we may be at the top of the Ferris Wheel after all those minis drove us this short, sharp way back up.

SPECIAL CORONAVIRUS EDITION: Halting

My email inbox took such a fusillade of stock volatility halts yesterday that I set two rules to sort them automatically. Emails rained in well after the close, girders triggered hours before and stuck in an overwhelmed system.

As I write, volatility halts Mon-Thu this week total 2,512.  Smashing all records.

You need to understand these mechanisms, public companies and investors, because high-speed trading machines do.

On May 6, 2010 the market collapsed and then surged suddenly, and systems designed then to interdict volatility failed.  They were revamped. Finalized and implemented in 2013, new brackets sat dormant until Mar 9, 2020.

Wham!

They were triggered again yesterday, the 12th. At Level 1, the market in all its forms across 15 exchanges and roughly 31 Alternative Trading Systems stops trading stocks when benchmarks fall 7% from the reference price in the previous day’s closing auction.

To see exchanges, visit the CTA plan and exclude Finra and CBOE (17 members becomes 15 exchanges). You can track ATS’s (dark pools) here.

The Level 1 pause lasts 15 minutes and trading then resumes.  Say the reference price was 2,400 for the S&P500 the day before. At 2,242, it stops for 15 minutes.  Down 13% to 2,123, it halts again for 15 minutes. At 20% down, the markets close till the next day (that would be SPX 2,000 in our example).

Here’s the kicker: Levels 1-2 apply only till 3:25p ET. If the market has been off 5% all day till 3:25p ET and then it swoons, it won’t stop falling till it’s down 20% – SPX 2,000.  Girders apply only down, not up. Stocks could soar 30% in a day but couldn’t fall 21%.

Then there are single-stock guards called Limit Up/Limit Down (LULD) halts (the stuff inundating my inbox). When a Russell 1000 stock (95% of market cap), or an ETF or closed-end fund, moves 5% away from the preceding day’s reference price in a five-minute span, the security will be halted.

Russell 2000 stocks (add the two and it’s 99.9% of market cap) halt on a 10% move from the reference price in five minutes, applicable all the way to the close. Prices for all securities must be in the LULD range for 15 seconds to trigger halts.

For perspective, high-speed machines can trade in microseconds, millionths of a second (if machines can find securities to trade). Machines can game all these girders.

Boeing (BA) was volatility-halted three times yesterday (market cap $87 billion, over $220 billion of market cap in April last year) and still declined 18%, 80% more than the DJIA (and it’s a component).

Our friends at IEX, the Investors Exchange (the best market, structurally, for trading) tracked the data. Full-service broker-dealers handle customer orders, as do agency brokers (like our blood brothers at Themis Trading). Proprietary traders are racing their own capital around markets.  Look at this.

It matches what we see with behavioral analytics, where machines outrace any indication that rational money is coming or going. It’s why real money struggles to buy or sell.

How have stocks lost 25% of value in two weeks with no material change to shareholdings (widely true)? This is how. Machines are so vastly faster than real money that it’s like shooting fish in a barrel.

A word on futures:  The Chicago Mercantile Exchange triggers halts overnight if futures move 5%. But that tells machines to bet big on the direction prices were last moving.

Let’s bring in Exchange Traded Funds (ETFs). They depend on predictable value in ETF shares and the underlying stocks. If ETFs have risen above the value of underlying stocks, market-makers short ETF shares (borrow them) and return them to ETF sponsors to get stocks worth less than ETF shares. And vice versa.

With a low VIX, this trade is easy to calculate. When volatility soars and ETFs and stocks move the same direction, market-makers quit. They can’t tabulate a directional gain. The market loses roughly 67% of its prices, which come from ETF market-makers. Machines then yank markets up and down thousands of points without meaningful real buying or selling.

Which leads us to next week.  Options expire. This pandemonium began with Feb options-expirations, where demand plunged.  If the market puts together two solid days, there will be an epochal rush to out-of-the-money call options before Mar 20. Stocks will soar 15%.

I’m not saying that’ll happen. It’s remotely possible. But we’re on precarious ground where ETFs subtracted from stocks suggest another 35% of potential downside.

Last, here’s my philosophical thought, apolitical and in the vein of Will Rogers or Oscar Wilde on human nature. A primitive society ignorant of the Coronavirus would blithely pursue food, clothing and shelter. Life going on.

Now our global self-actualized culture in one breath proposes we change the climate, and in the next paralyzes over a tiny virus.  I think Will and Oscar would suggest we learn to live (with viruses and the climate).

Whether we lose 35% or gain 15%, market structure is crushing human thought and shareholder behavior, and that fact deserves redress after this crisis.

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.

Selling the Future

Karen and I are in Playa del Carmen, having left the US after the Trump election.

Just kidding! We’re celebrating…Karen’s 50th birthday first here on the lovely beaches of Quintana Roo and next in New York where we go often but never for fun. This time, no work and all play.

Speaking of work, Brian Leite, head of client services, circulated a story to the team about Carl Icahn’s election-night buys. Futures were plunging as Mrs. Clinton’s path to victory narrowed. Mr. Icahn bought.

If you’ve got a billion dollars you can most times make money.  You’d buy the cheapest sector options and futures and aim your billion at a handful of, say, small-cap banks in a giant SEC tick-size study that are likely to move up rapidly. Chase them until your financial-sector futures are in the money.  Cash out.  See, easy.

(Editorial observation: It might be argued the tick study exacerbated volatility – it’s heavily concentrated in Nasdaq stocks and that market has been more volatile. It might also be argued that low spreads rob investors of returns and pay them to traders instead.)

If you’re big you can buy and sell the future anytime. The market last week roared on strength for financials, industrials, defense and other parts of the market thought to benefit from an unshackled Trump economy.

An aside: In Denver, don’t miss my good friend Rich Barry tomorrow at NIRI on the market post-election (Rich, we’ll have a margarita for you in Old Mexico).

We track the four main reasons investors and traders buy or sell, dividing market volume among these central tendencies. Folks buy or sell stocks for their unique features (stock picking), because they’re like other stocks (asset allocation), to profit on price-differences (fast trading) and to protect or leverage trades and portfolios (risk management).

Fast trading led and inversely correlated with risk-management. It was a leveraged, speculative rally. Traders profited by trafficking short-term in people’s long-term expectations (there was a Reagan boom but it followed a tough first eighteen Reagan months that were consequences of things done long before he arrived).

Traders buy the future in the form of rights and sell it long before the future arrives, so that by the time it does the future isn’t what it used to be.

They’re grabbing in days the implied profits from a rebounding future that must unfold over months or even years. Contrast with stock-pickers and public companies. Both pursue long arcs requiring time and patience.

Aside: ModernIR and NIRI will host an incredible but true expose with Joe Saluzzi of Themis Trading and Mett Kinak of T Rowe Price Dec 1 on how big investors buy and sell stocks today. 

Why does the market favor trading the future in the present? It’s “time-priority,” meaning the fastest – the least patient – must by rule set the price of stocks, the underlying assets. We could mount a Trump-size sign over the market: Arbitrage Here.

We’re told low spreads are good for investors. No, wide spreads assign value to time. Low spreads benefit anyone wanting to leave fast. Low spreads encourage profiting on price-differences – which is high-frequency trading.

Long has the Wall Street Journal’s Jason Zweig written that patience is an investing virtue.  Last weekend’s column asked if we have the stamina to be wealthy, the clear implication being that time is our friend.

Yet market structure is the enemy of patience. Options expire today through Friday. The present value of the future lapses. With the future spent, we may give back this surge long before the Trump presidency begins, even by Thanksgiving.

I like to compare markets and monetary policy. Consider interest rates. High rates require commitment. Low borrowing costs encourage leverage for short-term opportunities.  We’ve got things backward in money and the markets alike. Time is not our friend.

Upshot?  The country is in a mood to question assumptions. We could put aside differences and agree to quit selling the future to fast traders. Stop making low spreads and high speed key tenets of a market meant to promote time and patience – the future.

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.