Tagged: Knight

The Long and Short

In the timeless 1987 movie The Princess Bride, Vizzini the Sicilian, played riotously with a lisp by Wallace Shawn, keeps declaring things “inconceivable!”

Swordsman Inigo Montoya, portrayed then by Homeland’s Mandy Patinkin, finally says, “You keep using that word. I do not think it means what you think it means.”

You could say the same for short interest. It’s not what you think it means. Stay with me to the end, and you’ll see.

On August 2, 2012, Knight Capital Group’s algorithms failed. Monday at TABB Forum, Anthony Masso, CEO at trading risk-analytics provider Succession Systems, described how the SEC’s recent settlement with Knight successor KCG Holdings clarified a risk standard called the Market Access Rule. It requires brokers to have systems that forestall actions that may imperil themselves or others in the market. I’d paraphrase the law this way: “We order you to take whatever actions are necessary to prevent bad stuff. Thank you.”

That’s not what got my attention. The settlement reveals details about Knight’s errant trades. The broker bought, or went long, $3.5 billion of stocks; and shorted, or sold, about $3.2 billion. In less than an hour, its systems executed four million trades in 174 different stocks to create these positions.

This one tidbit is a tumbler unlocking vast secrets about market behavior. Knight’s algorithms were observably designed to build long and short positions of similar size principally to supply the storefronts of the stock market. When these positions failed to modulate, markets rushed into the vacuum, crushing Knight’s balance sheet.

Here’s the delicate balance in proprietary high-speed trading. Get it wrong by less than 10% and you’re done. Knight got it wrong. This same fragile trestle trains markets over the chasm each day. We’re all riding the rail.

ModernIR tracks short volume using algorithms. The daily average the past 50 days marketwide is 41%, not far off long/short equilibrium. Combined volumes on exchanges and dark pools total about 6.3 billion shares daily, meaning 2.5 billion shares each day are short.

Short interest in the S&P 500 is nearer 5% on average, though components can reach levels that roughly match daily short volume. The difference between interest and volume is that volume is just borrowed, while interest remains sold and outstanding.

Our data show that 11% of public companies have short volume above 50% of total volume. The highest in our client base the last five days was 61%. We’ve seen levels reach 85%, meaning nearly nine of every ten trades involved short shares – rented trading inventory. The lowest we saw was in a series of Class B shares trading just a few thousand per day where still 15% were short.

Elevated short interest can mean speculators are betting on a downturn. But it could as well be searing daytime demand for trading “inventory” – bowling shoes to put on for the day, for the game, traders and intermediaries finding renting cheaper than owning.

What concerns me is that short volume by definition in Regulation T is credit. So the market is heavily dependent on borrowing, just like the entire global financial system.

You have to see volume differently. Half of it is borrowed. Rented. Bowling shoes. High short interest is a product of frenetic demand on short horizons – not a certificate guaranteeing imminent pressure.

But realize that a hiccup in long/short balances can move your shares sharply – and it’s got nothing to do with ownership, or even shorting in the conventional sense. Inconceivable? No. And you know now what I mean.

The Great Debate

The Great Debate is upon us.

No, not the presidential one tonight. The other one, about equity markets. The SEC’s technology summit yesterday aimed at finding ideas for preventing another Aug 1 Knight Capital debacle from ever happening again included mostly the folks who huddled after the 2010 Flash Crash to prevent glitches from…ever happening again.

Since the Knight glitch came after efforts to prevent glitches from, yes, ever happening again, and since glitches and one-off flash crashes are routine now, reflected in continual halts and erroneous trades (including two yesterday early, even as the SEC summit was commencing), understandably hopes for change are dim.

We’ve gotten many questions in recent days. How do we control technology? Is technology the problem? Are markets too complex?

And the simplest one: Why can’t we shut the hummer down when it goes haywire? Right? Common sense tells us it can’t be too hard if it involves electricity. Pull the plug. Yank the doohickey or whatever out of the machine.

We’ll get a “kill switch,” sure. But HFT won’t end soon because structure depends on it. The major exchanges are averaging about 4.6 billion shares of trading volume, down from over 7 billion daily in 2009, when incidentally Dodd-Frank was crafted. Add 30% more in dark pools and volume is about 6 billion shares each day now.

If we divide that into what’s Navigational – moving stuff around – and what’s Fundamental (real buyers and sellers meeting), it’s about an 85%/15% split. We’re left with 900 million shares of “real” volume, with the rest from HFT, ETF arbitrage, automated market-making and so on. This is the glitch-infested stuff.

What happens if all 85% of it disappears? Nothing, if you’re Berkshire Hathaway’s Class A shares trading 400 shares daily with no navigational volume. For exchanges selling data and services to drive profits, it’s doomsday. The largest broker-dealers would leave equity markets. So would the 50-odd large high-frequency firms. (more…)

On the NYSE and Knight Floors

Denver is an icebox, so we went east to New York to warm up. Lovely here, the tree glittering at Rockefeller Center and the snowflakes magically materializing to music on the Saks & Co. façade. Festive!

Carmen Barone and the Barclays team graciously hosted me yesterday on the NYSE trading floor, and in the afternoon Marge Wywras at Knight Capital Group turned me loose with the traders on the Knight floor in Jersey City. That’s darned near a perfect business day to me. (more…)