On many occasions, significant moves in the market occur after a period of consolidation. Consider the recent trading action in the S&P 500 Futures. The index had a significant period of consolidation back in mid-November when the contract posted four of five closes between 1765 and 1767.50. Once that area was cleared on November 13th (1778.75), the index reached 1800 only four trading sessions later.
At this time, the index has posted five consecutive closes within a three point range from 1801.25-1804.25, which is rare in this volatile trading vehicle. This area should act as major support early in this week’s trading, and could be the base to catapult the market higher (since it is hard to argue the trend is anything but up). However, if this 1800 level is breached, a much overdue significant correction could take place, taking the contract down to the 1775 level and perhaps even as low as 1735. It is critical that this market hold the psychological 1800 level this week.
Every so often, a stock can get stuck at a key technical level as the bulls and bears jockey for position. I call these key levels “magnets”. Apple appears to be caught in the $500 magnet.
Take a look at the trading action in AAPL over the past 10 days:
Every time the stock rallies, the rally fails and the stock pulls back to test the 500 support. The opposite has held true as well. Every time the stock has fallen under 500, it turns around and rallies right back over it.
Technically, the magnet continues to hold for a number of possible reasons:
1) Traders have identified this area as support and continue to buy the stock at the 500 level. As the stock rallies, those same short-term traders scalp out of their longs which doesn’t allow the stock to gain any significant upside momentum. Eventually the stock just collapses back.
2) Short-term traders have identified the relevance of the 500 level and continue to short the stock when it pops. Again the stock cannot gather any upside momentum to break the force of the magnet.
3) The whipsaw effect. Traders continue to be whipsawed as they try to play the breakdowns through the 500 level. As the stock falls through the 500 level, longs leaning on that level bail, and shorts jump in playing the potential breakdown. The short-term trading herd moves from being long to being short, and the trade becomes crowded on the short side. The path of least resistance is then higher towards the 500 level, pulling the stock back up.
Regardless of the cause, if a trader can identify these magnet levels early on, there can be some significant opportunity to profit from these “Magnet Trades”, by simply fading the moves away from the level of significance.
In 2008, aluminum prices ran up to $1.40/lb. Alcoa (NYSE:AA), the largest aluminum producer had a nice run up as well, trading at $44.77 in May of 2008. Then the aluminum market turned south and over the course of the next nine months, the price of aluminum cascaded down, bottoming at $0.60/lb in February of 2009.
During this period of decline, Alcoa appeared to be cheap all the way down. It looked cheap when it traded at $30 in August. It looked even cheaper when it traded down to $20.93 in September. The value investors were swarming when it traded down to $9 in October. But the price just kept falling, and Alcoa finally bottomed out at $4.97 in February of 2009. A nearly 90% decline in just 9 months.
This pricing action looks eerily similar to what is happening in the mining stocks.
Gold was trading north of $1700/oz in November of 2012. But the gold market has got ugly, punishing every investor that was looking to gold for defense, and punishing the miners even more.
Take Barrick Gold (NYSE:ABX) for example. The stock was trading at $43.19 in September of 2012, but since then the falling price of gold has taken its toll on the miner. The stock price appeared cheap at $30.00 in March. It looked like a steal at $20 in April, but broke through $15 today.
Where is the bottom?
Judging from the price of gold, the bottom could still be much lower. As of today, gold has now traded down to $1200/oz. This is a serious issue for the mining stocks because the all-in cost of production of gold has been steadily rising. For many of the miners, this cost of production is now upwards of $1100-1200/oz. This means that if the price of gold stays at current levels, many mining companies will struggle to make money.
Barrick Gold is in a little better shape as they estimate that their 2013 cost of production will be around $950-1,050/oz. So it can still be profitable with the gold price at current levels. But needless to say, their margins are getting squeezed.
No one knows where the bottom for the miners will be, but Alcoa lost 90% of its value in that 9 month period as the price of the underlying metal declined. If the miners have a similar move, and if they struggle to remain profitable as the price of gold declines, it is not unreasonable to think that the fair value of these miners might be lower yet.
Being a big-time University of Michigan sports fan can create conflicts in your life. For example, it severely limits the colors in my wardrobe as I do not want to resemble in anyway whatsoever, or promote the colors of any of my hated rivals. Also, it can be a factor when handicapping other sporting events I closely follow such as the Kentucky Derby.
So you may be asking how does my allegiance to Michigan sports create a conflict for me in handicapping the Kentucky Derby? Let me explain. In the past, I have favored the winner of the Santa Anita Derby (especially if he is a long shot) as my choice for the Kentucky Derby. And this year’s winner, Goldencents, is partially owned by none other than Rick Pitino, who just recently led his Louisville Cardinals to a hard fought victory over my Michigan Wolverines in this year’s NCAA Basketball Championship Finals. So, do I sit out this year’s Derby and cheer for every other horse in the race? Or do I put my biases aside and rely on my handicapping skills?
Let’s examine the top contenders along with Goldencents to determine the appropriate betting strategy for the first leg of the Triple Crown. More times than not, a winner from one of the major prep races before the Derby (Wood Memorial, Arkansas Derby, Florida Derby and Santa Anita Derby) will be the eventual winner.
The only horse entering the race with a perfect record is the winner of the Wood Memorial, Verrazano. Being hailed as perhaps the next super-horse, the colt may go as the favorite. In addition to his victory in the Wood Memorial, Verrazano galloped to victory by 3, 16 and 8 lengths in his three previous starts. Veteran trainer Todd Pletcher (trainer of 2011 Derby winner Super Saver), will have the colt and jockey well prepared for the longer distance and large field. However, being the favorite in the Derby is not always a good omen, as the chalk rarely wins the race. In fact, going back to 1979 only five favorites have gone on to win the Kentucky Derby. With that being said, I will use him in some combinations with some other long shots.
One of the four other stablemates of Verrazano, Overanalyze, was the winner of the Arkansas Derby. Although he coasted to over a four length victory, very slow fractions on the front-end allowed him to do so. In the 21 horse stampede at the Derby, it certainly will not be nearly as easy to weave and bob from way back in the pack and coast to victory. The eventual winner will need to be in striking distance by the half and ready to mount a challenge. Also, his past performance reveals a pattern of losing a race following each of his four victories. Since his last race was a win in the Arkansas Derby, I am predicting the pattern to hold true to form. Once again, I may use him as a candidate for some combinations.
Orb, the winner of the Florida Derby, is the other candidate to go off as the favorite. He has dominated the horses at Gulfstream Park over his last three starts, coupled with his four wide move in the stretch to win the Florida Derby by almost three lengths is impressive. Once again, he was aided by slow fractions on the front-end and had plenty of kick to make his stretch run. More importantly, he has the most outside post (16) of all the major contenders and will have to expend some energy to get in good position for a final move. This stands in stark contrast to his usual come from behind style. Finally, being one of the potential favorites makes him a less attractive horse to wager on.
So where does over-analysis leave me? With the Santa Anita Derby winner and partially Rick Pitino owned Goldencents. After reviewing his race in the Santa Anita, his jockey was able to call on his horse for a move a few times, before heading home for a strong run in the stretch. With the Kentucky Derby being a long and grueling race, especially with a large field, the winner will need to be near the front end of the race and then have enough kick to make a stretch run. If Goldencents can get a similar trip to his mount in the Santa Anita Derby, he may be the next candidate to win the first Triple Crown since Affirmed in 1978.
Doug Clark, managing director of liquidity research for ITG Canada, was recently interviewed on TabbFORUM in a post called “Dark Pools & Private Schools”. In his interview, Clark questions Canadian regulators for their recent regulation of dark pools. He compares the restrictions placed on dark pools to prohibiting parents from sending their kids to private school.
But his analogy is flawed.
In his analogy, the parents are the ones choosing to take their kids out of the public school sector, to place them into the private school sector. But in many cases the retail investor is NOT the one choosing to send their orders to a dark pool. In some cases, they don’t even have a choice. It is often the broker/dealer controlling the routing, and making that choice for them (usually based on the payments they receive from routing their orders to a specific OTC market maker or dark pool). Following Mr. Clark’s analogy, this would be equivalent to the education authority taking kids out of public schools and placing them into private schools without the parent having any say, and getting paid to do it!
Secondly, the reason the parent would move their child from a public school system to a private school system is to receive some sort of benefit – better food, better teacher to student ratio, better security, better programs, as Mr. Clark mentions in his interview. But what is the benefit that the customer is receiving by having their order routed away from the public exchange? The chance to receive sub-penny price improvement on their order? These fractions of a cent give little nominal value to the customer, but have a significant effect on deterring displayed liquidity, especially in thinly traded issues.
Consider the following example.
Assume stock XYZ has NBBO:
Bid Size Ask Size
25.50 500 25.70 500
A retail investor places a market order to buy 500 shares of the stock. The order is routed to an OTC market maker who gives sub-penny price improvement to the order, and executes the buy order at 25.6999.
Instead of paying $12,850 for the stock, the retail investor pays $12,849.95 for the stock, saving a whopping nickel.
But the participant who placed the 25.70 limit order on the exchange, the displayed liquidity provider, is left unfilled.
Imagine if you were that participant that should have received an execution, but did not because your order was stepped in front of at the moment it was about to be executed. This leaves you with an unquantifiable loss, the loss of the missed trading opportunity.
Now imagine a different scenario:
Assume the same NBBO:
Bid Size Ask Size
25.50 500 25.70 500
A retail investor places a market order to buy 5000 shares of the stock. The OTC market maker, knowing this order will impact the price significantly, does NOT step in front of the 25.70 order, and allows the market order to route to the displayed market, taking out the 25.70 seller, and trading all the way up to 26.00 to fill the balance of the order.
The 25.70 limit order trader is immediately down 30 cents on the trade.
The routing of retail order flow away from the displayed market has distorted the risk-return matrix of displayed market makers, and they are hesitant to make markets in smaller stocks as a result of the increased adverse selection risk.
In fact, the matrix has become so distorted that our firm, Bright Trading LLC, recommended to our traders that they stop providing liquidity in small and mid cap stocks entirely. The rationale is simple, if you get filled on your limit order, it is usually because you are on the wrong side of the trade, and the price often blows right through you.
Therefore, there is little point to displaying liquidity in these issues, as the return no longer justifies the risk. Our traders have learned this the hard way. The OTC market maker steps in front of your order when it is on the right side of the trade, and allows your order to be filled when it is on the wrong side of the trade.
We believe that the distortion of the risk-return matrix of displayed market makers due to internalization, is the main reason that we have liquidity problems in the small and mid cap space. It is apparent that the Canadian regulator (and now ASIC) have similar concerns.
To rectify the situation, the Canadian and Australian regulator have mandated that orders routed away from the public exchanges receive meaningful price improvement over the NBBO. That way at least there is some benefit to the end customer from the routing of their orders away from the public exchange. It should also help to deter OTC market makers from stepping in front of limit orders, as they now have to assume increased risk (by giving meaningful price improvement) when internalizing a retail market order.
But ASIC may go further. In their recent report on dark liquidity, not only are they mandating meaningful price improvement, but they are also proposing a trigger to implement a minimum dark order threshold, to apply to securities where there is evidence that dark liquidity has caused degradation in market quality.
These actions by the Canadian and Australian regulator should be applauded as opposed to questioned. Displayed limit orders are the building blocks of price discovery. It is imperative that we protect these orders. The new policy decisions of the Canadian and Australian regulator should help to improve the risk-return matrix of displayed market makers and encourage market participants to display limit orders more aggressively, which should improve market quality in these countries.