Trading Education
Market Fragmentation Flash Crash
December 13, 2012 - 2:03 pm
Today a number of stocks had a mini flash crash exactly one second before the market opened. The affected issues: C, HPQ, T, WU, HES, WFC, KR, VTR, GS, S, RAI, WMB, CRM, IBM, LUK, & TAP
HPQ traded as low as $3.06 as you can see on the tape:
Today’s flash crash in these issues was caused by market fragmentation and inefficient order routing. These sudden market moves were caused when an order was routed “direct” to the Nasdaq (NSDQ), bypassing liquidity on the other exchanges. SEC rule 611, the order protection rule, is designed to prevent “trade-throughs”, which are trades being executed at prices inferior to the best-priced quotations. But this rule only protects the top of the order book, and the rule does not cover the pre-market trading session.
To better understand SEC rule 611, consider the following example:
Security ABC order book on Ask:
Size Price Exchange
300 25.00 BATS
300 25.02 BATS
300 25.03 NSDQ
NSDQ receives a market order to buy 600 shares of security ABC. The best available offer is on the BATS exchange at $25.00. NSDQ must route the first 300 shares to BATS because this order is at the top of the order book and is a “protected quotation” under SEC rule 611.
But here is where it gets interesting. Having satisfied the order protection rule by routing the first 300 shares to BATS, the remaining 300 shares is now routed back to NSDQ and executes against the NSDQ’s $25.03 quotation. The $25.02 offer on BATS remains unfilled. In other words, the second BATS order is traded through.
The participant sending the order actually gets an inferior price being filled at $25.03 on NSDQ when they could have been filled at $25.02 on BATS, but the $25.02 BATS quote (because it was not at the top of the book), is not a protected quotation and not covered by SEC rule 611.
In today’s example, the trades occurred during the pre-market session, so even the top of the book is not protected. With market liquidity being fragmented across multiple exchanges, order depth on one specific exchange can in some instances be pretty sparse, especially during the pre-market session. Sometimes directed orders are large enough that they can sweep through multiple levels on the exchange, causing the stock to have a sudden fall in price on that specific exchange.
This is what happened today on these 16 symbols. As you can see, it is very important to route your orders carefully in this fragmented market structure.
Note – Nanex has done an excellent job at analyzing the details of today’s flash crash event. You can view it here:
The Dogs are Barking
November 26, 2012 - 7:08 pm
RIMM up 50% this month. HPQ up 10% since gapping down after the Autonomy debacle. BBY up 6.6% today.
What is powering the sudden surges in these perennial underperformers? Are these companies turning it around? Are these companies fundamentally better than they were a week ago?
Josh Brown at the Reformed Broker just answered this question in his blog post, “Here is an incontrovertible fact“, in which he discusses the real reason behind the sudden resurgence in these stocks. The answer is market sentiment.
Stocks move on short term supply and demand. When the majority of short-term market participants are on the same side of the trade, the price will almost always move in the opposite direction. The herd is always wrong. Too many participants have thrown these dogs out, and some real Johnny-come-latelies were recently shorting them. But sorry to break it to you Johnny, nothing goes straight to zero. There are always short covering squeezes, glimmers of hope, and market sentiment shifts. And the market sentiment has shifted for all of these issues. These dogs are barking.
You know what happens when one dog starts barking in the neighborhood, all the other dogs start barking as well. So don’t be surprised if some of these other dogs start gathering some short-term interest.
RadioShack (RSH)
Advanced Micro Devices (AMD)
Alcoa Inc. (AA)
Alcatel-Lucent (ALU)
ITT Educational Services (ESI)
Apollo Group (APOL)
Zynga (ZNGA)
Supervalu (SVU)
J.C. Penney (JCP)
The bottom line is that there may be some short-term upside in some of these issues, but don’t get married to any of them. Just because the dogs are barking, doesn’t mean they don’t all have fleas.
DRIPS – A Scary Tool For Investing
November 20, 2012 - 11:43 am
Many investment advisors advocate for the use of dividend reinvestment programs (DRIPS) in their client’s portfolios. Some brokerage accounts actually have the setting defaulted to automatically reinvest dividends into the underlying companies when a customer opens a new account. I believe this is a big mistake.
Take a look at the share prices of Best Buy (BBY) and Hewlett Packard (HPQ) today. They are making new 10 year lows. The business model of both of these companies is broken. However, both companies have had a history of paying a nice dividend. If an investor had been banking those dividends for the past decade, they may still be down in both positions, but they would have had a substantial amount of their initial investment recouped, just from the dividend checks.
The story is quite different if they participated in a dividend reinvestment program, as the majority of those dividend payments over the past decade would have been reinvested in the companies at much higher prices, eroding the value of all of those dividend payments.
The underlying problem with DRIPS is that very few businesses stand the test of time. Industries change, technology changes, consumer tastes change, and companies have to keep reinventing themselves if they are going to survive. In many cases this simply does not happen.
Just ask the shareholders of Eastman Kodak. It paid a healthy dividend for the past 50 years. If you had invested in the company 50 years ago, and had been banking those dividend checks, your initial investment in the company would have been worth a small fortune just from all the quarterly dividend payments you had received.
But if you had been participating in a DRIP, all of those dividend payments, and all of that cash would have been gone when Eastman Kodak filed for bankruptcy earlier this year. You would have lost it all.
DRIPS work great in companies that continue to grow and stand the test of time. But most companies do not. Placing all your bets that the companies in your investment portfolio will be there when you retire is simply a very scary bet to place. The best way to continue to build your portfolio is to bank those dividend checks and invest them in other stocks and other sectors. Those dividend checks are the natural way to diversify out of core holdings, because very few companies last forever.
The V Bottom in Apple
November 16, 2012 - 4:46 pm
Everyone has been trying to call a bottom in Apple for the past 100 point down move. Every time the stock starts to consolidate, the bulls come out and say, “It’s forming a bottom.”
But every time they have been wrong, as you can see from this chart:
Why is it that Apple can’t consolidate and form a bottom? Because Apple doesn’t like to consolidate and form bottoms. It likes to make “V” bottoms, which is exactly what it did today.
A V bottom is significant for a number of reasons:
1) Participants who have shorted the stock had very little opportunity to cover because of the sudden spike back up (meaning there could still be participants caught short). Alternatively, when the stock consolidates, and appears to be forming a bottom, many shorts get nervous and cover their positions.
2) Participants who were picking bottoms by using reference points, have little chance to get long. Consider the four days of consolidation that we had from October 19th to October 23rd, when the stock had four consecutive lows near the $610 area. There was ample opportunity for bulls to be picking this bottom. We had a similar consolidation period in the past week in the $535 to $545 area. Again, lots of bulls scooping up stock. They were all wrong again.
Stocks move on short-term supply and demand. When too many participants get on the same side of the trade, the stock will almost always move in the other direction. Just like the recent spike in Facebook (FB). There were too many participants banking that when the lockup expired on Wednesday, releasing another 800 million shares, that a flood of sellers would come in and drive the price lower. The herd was dead wrong again, and the stock spiked higher.
But with Apple’s V bottom today, few participants had a chance to pick this bottom (unless they got lucky), and even fewer shorts had a chance to cover. It was too quick. That is why I think we have seen the short-term low in Apple. The V bottom is finally in.
Expecting a Pullback – You may be waiting for a while.
September 7, 2012 - 1:34 pm
Listening to the market chatter this morning, I’ve come to the conclusion that the majority of market participants believe that yesterday’s rally is unsustainable. I’ve come to a different conclusion.
For the entire month of August, the market was in a consolidation period. It was a battle between the bulls and the bears as the S&P futures traded between 1395 and 1420 for the better part of the month.
Yesterday’s Draghi spike opened the market into a critical resistance area. This looked like a nice setup for the shorts as the market opened up at the top of its recent range.
But this market threw those shorts a curve ball. We opened up in the 1412 area and never looked back, continuing straight up for another 18 points. This caught three different types of market participants by surprise:
1) Fundamental traders – that were banking that the Draghi spike would be short-lived used the opening print on Thursday to add to their short positions. Many of these traders expected the unemployment data to be poor again (just like the previous three reports). So they stubbornly held onto those short positions and have possibly added to them today.
2) Technical traders - that had previously played the index short from the 1414-1418 area shorted this open as well.
3) Opening traders (OPG traders), who employ a fair value type of strategy where they calculate the fair value of the individual components of the S&P based on where the S&P futures are trading. They buy those securities that are undervalued, and sell the securities that are overvalued relative to the S&P fair value. These traders also got caught short on the open, as many individual components opened slightly above their calculated fair value.
All of these traders were under serious heat very quickly yesterday morning as the index, and the majority of its major components, never had any type of significant pullback.
This short squeeze drove the market up to the 1430 area in the first hour of trading. We have now had a 5-6 hour period of consolidation where it is again a battle of the bulls and the bears, but this time I believe there are significant bears that are sitting on some ugly short positions. Many of the traders that shorted yesterday’s open are still sitting on these losing positions hoping for a pullback. I’ve learned one thing in my 13 years of trading, when you start hoping in a trade you are usually in big trouble. I think those traders that are still shorting this market and hoping for a pullback are going to be rudely awakened, as I think the next major market move is going to be up again. Stay tuned to see if this market can squeeze these shorts further.
