MTL

Flash Crash Analysis

noreply@blogger.com (MTL) — Wed, 06 Oct 2010 20:32:00 +0000

http://www.nanex.net/20100506/FlashCrashAnalysis_Intro.html

This came out about 6 weeks after the flash crash. The analysis is as good, if not better, than anything that's come out since then. This includes the recent SEC statement/report that supports the "fat-pinky" theory (reference http://www.reuters.com/article/idUSN3013208820100930). Larry Levin summarizes this statement as "nonsensical drivel" (reference http://www.secretsoftraders.com/stocks/sec-nonsense-241623)

To summarize, many of the HFT (high-frequency trading) shops look for the same buy/sell signals, often in the form of flash trades (cross-exchange orders that seek to exploit price differentials). Usually, competitiveness among HFTs maintains a sort of balance, promotes efficient price discovery,
and provides 30%-70% of total market liquidity. However, on May 6, there was a confluence of circumstances that caused these HFTs to exert an usual amount of selling pressure, which initially drove price down. When they realized that market conditions had become abnormal (i.e., their systems
were either generating unsuitable signals or receiving inaccurate data), they logically shut their systems down, but with the result that much market liquidity disappeared (albeit briefly), thus inciting a wider panic.

While liquidity is generally good, the reality is that we've become addicted to this heightened level of liquidity that HFTs provide. Efficient markets thrived without flash orders in the past, but can they ever learn to do so again?

To those interested, I recommend reading the following explanation as a alternative to the SEC's orthodoxy: http://www.nanex.net/20100506/FlashCrashAnalysis_Intro.html.

Cheers!

Is regulatory arbitrage harmful to U.S. businesses?

noreply@blogger.com (MTL) — Wed, 15 Sep 2010 17:22:00 +0000

Here's an interesting article about the effects of derivatives regulation.

http://openmarkets.cmegroup.com/features/moving-out-2/

"Trading the News"

noreply@blogger.com (MTL) — Tue, 07 Sep 2010 01:02:00 +0000

Understanding Market Psychology: Anticipating the market’s reaction to a perceived change in the fundamentals

This week, I would like to impart upon my readers hard-learned lessons from “trading the news”. If you’ve ever been caught in a situation in which the market reacts differently to new information than you would have expected, and you do not understand why, you should probably read on...

In the most basic sense, traders follow the news because it contains up-to-date information about the market fundamentals. Whether we base our trading decisions on the latest economic reports, earnings reports, weather reports, world events, or policy, we are in essence interpreting the fundamentals.

If you’ve read up on our philosophy, you may already know that we believe that it’s impossible to understand the fundamentals in their entirety. If market fundamentals are defined as anything that can affect market supply and demand, then they are largely dictated by crowd psychology. In other words, supply and demand are determined by the combined perceptions of all market participants. Psychology is not a "hard" science, however. If the best possible understanding of an individual’s psychology is fuzzy at best, then understanding the systemic psychology of an entire marketplace is out of the question.

Thus defined, fundamentals can encompass almost anything yet are paradoxically also market specific. But just because the markets are impossible to understand and predict, does not mean that they react randomly to a change in their fundamentals. It is also does not mean that we cannot profit from trying.

In the most simplistic sense, good news should be good for the market, while bad news should be bad for the market. When the employment situation improves, for example, we might expect equity indices and treasury yields to rise. To build on this idea, good news is defined as anything better than expected, bad news is worse than expected, and neutral news is on par with what is to be expected. To define expectations, traders and investors look at surveys and consensuses for economic releases, forecasted earnings for companies, and assess how the current news cycle fits into a broader context with regard to both its nature and frequency.

However, simplistic notions can mislead. For example, assume that the markets have taken a beating from a string of negative news and much poorer than expected economic indicators. However, earnings remain on-target. When payroll comes out indicating slightly lower than expected, the markets rally. If this result seems counter-intuitive, it’s because it is. These kinds of discrepancies exist because there are differences between market participant expectations, and market sentiment.

In the former example, markets rallied on news that indicated the economy was performing worse than economists’ predicted. The reason for this was probably because the market had already factored in an extreme form of pessimism. When news came out indicating that the underlying economic situation may not have been as been as expected, the market reverted to what it should have been based on company earnings.

This observation, (which I assure you, is based on my past experiences) indicates that traders need to not only examine what “experts” expect versus is systemically expected, but also examine what expectations are already factored into price versus what expectations are not. While some might argue that all information is already factored into price, this is not possible because no one has complete knowledge of the present, not to mention the future. In order to determine what information is factored in, traders need to form a subjective assessment of market sentiment. Is the market factoring in negative sentiment, positive sentiment, or neither?

Instead of anticipating the effects of news from a single dimension, we need to anticipate it in terms of market expectations as well as market sentiment. The following table anticipates market direction (for equities) based on several market conditions:

This methodology can be further utilized to more accurately anticipate the effects that fundamentals have on the equities markets by examining the relationship between earnings versus sentiment.

Another application might involve examining the relationship between equity valuations (based on earnings) and other fundamental factors.

Interestingly, the above table demonstrates one way to determine what emotions are already factored into the market price. If equities are priced below earnings valuations, the market probably factors in a degree of pessimism. If equities are priced above earnings valuations, the market probably factors in a degree of optimism. And if equities are priced on-par with earnings, the market is probably neutral.

While the above tables and statements are true for equity markets, they can easily be changed to reflect the effects of fundamentals on other markets.

While they may be counter-intuitive, the views expressed herein are not controversial. In fact, they confirm the conventional wisdom of the great Warren Buffet, who states, “Bull markets are born on pessimism, grow on skepticism, peak on optimism and die on euphoria”.

In order to form an accurate interpretation of a market’s directional tendency, we must first discard the idiosyncratic blinders that drive the masses into alternating bouts of hysteria and euphoria. When everyone is sure that market can only go down more, there is the contrarian argument that says it cannot if those expectations are already factored in. For example, J.P. Morgan, who, after hearing his shone-shiner’s advice to buy stocks, shorted the market right before the crash of 1929 to make millions. This basic lesson is that when everyone is already as optimistic as possible, the market factors this in, and more upside is unlikely. Likewise, when participants are already as pessimistic as possible, the market price factors in an extreme form of pessimism, which indicates that a bottom is likely to form. These observations do not disallow for extreme occurrences to drive a very optimistic market higher, and a very pessimistic market lower, however.

There are limitations to estimating market sentiment, however. It is an easy enough task to say that sentiment matters, but much more difficult to assess it and apply it. Because market sentiment depends on participant psychology, any assessment is inherently subjective. To that end, various indices exist that attempt to measure market sentiment (see http://www.sentimentrader.com/, http://esi.dowjones.com/). Others claim that market sentiment can be measured using various technical indicators including candlestick patterns (see http://www.yourtradingcoach.com/Videos-Technical-Analysis/Candlesticks-Vol-2-Candlestick-Sentiment.html). There is also the argument that sentiment can only be accurately measured by having one’s “finger on the pulse”, by keeping oneself up-to-date and well-informed. I, for one, believe that the best indication of market sentiment can be garnered by contrasting price versus value. A good axiom to live by is, price is what you pay, value is what you get in return (paraphrased from Warren Buffet).

There is no right or wrong way to probe the market’s mood. If we left something important out, please feel free to insert your own method. Whatever method you decide is best for measuring market sentiment, you are probably correct.

As always, we appreciate your comments and feedback. Good night and good luck.

Dividend Scalping - Beating The Yield Curve with Equities

noreply@blogger.com (MTL) — Thu, 26 Aug 2010 21:25:00 +0000

Dividend Scalping - Beating The Yield Curve with Equities

I am surprised by how many of my friends have their savings in a "riskier" money market yielding a 1% return for a 1-year investment. To their defense, they are getting a much better deal than they would had they loaned to the US Treasury, which yields 0.25% for a 1-year investment. However, what most people do not realize is that the stock market (using the S&P 500 as the barometer) produces an annual dividend yield of about 3% (See Futures Fair Value). That may not sound like striking gold, but it's 1200% better than lending money to the Federal Government via the US Treasury.

If the stock market is such a good deal, then why haven't investors returned to it?
I don't have a complete answer, but in short, the public has lost confidence in the old adage that equities yield greater returns than debt. In other words, the ordinary investor has been badly burned by the last recession. He is adverse to his portfolio losing its value, so he has flocked to the safety of Treasury securities and other debt instrument (ergo the present bond bubble).

To his credit, he realizes that equities have one major drawback... you can lose your principal. Our parents told us to buy stock because, from the 1940s to 1998, the stock market had one direction... up. The bursting of the tech bubble shook investor confidence for a little, but stocks resumed their meteoric rise again through 2000. The recession of 2001 through 2003 can be partly attributed to 9/11, which rattled our beliefs in American Hegemony and set into motion an era of vastly increased government spending. But once fears subsided, the stock market began to recover and reached new highs again in 2008. When the full extent of the effects of over-leveraging debt had been realized in 2007, the housing bubble was first to go bust. Equities then followed. Between December 2008 and March 2009, the S&P 500 had lost 60% of its value.

Enter the modern era of equity volatility...

While we have recovered from those lows, volatility has behaved differently since. It is not unusual to have days where the stock markets will suddenly drop by 3% --- that's about 300 Dow points. To put this in perspective, "Black Monday", which saw a 97 point drop in the Dow, is just a day at the office. The average joe, unwilling to risk losing the value of his principal investment, has been reluctant to re-enter the stock market.

Fortunately, there are strategies by which investors can still invest in equities, potentially beat the risk-free yield (i.e., zero-rate), and still protect their principal investments. ETFs provide one route, but I would like to hone in on one strategy in particular that utilizes futures contracts that I like to call dividend scalping.

In short, dividend scalping is hedging a high-yielding portfolio of stocks with the reverse position in an appropriate futures contract. In other words, it is going long a portfolio of stocks that offer high dividend yields, which are linked to the performance of a stock index futures contract (see beta correlation), and then shorting that futures contract. The S&P 500 currently yields about 3% annually in dividends. Since interest payments and dividends are factored into futures fair value, your equity portfolio that is hedged against the reverse position in the futures has to beat this yield (plus any interest you owe for margining your position over the discount rate) in order to produce a net return. For example, if my equity portfolio (assume a perfect beta) yields 8% annually, the futures contract that I am short reflects an implied 3% yield, and I can pay for the equities in cash, my effective annual yield will be about 5%.

A 5% - 8% annualized dividend yield is realistic. Remember, however, you have to discount this yield using the appropriate fair value calculation, and also factor in any interest payments you owe to your broker or lender. I would be skeptical of any equities yielding higher than 8%, because you to ask why those stocks are paying dividends that high, and determine if this is realistic and sustainable for your time-horizon.

The most difficult part of this approach is actually building your portfolio. You actually have to do your homework, which scares a lot of people. Choosing stocks with high yields is easy enough but you also need to ensure that your portfolio maintains its beta-correlation as much as possible. You also need to diversify appropriately, wich will depend on the futures contract you choose to short. And the best part is you always have to pay attention to the fundamentals. A company with a healthy balance sheet, with a neatly carved niche, and under good management, is more likely to maintain or exceed its beta expectations. If your stocks lose their beta by outperforming the market, do not panic... making money will not hurt you.

Now, let's walk through an example where I will be building a portfolio historically linked to the performance of the S&P 500 Index.

Steps:

Choose your futures contract to short:
This must be the first step, because you have to know what the base beta is before selecting your portfolio. For example, if you are shorting the S&P 500 Futures, you should diversify into all sectors. However, if you are shorting the Dow Futures, the bulk of your portfolio should be in manufacturing and industry. As a default, we will be selecting the S&P 500 Index. For information regarding the S&P 500's constituents, please visit www.standardandpoors.com.
Build your equity portfolio:
There are many stock screeners available. I recommend using Google Finance's stock screener because its free, easy to use, and is powered by Google's uber-cool search engine. The major limitation is that only the beta calculations of the S&P 500 are calculated for you.

Part 1 - Select your parameters:
The first level of parameters that we are looking for are Dividend Yield (%) and Beta. See below for an example from Google Finance:

Based on the criteria of stocks with yields greater than or equal to 4% and beta of between .85 and 1.15, there are 98 stocks to choose from for our portfolio. Please note that all individuals stocks do not need to have a high beta, but that your portfolio beta is the most important factor. For example, if I pay $10 on 10 shares of A with a beta of .5, and pay $20 for 5 shares of B with a beta 1.5, my portfolio beta still equals 1.

Part 2 - Refine the search by market sector:
In order to build a portfolio that tracks the S&P 500, we should have an idea of how stocks in the index are allocated, and allocate our portfolio accordingly. About 11% of our portfolio should be in energy, 3.5% in materials, 10% in industrials, and etcetera. The following table is available from Standard & Poor's Index Data Platform.

Part 3 - Examine the fundamentals:
Before selecting a stock, prudence dictates that we should have a good idea of company's fundamentals (e.g., the company overview, management, earnings, balance sheet, etc...). We have to do this because we need to make a qualitative judgment of a company's viability in the short, middle, and long runs. Is it feasible that ConocoPhillips can continue to pay a 4.02% dividend for an extended period? Probably. Is it feasible that Company X can continue to pay a 10% annualized dividend indefinitely? Perhaps not.
Part 4 - Continue to build your portfolio until its value is a multiple of one futures contract:
Repeat step 1 through 3 until our portfolio equals the size of at least 1 futures contract. The contract value of 1 point in the E-Mini S&P 500 Futures contract is $50. The index is currently at about 1150. That means the value of one futures contract is $52,500
Part 5 - Back-test (optional)
Before buying stocks, you may want to re-create your portfolio using a simulator. This will help you determine what your real transactional costs will be. Also, you may want to test whether your portfolio has performed as expected.

At this point, if you're ready to pull the trigger, buy stocks and short the futures contract. Your principal investment is effectively hedged because a loss on the cash position (stock) will be offset by a gain on the futures. Because the basis between cash and futures narrows towards expiration, you should expect a loss of about 3% per year on your basis position, but which will be offset by your high yield. Again, if your portfolio's annual dividend yield is 7% of its total value, and the annual fair value premium is 3% of the index's value, you would expect your portfolio to earn about 4% on its principal per year.

Managing your portfolio is another matter. If you did well in choosing your portfolio, the need to manage your portfolio should be minimal. However, you absolutely have to manage your futures position by rolling it near expiration (shorting a deferred futures contract minimizes this need, but the spreads between the bids and offers are typically much wider). If for some reason, your portfolio's correlation with the index deteriorates, you'll have to manage your position to re-establish a stable beta correlation. Furthermore, if your portfolio's yield diminishes, you will also have to manage your position to bring yields back up. Micro-management is time consuming and racks up incremental transaction costs. I implore you to due diligence when selecting your portfolio the first time around to minimize this need.

In summary, there may be ways to beat the risk-free yield of .25% on a 1-year investment. Riskier money markets currently yield 1% for a 1-year investment. Dividend scalping may be a way to beat even the risky yield. Realistically, you can produce net annual returns of 2%+ on your position, but also have to factor in fair value premium and transactional costs. Carefully selecting your portfolio to track performance of the index futures contract will minimize the need to manage the portfolio, thereby minimizing transactional costs.

The upsides to this approach are:

You can beat risk-free yield, probably by scales of magnitude. There are many equities that pay quarterly dividends of 1% or more.
Your principal investment is protected from losing its value by the opposite position in the futures.
Interest rates are low, which means that borrowing margin is cheap compared to dividend yields, and that discounting the future value of your returns will have a smaller negative impact on your effective yield.
Many brokers will allow you to margin your futures poisiton(s) with equities.
Total flexibility -- your position in equities is 100% puttable. You can liquidate your position at any time. In the debt market, on the other hand, your capital is locked in at a fixed (or sometimes floating) rate for a definite period of time. If rates go up, opportunity to invest at a higher yield is lost because your money is tied up elsewhere.

The downsides are:

Your portfolio could lose its beta correlation.
The yields on the your equity positions could fall.
Short term interest rates go up. This strategy works well right now because interest rates are so low compared to dividend yields. If interest rates go up significantly, there may be no point in trying to beat the yield curve in the first place.
If your portfolio loses beta or yield falls, you'll have to manage your portfolio to maintain its correlation and yield.
If you have to manage your position too much, transactional costs could be prohibitive.
This approach requires access to cash. Most brokers require you to have at 25% percent of your portfolio's value in cash before allowing stocks to be bought on margin. For example, if I wanted to buy an equity portfolio with a value of $52,500 (one E-Mini S&P), I would need at least $13,125 on deposit. In this scenario, my broker would lending me $39,375 and me charging interest on the principal. However, if I bought the equities outright, I would not have to adjust my net returns to account for interest owed because the discounting of future cash flows is already factored into the fair value premium (i.e., the cash to futures basis).

I hope you found this helpful, enlightening, or least interesting. Please leave us with your feedback below!

- MTL

T-Bond Futures have reached all-time highs and why we're still bullish on them

noreply@blogger.com (MTL) — Wed, 25 Aug 2010 08:14:00 +0000

We are seeing Treasury Futures prices hitting historic highs. The knee-jerk reaction is to say that they are over-valued. Indeed, there has been talk of a bond bubble. While we agree that all bubbles must eventually come to an end, we have reason to suspect that there is still a good deal of potential upside to this market.

We had initially believed that t-bond futures prices could realistically only go so high, perhaps 136 seemed like a good ceiling. But one of our colleagues was the first to indicate that bond prices were likely to go up more, because for the last 18 of 19 years, bond futures prices had gone up between the months of August and February.
We remain unsure of the causal basis for this phenomenon, but it is sufficient for us to acknowledge that it just exists.

After some more in-depth research and analysis, we believe that the T-Bond futures prices could go even higher before busting. How high? We have no idea, but its plausible that if we are truly entering an era of Japan-like interest rates, T-bond futures could reach as high as 167-09+.

We actually have no idea as to where the top of this bond market might be. In fact, we may have reached the top already. What we do know, however, is that it's ill-advised to arbitrarily pick a top to this market for no reason, other than because it either looks good on a chart or because you think that bond futures prices are range-bound. The only for-sure thing is that yield cannot go below zero. If there were no yield to discount future cash flows, the present value of bonds would equal the sum of all future cash flows. While completely unrealistic, zero-yield would mean that T-Bond futures would be trading close to 190-00 (per $100 par value).

We'll explain how we came up with 167-09+ as possible top for this market in a moment, but if you are unfamiliar with the particulars of T-Bond Futures, please read the footnote at the bottom of this post(1). If you are familiar with the terms and concepts of money market instruments and their derivative products, please read on...

We believe that 167-09 could be an extreme high for T-bond futures because that would be its price if the US Treasury Yields become like Japan's. Although yield is subordinate to price, it is often more useful to consider bonds in terms of yield rather than price because we know for certain that yields cannot be lower than zero. Yields also give us a comparative basis by which to judge our Treasury Bonds against other bonds, whether they are foreign government bonds, municipal bonds, or corporate bonds.

With the increasing concerns of an economic slowdown or even of a double-dip, the effects of a prolonged and unavoidable deleveraging, there has been talk that the US is entering a new regime of ultra-low interest rates. It is has even been suggested that the US will likely follow suit after Japan. Yields on JGBs (Japanese Government Bonds) are significantly lower than those on US Treasury securities.

The likelihood of this scenario remains a topic of heated debate. Some argue that Japan leads the US economy by a decade. Others claim that it is impossible to have an apples-to-apple comparison between Japan and the United States. For our part, we don't take a hard stance on this issue, but we do believe that the circumstances that caused Japan's ultra-low interest rates are similar to the current economic conditions facing the US. The reason that Japanese yields were hit especially hard was because the Japanese recession of 2008 came when it was still limping from a deflationary crisis that had plagued it throughout the 1990s. While the US economy has proven more resilient, if fears of deflation are realized in the coming years, you can bet that yields are going lower. Although we don't think that while US Treasury yields are not likely to become as low as Japan's, it is in the realm of possibility, and also a useful thought experiment.

For the sake of discussion, let us assume that this is possible, and that we are entering this new regime of low yields. We crunched some numbers for you, and here are our results.

First, we examine the current yields on US Treasury securities:

(Data courtesy of Bloomberg.com)

Then compare them to JGBs.

(Data courtesy of Bloomberg.com)

Next, we look at the fair value detail of the CTD bond. It is a 6% coupon, so there is no need to perform any conversions.

(Fair value calculations courtesy of Bloomberg Professional)

This tells us that, given our initial input values for the US Treasury nominal yield curve, T-Bond future prices should be at 135-19 (the last two numbers are quoted in 1/32nds) upon delivery. At the time that this data was run, the futures were trading close to 134, which reflect the positive basis between cash and futures.

And finally, we interpolate the points from the JGBs onto our fair value analytical tool, and we get the following:

(Fair value calculations courtesy of Bloomberg Professional)

This chart tells us that if US Treasury yields go to Japan's current levels, the T-Bond futures could trade higher than 167.

We would like to acknowledge that we utilized Bloomberg's Professional Terminal to run the scenario analysis. We do not endorse any products, but we must admit that Bloomberg's Professional Terminal is very powerful in the right hands.

Our time's up for now. Stay posted as we continue to provide you with facts-based analysis of the derivatives markets.

- MTL

FOOTNOTE:

Because we don't expect everyone to be familiar with the fundamentals of the t-bond futures contract, we'll briefly review some bond concepts. The T-Bond futures contract is traded at the Chicago Board of Trade. The contract's par value is $100,000, with price quoted as a per cent of the par value. The price value of 1 points is $1000, and the tick size is 1/32 of 1 point ($31.25 per tick). The options tick in 1/64 of 1 point ($15.625 per tick).

As with all futures contracts, the futures fair value equals the spot price plus carry. Carry is comprised of financing costs minus earnings (and/or interest-payments). For a 6% coupon Treasury Bond, the carry is currently negative so the futures trade at a discount to the spot (i.e., you earn money above the prevailing financing costs by holding the cash bonds). The T-Bond Futures price reflects what the current market value of a 6% coupon is expected to be at delivery. The contract is settled in actual US Treasury Bonds with at least 15 years remaining until delivery. Any coupon is eligible for delivery. To put different coupon bonds on roughly equal footing upon delivery, the long position receives an invoice which is the futures price multiplied by a conversion factor plus any accrued interest. The short position decides which bonds to deliver and when to deliver them. It is to the short's advantage to deliver the cheapest possible issue of bond (called the CTD, or "cheapest to deliver), which is determined by the difference between the repo (repurchase) rate and the implied repo rate (IRR). The bond issue where the difference between the repo rate and the implied repo rate is the least negative is the CTD issue. As long as the yield curve is positively sloped, the cheapest date of delivery is the last possible day, which makes sense because the short accrues more interest for holding the bond than he must pay in interest for borrowing the money to hold the cash bond.

As of right now, the cheapest to deliver bond is the 6% coupon with a maturity date of 02/15/26, but that will not always be the case because this issue will be ineligible for delivery into the March 2011 contract. That the 6% is currently the CTD is somewhat convenient because it nullifies the need to convert the CTD issue into the 6% coupon, which the futures contract pricing assumes. This will be important when we look at the fair value of the CTD issue under the given yield curve interpolations.

Welcome to MTL Futures!

noreply@blogger.com (MTL) — Mon, 23 Aug 2010 15:21:00 +0000

This is my first ever blog, and first ever blog post. I've been a little late to the scene, but am ready to dive in head-first. Please continue to check in regularly as we continue to improve the site and provide leading-edge content.

From the team and I, we wish you a happy trading day!