One of the quotes that guides my
investment and trading philosophy is attributed to Benjamin Graham:
In the
short run, the market is a voting machine. In the long run, it is a
weighing machine.
-
Benjamin
Graham
With this quote in mind, I look for
occasions when commodities and stocks have diverged from fundamental value, and
seek to profit from that divergence. Often, the divergences can last
longer than anyone might expect. But, that is a topic for another
article.
In this article, I want to look at
this quote in a specific and practical way, and apply it directly to the recent
"flash crashes" that we have seen in tech stocks, gold, and now
silver.
Graham says, "in the short
run, the market is a voting machine." Here is the one of the
problems with that true statement: there are entities who have the ability to
stuff the ballot box and profit
from nano-second moves in the markets. At certain times of limited
liquidity (or otherwise), the market "voting machine" can easily
become an "arbitrage machine."
Silver Flash Crash
As has been widely reported, the
COMEX silver market (owned and operated by CME Group) "flash crashed"
from a high of $16.07 to a low of $14.34 before recovering to close at $15.90
over a 5 minute trading block of 8,000 contracts. This many contracts
amounts to 40 million notional ounces of silver, 4.4% of annual mine supply
traded in 5 minutes!
Source: TradingView
Peter Pan Becomes a Pirate
One of my favorite quotes from film comes in one of the modern renditions of Peter Pan in the movie Hook. Peter Pan (played by Robin Williams) has left Never-land, and has become a swashbuckling investment banker. Wendy goes to Peter Pan to let him know that he is needed in Never-land. Upon hearing about Peter Pan's new job, Wendy is astonished to see that the boy hero Peter Pan is now playing the part of a real-life pirate.
While I have not become a pirate, I
have found that it can be occasionally profitable to think like one. In a
game theory analysis of the commodity markets, I try to think like a pirate
would think.
If I Were A Pirate . . .
Before we get to our pirate flash
crash strategy, let's look at a recent bid-offer stack for the iShares Silver
Trust (
SLV). In this example, there are
almost 400,000 bids to buy SLV at 14.91, and almost 110,000 offers to sell SLV
at 14.92. Most retail investors have the ability to see this bid-offer
stack, and the same kind of bid-offer stack exists in the futures markets in
addition to the stock markets.
Source: E-trade
If I were a pirate (I am not),
having the means to do so (I don't), I would evaluate the bid-offer stack of my
target commodity, and during times of illiquidity (like 4am EST on a Monday, or
7pm EST on a Thursday), I would set up limit purchase orders 10% below the
current price (for example), and then place a sell order that hits every bid in
the bid stack (and triggers known and unknown stop loss orders at key technical
levels).
The cascading effect of the flash
sale, combined with the known and unknown stop loss sale orders (designed to
protect long positions and/or profit from a new downtrend) might cause price to
decline to the place that I had established my purchase orders.
All of this can be optimized by HFT
algorithmic computers that have a form of market price omniscience, being fed
with the bids and offer data, and oftentimes the stop loss data as well.
Five minutes later, price recovers
almost to where it was before, and I would have arbitraged the bid-offer stack.
Who Loses In This Flash Crash?
The person who loses in this flash
crash is the retail and other investors who do not have the same level of
information and market-moving ability as others, and have attempted to protect
their long positions with stop-loss orders.
Here are a couple of tweets from
this morning that elaborate on that point. First of all, I am impressed
that CME Group responded quickly to adjust and correct some of the orders
during the flash crash period.
One trader reported that he had
established a protective stop loss order at $15.80/oz. Nevertheless, stop
loss orders are sometimes only triggered if there is an actual bid or offer at
the level of the stop loss order. In this case, the trader first had an
effective stop loss at $15/oz before it was corrected to $15.56/oz by CME
Group.
Either way, the retail investor got
fleeced by a 5 minute up-down spike in the price of silver. After the
dust had settled, and if this trader had not had the protective stop order of
$15.80, he would have still had his long contract at a value of $15.90.
Applications
We have attempted to alert readers
to this kind of activity before, but it is of course complex and takes some
contemplation to follow along. This example above is a more detailed
example of what I attempted to explain in one of my prior articles:
Trading JNUG and NUGT? Play
Blackjack Instead
.
Because of this kind of activity
stop-running activity can occur in all markets, we try to focus on the
end-of-day closing price and set mental stops, not actual stop loss orders for
our swing trading holdings. Unfortunately, some or most of the stop loss
order information is sold as information to firms with the ability to profit
from that information.
I continue to try and think like a pirate to get a sense for where the markets might be arbitraged next. I have developed some interesting tools and information that I share with my Seeking Alpha subscribers, such as the option market price magnets for gold, silver and crude oil.
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The author behind Viking Analytics has over twenty five years of experience as a financial analyst, business developer and commodity trader. In 2006, he founded a commodity recycling business, which he helped to grow to $20 million in revenues. After the business was sold in 2015, he has consulted for clients in the areas of finance, business development, and alternative investments. He loves to follow and study the financial markets and has become a believer in sound money.
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