Free Markets vs. Fair Markets: Dismantling the Fat Finger Theory

Includes: BA, BHP, DD, DOW, FCX, LMT, SPY, V
by: C.S. Jefferson

People believe in free markets, not markets in perpetual free fall; and certainly not in markets that are free to do whatever select proprietary trading desks decide ultimately drives markets in the direction of their choosing. What matters most of all is whether or not ordinary investors can participate in a fair market. The shame about an event like that which transpired last week is that it has been a very difficult struggle to repair the trust that was already broken after the collapse in the markets throughout 2008 and early 2009. Make no mistake, this occurrence was an intraday crash despite any news outlet downplaying it with euphemistic adjectives, and it only further confirms the public’s perception of the stock market ultimately being a rigged casino.

Call it what you want, computer glitch, trading error or whatever inane explanation attempts to justify last week. But the worst and least plausible excuse of all had to be this patronizing rumor mongering promulgated by mainstream financial news services blaming this unnamed, yet mysterious, rogue trader with an uncanny “fat finger”, who somehow caused a cascading effect in the markets by pressing billions, instead of millions, on a single trade execution.

I didn’t realize distended trigger fingers were now an epidemic on trading desks. The only time a person should ever fear a fat finger is when they are awkwardly bent over in the proctologist’s office and, unfortunately, on volatile days like these, the analogy holds equally true in the markets. Other than that, the notion of yet another repeated lone gunman theory sounds like a convenient way to rationalize wide systemic risk without ever having to own up to fixing the real problems in a market dominated by algorithmic trading, naked short selling, dark liquidity pools and high frequency trading.

The simple truth is that what we experienced was an intraday market crash that broke all the records--there is no denying it. Whether the price action of the trades were legitimate or not, they sure were real to anyone that was knocked out of their positions on a stop order, or handed a margin call the next day and forced to liquidate. In fact, this would explain the continuation of volatility the following Friday after the crash, as I would imagine there was a lot of portfolio rebalancing going on throughout the day.

Put it this way: If the whole panic selling crisis could actually be caused by a single person with a fat finger, then the system is truly broken and beyond repair; or worse, the market remains extremely vulnerable for someone to exploit such event driven volatility. Whatever the trigger is that precipitates selling, the real culprit is the fact a domino effect and chain reaction exists to begin with. I suppose a forensic analysis will tell the story once trades are settled and accounts reflect who made and lost money in their accounts.

What’s worse: The fact a fire started in the first place? Or the fact that the arsonists who started the fire weren’t caught and brought to justice? Let’s say you take the proposed litany of excuses used such as computer glitches or fat fingers at face value without concluding intent. Does that not automatically invalidate any trades that occurred during that short period of time? Why aren’t all of these transactions at extreme market disparity simply null and void? Without recrimination, trust is not restored and the only assurance market participants will ever receive is the benefit of short-term memory.

Letting bogus trades stand at all was like allowing only the privileged players in the market to make bets on the winning horse after the race has already won. It’s the oldest con in the book called wire fraud and individual investors have been ripped off on fictitious bands of volatility. I truly feel sympathetic for anyone that was prematurely knocked out of the market by stop loss orders, and worse, those that were liquidated due to margin calls.

In this case, scalpers and proprietary trading desks masquerading as market makers failed to do their job and step in as required to maintain liquidity and keep tight bid/ask spreads. It is clear market makers stepped to the side and allowed the market to crash intraday. I understand they were doing what is in their best interest, simply because the risk was catastrophic, but if we cannot rely on market makers to be the backstop when liquidity dries up and overwhelms the bid to maintain order, then there needs to be systematic fail safes and circuit breakers in place that can stop outright market manipulation by share dumping via naked shorting.

How many of those trades were initiated by naked shorts slamming the market down, further triggering legitimate sell orders in a chain reaction? This type of volatility was manufactured and it is time to not only set regulation in place, but to enforce it to prevent fictitious transactions which punish retail investors most of all. Trades taking place off major exchanges that are obviously aberrant dislocations should not print on the tape--especially if the volume of that transaction does not support the price deviation.

High frequency and flash trading to me is like allowing two car dealerships across the street from each other to swap the title back and forth to jack the price up until you happen to come along and want to buy. Even though the car you are buying never moved from the original lot it was parked in, you’re now paying more than what it was selling for earlier in the day. You’ve essentially been hustled into overpaying for a car based on a phony bid and fictitious demand. Is this what constitutes volume and liquidity these days?

Reg NMS is a failure for the integrity of the market. There is no way price manipulation based on a low print across the tape should be allowed to effect real price discovery that should only be determined in the light of day on a transparent, regulated exchange. Intended to bring speed of execution and order routing, it removes the whole incentive for a company listing a stock on a particular exchange if someone in a back room with a server can operate block trades that would ordinarily determine real supply or demand. Turn back the dial, stocks should only trade the major exchanges they are listed on to maintain the integrity of the price action without violation. In every sport there are rules designated for everyone to follow, the capital markets should be no exception.

While I can’t say for certain, here’s my take on the situation: Quite simply, traders have been itching for a pullback to reload their positions on the long side after such a run over the course of the last year. It wasn’t one stock or sector that took the hit to be legitimately considered a glitch, it was everything at precisely the same moment in time. Selling begets selling until it overwhelms the legitimate bids. All week long, you heard the cacophony of analysts and traders alike almost celebrating the fact the market was heading down in an orderly fashion. However, what spooks traders playing the short side or strategically waiting out a buying opportunity is the unpredictable and irrational volatility in a sell off like what occurred in a near 1,000 point drop.

The professional investment community has been clamoring for a “10% technical correction” for a long time and too many people were leaning on the same side of the trade--what they didn’t expect was for a 10% correction to occur in a matter of minutes. An orderly sell off is one thing, a market crash is another no matter what side of the trade you are on. Too much consent among institutional players leaning aggressively on one side of the position, waiting for the moment to jump the starting blocks when the gun goes off. What we saw was indiscriminate selling pressure brought on by aggressive naked shorting. Cue up the tape, was the overwhelming buying pressure and snap back recovery in the market opportunistic buying or short covering?

What was truly frustrating as a trader was that on a day like this, I looked for opportunity to get aggressive by buying call options. However, eerily similar to the crash in 2008, large spikes in the VIX pushed option premiums out of whack so that at-the-money and out-of-the-money options were way overpriced relative to the underlying descent in the price action of the stock. The only way to take advantage on the long side was simply to add more stock at a discount, or become a seller of premium--I opted to sell long puts held against shares and write cash secured puts on stocks I’m willing to own. This only works if you are both willing and financially able to have shares put to your trading account.

For some time I’ve felt the market was no longer cheap, but wrote in my last article that there were four stocks in particular that I thought would give investors an opportunity to go long and participate in the market with less risk to the downside. Those four stocks were Lockheed Martin (NYSE:LMT), Boeing (NYSE:BA), Dupont (NYSE:DD), and Dow Chemical (NYSE:DOW); all of which have outperformed the market since then, with three out of the four paying high dividend yields. I remain long in all of these stocks and would probably add in more positions if they trade much lower. Whatever market event, systemic shockwave, or excuse the market has to pull a rabbit out of its hat to trade lower, none of these stocks are in jeopardy of collapsing. Can they trade lower? Absolutely, but with the exception of DOW, they never suspended or lowered their cash dividend during the worst economic crisis of our generation.

Other stocks I hold remain the same from prior recommendations. Freeport McMoran (NYSE:FCX) and BHP Billiton (NYSE:BHP), two fantastic metals and mining stocks already under short-term selling pressure. Unfortunately, the proposed “miner’s tax” in Australia is a very real threat to balance sheets and may, in a perverse way, be a form of asset repatriation that could gain traction in other resource rich continents. They are high beta securities which presents a certain level of unwarranted risk, but they also capture an exaggeration to the upside when the market recovers. I also own Visa (NYSE:V) which is the only financial stock I’m interested in holding at the moment.

I am fully invested as far as my core stock positions go and, unless I see a continued sell off where stocks become too cheap to ignore, I’m less inclined to add more to existing positions--although, BA in the mid-60’s did get my attention enough to write some cash secured puts as opposed to adding more shares. However, days like these are painful reminders of why I always remain hedged against my long positions. Moments like these are opportunities to utilize the dislocation in the market to sell puts as hedges for profit and capitalize on premium if you believe, as I do, the fundamentals are intact.

I would be inclined to think the market is very oversold in the near term and judging by the EU resolution to reaffirm their currency and reaction in the futures markets we can see a major snap back this week. Could the market trade much lower? Absolutely. Whether it’s playing unemployment number bingo month to month--say what you want, those numbers are trending positive--parliamentary elections in Britain, or EU austerity measures on Greece’s exaggerated debt contagion, they are all tangible headline excuses to grab, but insufficient to justify this type of selling against good earnings and fundamentals in the long term for U.S. equities in particular.

Having said that, the cost of hedging my long positions with married puts and/or collars, outweighs the consequences of being wrong. As an investor, one must choose to allow themselves to be chased out of their positions amid the panic.

Ultimately, the stock market is neither free, nor is it fair. While I believe this market is headed higher for reasons based less on macro-economic issues and based more on a liquidity driven rally--after all, it may be a crooked casino, but it’s the only game left in town once the real estate market folded--volatility is, inarguably, here to stay. So, folks, prepare yourself and hold on for the ride.

Disclosure: Author holds long positions in [[BA,]] LMT, DD, DOW, V, FCX, BHP