After the nine days of trading since the Facebook (FB) IPO there have been dozens of opinions written as to what prices the stock will trade in coming days, all by individuals of a variety of backgrounds and experience levels.
At Tuesday the 29th we had the first chance to see what FB price range was being forecast by the self-protective hedging actions of the professional community of market-makers. This approach is a branch of behavioral analysis that looks to the productive and intelligently-guided activities of investment professionals, instead of the erroneous and mistaken responses that humans often make.
Stock prices are the product of the expectations of knowledgeable, big money investors and their transaction facilitators. The seriousness of this game requires that they guard those anticipations closely. But to get money moved where desired, the trade facilitators have to be given some idea of how far the investors are willing to go.
The prevalent volatility of prices also requires that they guard their capital carefully. So when facilitators are required to take risks (provide market liquidity) to complete volume transactions for their big-money fund clients, they hedge their exposures with price insurance, commonly called listed options.
If you want to know how someone values something, see how he spends his money on it. Self-protection is a strong motivator.
Hedging always has a cost, and for the trade facilitator, it has to come out of the spread he might otherwise earn on the transaction. So he buys protection frugally, never beyond what he believes is necessary.
Still, options activity motivated this way makes up 2/3rds to 3/4ths of the options volume in most actively-traded stocks. There, the options pricing is dominated by their presence.
Who sells the insurance? The proprietary trading desks of other trade facilitators. They are as equally well-informed as the house buying the protection, but for an adequate price (in the insurance seller's judgment), the deal gets done. Both buyer and seller come away with a derived gain.
There is a developing public attitude that unfairness in markets is now preventing ordinary individual investors from getting a fair shake. That makes an opportunity to legally peek at the cards of the market pros irresistible. We intend to make this possible on FB as a free public service as long as the interest continues and our situation permits.
Here is what we see from their hedging on, May 29th. They were willing to pay for price insurance, out of trade spreads they could otherwise put in their pockets, guarding against FB prices as low as $25.99 and as high as $34.63. From the end of day price of $28.84 these extremes represent a drawdown of -10% and a gain of +20%.
By pure coincidence this represents a reward-to-risk forecast of 2 : 1.
The options volume in FB this day was a hair under 10 million notional shares, with some trades as large as 200,000 shares, others only 100.
Our firm has done this analysis daily for more than a decade on over 2,000 other stocks, using publicly available information and a model that has not been changed in all that time, despite widely varying market conditions. What we do can be done by anyone else with the same data and understanding that we have as to how markets work.
We don't yet know how well the market pros' expectations for FB will be reflected in its future prices. But we do have an enormous actuarial backlog of their accuracy of estimates on other stocks. Here is what they have said (before the fact) about upcoming Apple Inc. (AAPL) stock prices.
The following pictures assemble over 1100 trading days of AAPL price range forecasts implied from market-maker hedging actions daily during the past 4-5 years. Each day the end of day market price for AAPL has been compared to the forecast price range as an index of how far up (in percentage terms) it is from the bottom of the forecast range.
As an example of this Range Index, imagine a stock selling at $50, with a forecast range of $10, running from $48 to $58. Its Range Index is 20, since 50-48=2 and 2/10=.2 or 20%. Prices outside the range are uncommon but not unheard of, and run from minus numbers to over 100. The FB Range Index on May 29th was 32. On June 1 it is 36.
To see how effective the forecasts on AAPL have been at various levels of Range Index, we have cumulated their results from the extreme low RIs (cheapest) and extreme high RIs (most expensive) to the median (mid-point) RI.
The count of Range Indexes is cumulated at each level, as a percent of all RIs in the sample. They are pictured as the vertical blue bars, measured by the left margin scale.
The first picture shows at each RI level, in the three months following each forecast, the average proportion of market days that ended with a price higher (green line) and lower (red line) than at the day of the forecast. The two amounts are complimentary and opposite, symmetrically.
What properly may be inferred from this is that market-makers hedge more against rising prices of AAPL when the odds are high that prices will rise and more against falling prices when that is likely to occur. The pros have anticipations that are insightful for more than just the next day or two.
We should be interested in whether these price changes are trivial or significant. So here is the same framework, showing what the daily average percentage price changes actually have been following each Range Index level, measured by the picture's left hand scale.
Indeed, when market pros see far more upside than downside (low RIs), price gains of +10 to +15 are probable, and downside losses of -5% to -10% may occur. At higher RIs, losses of -10% to -15% are prevalent, and gains of only +5% are typical. See the left-hand scale.
Since there are more winning buys at low RI's and fewer losers there, the difference between the price changes is accentuated. At the other end of the RI scale the reverse is true. An integrated picture comes when the ODDS and the PAYOFFS are combined.
The odds-weighted price changes, netted against one another at each level of Range Index show how well the market-making transaction facilitators place their bets in anticipation of prices yet to come. This also is testimony as to the trading efficiency of US markets where there is continuity and liquidity in volume.
So, in the case of AAPL, the market pros are earning their 7-8 figure salaries and bonuses.
If it turns out they can do as well with FB, we may be able to help you level the playing field. Check our daily updates here to see for yourself.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.