Saturday, May 15, 2010

The day the computers panicked PART 3

“Sometimes you eat the bear and sometimes the bear eats you”

Some reader may know the source for that quote; I’d appreciate the reference. It’s cuter and more memorable than “Can’t win ‘em all” or “You win some; you lose some.” Besides, given the topic, it’s more appropriate. The topic is how to beat computer-generated meltdowns. You can call them a “flash crash,” a “one minute meltdown,” or an “insta-bear.” Most of them actually last more than minute. But, they’ve been some nice opportunities.

The March 30 posting on this blog entitled “Wall Street doesn’t run the world” states: “…the individual knows more about their timing requirements and has more control over them than do most institutional investors.”

There are many ways to take advantage of that control. This posting discusses some. In the posting cited above, other considerations important to individual investors are discussed. Using the techniques discussed here involves tradeoffs between those considerations, thus the citation rather than just the quote.

One consideration that will be explicitly addressed is tax treatment. Tax treatment, however, doesn’t impact whether the techniques work, but it influences how to implement the techniques and where each technique works best. But, the treatment of tax considerations only covers whether the techniques are workable in tax deferred accounts.

This posting addresses how to benefit from a meltdown using techniques that also pay off regularly. It also addresses things that backfire in a meltdown. One caution when discussing trading techniques: no technique is a substitute for common sense. Some people get so fascinated with technique they forget what they’re really doing. Technique is marginal; investing is substantive.

So, you ask: Why write about technique? Well, the previous posting mentioned quantitative funds. To some extent, they earn a rent on their analysis of the market, but, whether they know it or not, flash trading and dark pools have introduced another element. Much of their return is a rent on insider information. Since you or I would go to jail for trading on insider information, the techniques discussed are a way to level the playing field by partially protecting oneself from this insider trading by taking advantage of the behavior it spawns.

“Guarding Against Market Gyrations” at also discusses the topic. Although I disagree regarding one of the techniques recommended, the article is worth reading. The very first point it makes is also probably the most important thing to remember. Using market orders leaves one totally vulnerable to any sudden changes in the stock’s price.

A previous posting when discussing asymmetric returns stated: “Even the probability of lesser forms of illiquidity get mis-estimated. Consider big, instantaneous changes in price (“discontinuities” or “gapping” in investor jargon). If one has investments, there is a good chance one asset experienced a gap in price during the time it takes to read this posting. It might be small, but it isn’t unusual. Some investment advisors recommend always using limit orders as protection against discontinuities being used to the investors detriment.” In a meltdown, many assets (stocks, indexes, bonds, commodities, even currencies) are likely to gap. It is the classic example of why market orders are dangerous.

The second point is related to market orders, but it addresses “stop loss” orders. I dislike market orders so much that the dislike explains why I differ with the market gyrations article on “stop loss” orders. As stated in the last posting on this blog: “A “stop loss” is a limited protection. It doesn’t guarantee a price when an asset price “gaps.” That’s the same lesson learned in October 1987. Further, they don’t protect one from volatility. One can get “stopped” out of a position at a price that is lower than the price a few seconds later. In fact, the presence of a large number of “stop loss” orders increases the probability of “gapping” because once the “stop loss” thresholds have been crossed the orders all become market orders to sell.” It’s a judgment call, but data seems to support the contention that in a meltdown “stop loss” orders are likely to do more harm than good. The “stop loss” may be a technique that meltdowns has made obsolete.

The third technique is a buy order with a price limit that is “good until canceled.” One has to remember the order has been placed and treat it as money spent. Certain conditions have to be met for this trade to make sense. The conditions are (1) one has money one wants to invest in a specific stock if it can be purchased at a given price, (2) one doesn’t currently have an alternative that is as attractive as waiting to get that stock at that price, (3) one has a strong conviction about the purchase at the target price, and (4) one can remember to remove the order as soon as any of those conditions are no longer met.

To illustrate, let’s assume someone had been watching P & G trading at about 62 earlier last week. Further, suppose one heard that P & G’s earning announcement disappointed some institutional traders. This may have alerted some people to a possible drop. Now suppose the observer wasn’t willing to dismiss those earnings concerns. But, one thing the observer felt comfortable saying was that if it dropped to 55 the reaction was overblown. If the “good until canceled” order was on the books on Thursday, the observer would have made a good buy and could trade out now at a profit.

I intentionally chose P & G for the illustration since there were rumors surrounding P & G at the time. The strong conviction is important because the risk with any standing buy order is that one could end up buying a broken company and there will always be rumors. But, that risk would be there regardless of the purchase price. Psychologically, however, the act of buying at the point where it becomes apparent the company is in trouble makes it seem more painful. (Darned if I didn’t just see the same example of using “good until canceled” orders using P & G at 40 or 50. Oh well, hopefully, more people will use the approach to get stock they want).

The fourth topic is a note on a technique that doesn’t work. For most individual investors, having some liquidity available during a computer driven meltdown doesn’t help. The proverbial “cash on the sidelines,” is always nice. As they say, it lets the investor take advantage of opportunities. But, one opportunity it won’t let most investors take advantage of is a flash crash. They happen too fast.

To illustrate, with two personal stories. Last Thursday during a break at a conference, a number of us were watching the meltdown on CNBC. When they showed P & G’s plunge, I turned around and muttered “I have to get to a broker or a computer.” A concerned voice asked “Are you getting out?” My response was “Heck no; I want to buy P & G. I’ve been waiting for an opportunity.” By the time I got to the end of the table, the DOW had recovered about 500 points and P & G was showing a 50% recovery and gapping up. Unless one was sitting at a very high speed trading desk, there was no opportunity without the order already being on the books.

In the October 1987 one day 20% meltdown, a similar thing happened. Back then one traded through a broker mainly over the phone. Every broker’s phone, even the brokerage office’s lines were busy from late morning on. It was so frustrating that late in the afternoon, I left the office to drive to the broker’s office. I was desperate to put whatever money I had into the market. I arrived about fifteen minutes before the market closed. The office lights were off. A frightened administrator unlocked the door when I explained I was a customer. She told me the office had shut down. They couldn’t get the flood of sell orders processed and everyone went home. They were just too discouraged and sad. Further they feared irrate customer would get violent. When I said I wanted to buy, she just said she wasn't a broker and they had closed down the system.

So, based on personal experience, be advised: if cash on the sideline is how you plan to take advantage of computer panics, be sure you have a technique for getting the trade done before the computers reverse field.

The fifth topic is watch lists. A watch list that’s on hold for something to happen so that the investor can act will often be of limited use when computers panic. Don’t take that wrong; an investor should have watch lists for buys and sales. But for meltdowns, the logical response is a watch list (or part of a watch list) that is set up to act when conditions meet set criteria. That is the essence of this posting. If by contrast the investor can’t identify a single thing that is advisable regardless of daily updates, the investor needs to learn more about what they’re considering. Granted, other opportunities may come up, but if they aren’t there today their relevance today is limited.

So far, everything said involves techniques that can be applied in taxable or non-taxable accounts. Now it’s time to discuss some techniques most brokers won’t accommodate in tax-deferred or non-taxable accounts. Also, since the discussion involves options, it seems appropriate to remind the reader that the topic is meltdowns only. Buying panics aren’t addressed even though they often occur in other assets simultaneously with meltdowns in equities (or bonds).

The technique is selling puts as a way to acquire a stock. To review, selling a put is giving someone the right to sell you something (a stock in this case) at an agreed upon price (the strike price). The technique has been mentioned negatively on this blog a few times (for example, in connection with regulatory reform on March 4 in “Putting the adults in charge of derivative trades” the posting noted: “…selling naked puts, do it often enough and eventually you’ll get a collateral call.”). In a meltdown it won’t be just one put that gets “assigned” They can all get assigned (i.e., the people who bought the puts could all require that the seller of the puts honor their commitment and buy at the strike price).. Thus, the person who sold the put sees all their liquidity evaporate at a time when they might like to have some money. The person selling the puts could use up their entire margin, and if stocks keep falling, end up getting a margin call.

The real point, however, is the realization that the person selling the put had already given up that liquidity when they sold the put. People will say things like “I’m selling puts so that I can hold onto my liquidity while earning a little more than cash earns.” For them, a better way to look at it is that they are using their liquidity to buy the cash flow from the time decay of the option. As the obligation goes away over time, they are getting paid back with their own liquidity. So, in a sense, they sold their liquidity for whatever they got for the put and now they’re getting it paid back in installments from their own funds.

When discussing asymmetric returns on May 1 in “ Sometimes Wall Street provides more entertainment than Hollywood: PART 2 the losers “ the reason this is important was explained. It worded the reason as: “asymmetric returns are so dangerous. Making the mistake outlined above is often profitable most of the time. The Pavlovian response to the repeated positive feedback is dangerous for two reasons. First, it is a tempting trade since most of the time it makes money…. Second, the positive feedback reinforces the tendency to underestimate the risk. Thus, there is a tendency to “up the ante.” In businesses, this takes the form of increasing the risk exposure or even ignoring risk guidelines.”

So, selling puts to generate income can be deadly in a meltdown. However, selling them to purchase a stock can be beneficial. Granted, in a flash crash one may not get assigned. Similarly, the stock could “gap” right through the strike price, leaving the put seller obligated to by at a price above the market. But, if the investor wanted it at the strike price, they could just have likely bought it at that price and experienced the same paper loss. Further, if short run paper losses really upset a person, stocks aren’t the place to be.

A disclosure is in order; so, let’s get it out of the way. This posting addresses only one of many ways an individual can take advantage of their control over their timing requirements. My preferred approach was recently characterized as “diversification across time.” That characterization was so catchy it deserved quoting. A consequence of diversification across time is being close to fully invested most of the time, thus perhaps not maximizing the potential returns from computer panics. But, the strategies discussed here don’t require anything as dramatic as a flash crash. They work and I take advantage of them.

One might question why protective puts and covered calls weren’t discussed. Both covered calls and protective puts are effective techniques for reducing volatility. In fact, buying a put, so that one knows the minimum price one will get for a holding, is certainly more effective than a “stop loss.” But, both are designed to reduce volatility. The topic of this posting isn’t reducing volatility of investments; it’s profiting from market volatility. That’s why the discussion of “stop loss” focused on how they backfire. Similarly, covered calls trade off potential up side volatility for the price earned by selling the call (technically the time decay on the calls). Not an appropriate technique for profiting from volatility.

One final point, circuit breakers on individual stock will move computer panics to other markets. But, the techniques discussed work fairly well with good old fashion human panics. Thursday’s real lesson for individual investors should be not to invest in stocks unless one can tolerate volatility. If one might need liquidity over the near term, don’t buy stocks. ">

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