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Reader Questions Answered

Thin holiday markets and new year volume pick-up

The following two questions came in from one of my newsletter subscribers in regards to comments I made about how the markets can trade around year-end and into the new year.

1. Regarding your 2000 EUR/JPY trade: I am wondering if your success with that trade was more a function of fundamentals than the low volatility of the holiday period. Everyone knows that there was a G7 coordinated campaign to prop up the Euro. Being both a position trader and a Forex analyst, it wouldn’t be a surprise if we were told that you considered that information in your decision. Lack of offers during the holiday period may have helped, but it’s hard to get a sharp move of thousands of pips without some fundamental development that the market perceives as a game changer.

In fact, I wasn’t actually working as an analyst at that point. I was coaching volleyball full time back then. My analysis was strictly technical in nature, which is what I tend to favor in my own forex trading in any case.

The point about there being a fundamental driver is a good one, as there is almost always something underlying a directional move in the market (though Wednesday’s trading demonstrates that it isn’t always the case for short-term moves), but it’s not an either/or thing. There is no doubt in my mind that reduced volumes around the holiday period helped to accelerate that rally for the simple reason that there weren’t sufficient offers on the other side to resist it. When the volume did start coming back in after the first of the year, there was a very sharp retracement, and in fact it wasn’t until a year later that the market was able to extend the late 2000 rally into the trend that eventually topped out in 2007.

2. You make it sound as if everything will be back to normal in terms of volume on January 3rd. I have noticed (and others have commented likewise) that the first two weeks of the year are similar to the last two in terms of liquidity. Is that definitely NOT the case in your experience?

Actually, if you look at stock market volume you’ll see it snaps back very quickly. For example, in 2010 the last two weeks of the year show 105mln and 76mln shares respectively (I’m looking at an S&P 500 chart – not total market volume). The first week of 2011, however, shows 197mln, which is basically in line with the volume peaks from normal period weeks before that. There’s a similar pattern looking back to prior years.

Note that volume and volatility aren’t necessarily the same thing. There are reasons why there’s increased volume flow in the markets to start the new year – reasons which contribute to the seasonal patterns which tend to be in force. And keep in mind that volume and participation isn’t necessarily the same thing either. Just because more money flows back into the markets (or through them), it doesn’t necessarily mean there are many more traders and investors active (though certainly it’s often the case).

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The Basics

Influences on Price/Earnings Ratios

The Price/Earnings ratio (P/E) is a metric commonly used in fundamental analysis of stocks – both individually and in terms of indices. It can be a useful gauge of relative over- or under-valuation both in terms of looking at a stock or index singularly, or in comparison with others. For example, one could evaluate where the current P/E of JPM is in terms of it’s historical levels and/or in terms of how it compares to BAC, C, WFC, and others in the banking sector.

It’s not recommended that P/E be used in isolation – meaning low P/E = cheap stock, or vice versa. There are reasons why a P/E can be low or high, including changing expectations for growth rates which have not necessarily started showing up in the earning data. For that reason, you should only use the P/E in conjunction with other forms of analysis.

Looking at Stock Valuation Math
In thinking about doing so, it’s worth noting the two mathematical influences on the P/E ratio when looking at the valuation of a stock. They are the earnings growth rate and the interest rate. Stock valuations are done by determining what future earnings are expected to be, then discounting them back to the present by doing a Present Value (PV) calculation.

Earnings growth rate assumptions obviously factor into the expectations for future annual earnings per share figures. The table below shows the impact of different levels of growth rate expectations for earnings on valuation, and thus P/E.

The above calculations only go out to 5 years. Valuations are often done with an additional perpetual growth rate for the years beyond #5. For the purposes here, however, five years is enough to make the point.

Notice in the yellow Value row how the valuation of the stock in question (based on adding the PVs of the earnings forecasts for Years 1 through 5) rises as the assumed annual growth rate (left column) goes from 0% up to 20%. Using the Year 0 earnings (current year achieved result) as the E in the P/E, and the valuation as the P, we get the P/E listed in the right-most column. Notice how it rises in line with rising growth rates.

Now, this probably won’t come as a big surprise. It’s commonly understood that higher earnings growth rates translate to higher P/Es. That’s why the P/E of a perceived growth stock will generally be higher than the P/E of a more mature stock, like a utility. It also should be noted, however, that P/Es also vary because of interest rates. The discounting of future earning’s done in the valuation process employs an interest rate to calculate the PVs. Thus, interest rates impact P/Es.

The chart below provides an example.

The chart above shows the P/E value of a stock with a 5% annualized earnings growth rate with valuations determined using discount rates from 1% to 10th. Notice the steady decline as interest rates rise. It’s not a big change, of course. Changes in earnings growth rates are more impactful. This may be something very important for the stock market moving forward, however. If we think interest rates are going to be rising in the years ahead, then we have to factor in slightly lower P/E ratios.

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The Basics

The Cost of Trading

Last week I wrote a post for the Currensee blog addressing a recent SmartMoney article attacking forex trading from the perspective of costs. The article was full of misinformation of the sort I’m coming to expect from those writing about forex (and trading in general) from a journalistic point of view. I wasn’t shy about taking the author and her editor(s) to task for the piece’s short-comings.

One of the core elements of the discussion in my post was the impact of spreads on one’s trading. In the spot forex market spreads are readily visible because that’s how the market presents price feeds. In exchange-traded markets, however, spreads are often quite opaque because it’s traded prices that are the dominant presented part of prices feeds. The fact of the matter is, however, that bid/ask spreads exist in all markets.

Over the last couple days I’ve been collecting spread indications from a wide array of markets at random 15-30 minute intervals during the NYSE trading day (to ensure that all markets involved are open and active rather than including pre-market and other non-primary sessions). Here is the result of the study including some of the most actively traded market instruments.

The equity instruments were selected based on regular inclusion among the most actively traded securities (on a shares basis), so the list includes a couple of index ETFs as well has high profile individual stocks. The Treasuries list includes the current on-the-run securities, meaning the ones most recently auctioned. The futures prices are for the standard contracts except where specifically noted. Prices for the noted forex exchange rates are from the EBS dealing system. All of the above information was derived from real-time prices. (Keep in mind that markets less active than the ones presented here will tend to have wider spreads.)

The Data
I’ve a couple of primary sets of information in the above table. One is the spread. In order to standardize the comparison, I’ve expressed that in terms of the dollar value of the spread relative to a $100,000 trade. Obviously, these securities trade in a wide array of different contract and position sizes, so this isn’t meant to indicate some real-world fixed contract value. The $100,000 was just selected to make the spread values as expressed in dollar terms easy to understand and compare side-by-side. The “Avg $ Sprd/$100k” column shows what the average spread was based on about 30 intraday observations, with the “$ Sprd Rng” column indicating the range of spreads observed.

On the right side of the table I’ve incorporated broker commission estimates to provide a second set of comparative information by way of total trading cost. I’ve used $7.95 per side for the equity trades and $7.95 per round turn for the futures contracts. Brokers often will do commission-free transactions for Treasury trades, so no commission is factored in there. Similarly, zero-commisson trading is readily available for retail forex trading, so no commission is factored in there either. Obviously, the reader can replace what I’ve listed with their own numbers for a more personal comparison.

And the winner is…
If you want lowest cost trading then you want to stick to the short-term interest rate market. Spreads on 2yr and 5yr Treasury Notes are under $10 for a $100k trade, and they average under $3 for 3mo Eurodollar futures (note that this is Eurodollar, not the EUR/USD exchange rate). It’s worth noting that these are the very same markets where my volatility comparison between markets shows the lowest levels of volatility.

Beyond the short-term rates securities, the all-in cost of trading for the major forex pairs holds a modest edge over most of the other instruments included in the study. The futures markets, however, are mostly fairly close. It’s in the individual stocks where we start to see the total costs extend away from the overall group average, largely because of the broker commissions.

Market maker’s dream
Of course the one figure jumping off the page is the spread cost of Citi (C) stock. The bid/ask spread is $0.01, and the stock is (at this writing) trading below $5. That means the spread value is quite a bit higher than the same spread for the Qs trading in the $50s. Now consider that 350-400mln shares of C traded during the period of the study. That’s better than $1.7bln worth of volume. At about $205/$100,000 we’re talking about something around $3.5mln in spread differential per day!

It’s good to be a market maker in Citi shares these days!

Factoring in leverage
Note that in now way is leveraged trading factored into the figures above. They only reflect costs per $100,000 traded. That means costs as related to the value of one’s account is going to depend on how much leverage is being applied. For example, someone trading $100,000 worth of EUR/USD on a $10,000 account (10:1 leverage) will have a cost of about 0.1% ($11.10/$10,000). Similarly, someone trading $100,000 of the SPY on a $25,000 account (4:1 leverage) would have a cost of about 0.09% ($23.14/$25,000). To fairly judge the cost comparison between markets, one needs to do so on the basis of how much leverage is being applied and how frequently trades are being done.

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The Basics

How Markets Can Fall Without Actually Trading

One of the things many market participants fail to realize is that prices do not require transactions taking place to move. In fact, they tend to move most rapidly in the absence of trades. Why? Because when transactions are taking place it means buyers and sellers have come to at least a temporary agreement on value. Prices move most aggressively when there is no agreement, when one side has to give in to the other and alter its perception of value.

The confusion about all this comes from the fact that the most commonly known exchange price feeds show only transacted prices, not the bid/offer indicative prices which actually underlie everything. Forex traders don’t suffer this problem, of course, as they are used to see an indicative market. Most options traders are also well aware of this issue as thinly traded options can show last trades that are vastly different than the current price at which a trade could be done.

So here’s the deal. When all the buyers disappear from the market – meaning they pull their bids – the market falls until it finds a level at which the buyers are willing to come back in. That means market orders can get filled WAY below where they were expected to be filled. That seems to be at least part of what happened during the market plunge last week.

Here are a couple of good examples (hat tip to Wall St. Cheat Sheet)

“Of all the mysteries of the stock exchange there is none so impenetrable as why there should be a buyer for everyone who seeks to sell. October 24, 1929 showed that what is mysterious is not inevitable. Often there were no buyers, and only after wide vertical declines could anyone be induced to bid… Repeatedly and in many issues there was a plethora of selling orders and no buyers at all. The stock of White Sewing Machine Company, which had reached a high of 48 in the months preceding, had closed at 11 on the night before. During the day someone had the happy idea of entering a bid for a block of stock at a dollar a share. In the absence of any other bid he got it.”
John Kenneth Galbraith, 1955, The Great Crash

“I started accumulating stocks in December of ’74 and January of ’75. One stock that I wanted to buy was General Cinema, which was selling at a low of 10. On a whim I told my broker to put in an order for 500 GCN at 5. My broker said, ‘Look, Dick, the price is 10, you’re putting in a crazy bid.’ I said ‘Try it.’ Evidently, some frightened investor put in an order to ‘sell GCN at the market’ and my bid was the only bid. I got the stock at 5.”
Richard Russell, 1999, Dow Theory Letters

This leaves one with the very legitimate question as to whether it is a good idea to use market orders or standard stops, which become market orders when their trigger price is met or passed.

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Reader Questions Answered

Market Makers and Opening Gaps

I received the following email from a trader named Ben.

I do have a question regarding the money maker and rapid price swings in equity prices. I understand /why /it happens but not /how./ It is the money maker who actually ticks the quote number up or down correct? It would make complete sense to me if there were only limit orders, where buyers indicate the max price they will pay and sellers indicate the min price they will accept. The money maker would simply have to match buyers to sellers. But with the market orders, it seems to me that the money maker is given a lot of freedom to change the price very quickly based on the volume of buyers and sellers at any given time. And I think that, in part, is what can drive prices up or down very quickly. The money maker makes his money on volume of transactions, not the price of transactions.

Then there are the instances of violent price swings immediately upon the market opening, based on good or bad news from the day before, after the market closed. My thoughts above apply, but the situation is a little different because the change in price tends to be almost instantaneous whereas the earlier case tends to happen over a few minutes or hours. I believe what happens is a large volume of automatically executed trades by people who had previously set up stop-limit or stop-loss orders. That triggers the immediate fall or rise in price and then rest of the market kicks in to react. The media is quick to report the violent price swings and the public then gets bullish or bearish real quickly. There are some more experienced traders who explicitly buy/sell on ups/downs. But something would still have to make the price rise or fall by say 10% to set the trigger. The initial rise or fall is probably from market order trades and then the fall/rise is sustained by a large volume of automated orders.

What do you think? After writing my piece above I have it worked out that the price swings are initially driven by freedom given to the money maker by those who execute market order trades.

First, I’m pretty sure that by “money maker” Ben means market maker. I can’t help but chuckle about the truism behind the error, though. 🙂

On the subject of the cause of initial price gaps at the open of trading, let me first say that there is overnight or pre/after-hours trading in so many stocks these days that what we may see on gaps on the daily chart of exchange-fed prices isn’t really a gap. It’s more like the reflection of a time break. Think of how an intraday chart would look if you didn’t show the trading that took place between 11:00 and 1:00. Chances are there would be a gap.

Now in the case where exchange trading is the only trading, it’s a question of price matching. The market maker (or specialist) looks to all the orders which have collected overnight and in the pre-market to come up with an initial price which best clears the market. That means the point at which the volume on the buy and sell side will most effectively match up. Of course from there the opening price will then impact standing order, causing knock-on reactions off that starting point.

As Ben noted, market makers make their money mainly from buying at the bid and selling at the offer. The more they do that the more money they make, so it behooves them to set their price at the point where most volume is going to transact. You can think of price movement as the continuous process of market makers adjusting the bid/offer to try to maximize volume. After all, it doesn’t make much sense to keep price at a point where no trades will get done.

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The Basics

Price Movement Causality – Not What You Might Think

I saw the following statement made on the BabyPips site:

Forex charts are nothing but a chart of human emotions, most notably fear and greed. People don’t buy and sell because the price moves, it’s actually the other way around. Price moves because people buy and sell. All you need to do is predict where a lot of people will buy or sell and you can be a profitable forex trader…

Prices and Emotion
While the movement of prices (which of course is what charts display) are influenced by human emotion, they aren’t the only driver. Straight forward supply and demand also plays a meaningful part of it. Point blank, if there’s more demand for something than supply prices are going to rise. Emotions may slow that down or accelerate that, but eventually it’s going to happen.

And supply/demand isn’t just a long-term “fundamental” thing. It can factor in the short-term as well. For example, if GE needs to hedge a EUR 2bn transaction, that’s a big chunk of supply that will come in to the market which is at least going to make rising EUR rates very unlikely in the short-term.

People Don’t Buy/Sell Because of Price Movement
Secondly, people most definitely buy and sell because of price movement. Think about what gets you into a trade. If you’re system based then you’re entries and exits are almost certainly based on price moving to a point or through a point. Not that all trading decisions are made based on price movement, but many are.

Prices Move Because of Buying and Selling
Price actually move through the lack of buyers or the lack of sellers. The way most people think about it is that prices rise (for example) because of an increase in buying. That’s not the way it works, though. It’s only part of the equation.

Prices rise because there is insufficient selling interest at a given price to offset the buying interest. The market thus must move higher to find the selling interest to match the buying interest. This can happen if there is and influx of new buying which overwhelms the selling interest (meaning all the willing sellers have sold and none are left at current prices). It can also happen if there’s a drop in selling interest. It’s a relative relationship. Prices will only move when there’s an imbalance. It doesn’t have to mean that one side rises. An imbalance could just as easily come in when on side falls more rapidly than the other – for example selling interest falls more rapidly than buying interest.

All of this is why volume analysis is so useful (and open interest in futures/options). It can tell you whether prices are moving on the basis of more interest coming in or just because selling interest has faded more quickly than buying interest.

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Reader Questions Answered

Where does forex leverage come from?

A question was posted on BabyPips which occurred to me as being something readers here might wonder about as well.

I understand that it comes from other people’s deposits and from the broker’s capital. However, where is the limit? I understand that with stocks, its basically a loan from a bank, i.e., you will pay interest if you hold it for any appreciable amount of time.

Forex has only the interest rates on the currency themselves. But, there has to be limit, right? To do a crazy example, let’s say you dumped $10mil cash in a forex account. At 1:400, that would be $4 billion. That makes no sense since most brokers don’t have nearly that amount of capital – even if they did, it would leave no capital left for other traders to use.

So where exactly does the money come from? Most offer high leverage in comparison to stocks, or certain other instruments, so I’m just wondering how this is possible. I’m aware that not everyone will be using 100% leverage 100% of the time, but there still has to be limits.

The question comes from what would seem to be an incorrect mental point of reference where the forex market is concerned. The poster is expressing things in terms of stocks where actual ownership of an asset takes place. This is erroneous. Spot forex is akin to the futures market where traders are exchanging agreements, not ownership.

Forex = Futures
In the futures market when a trader goes long gold, for example, what’s happening is that they are agreeing to buy gold at a defined price at some specified time in the future. They aren’t buying the gold now, just agreeing to so it in the future – thus the term “futures”. The value of their position is based on the fact that their agreement is at a fixed price, while market prices are changing, potentially giving them a chance to sell that gold (were they to take delivery) at a higher price than where they bought it. Of course they do not have to hold the futures position through until delivery. They can simply enter into an offsetting agreement and thereby get flat.

Spot forex is basically a 2-day futures contract (technically a forward, but they are essentially the same thing). That means when a trader goes long EUR/USD, for example, they have entered into an agreement to provide USD in exchange for receiving EUR. When the trader wants to close out that position they enter into an offsetting agreement (call it going short if you like). If the trader holds a position overnight, the broker basically offsets the open trade at the end of the current day and then opens a new one at the start of the new day. That’s the roll. Depending on the broker that is either obvious or transparent.

Margin is Surety, Not Down Payment
With forex being an agreement based market, not an ownership market, the capital requirements of the liquidity providers are much lower relative to the size of the trading volumes than would otherwise be the case. This is because margin in forex (and futures) is a surety for the broker (and the system as a whole) to make sure there is coverage for any variation in the value of the future/forward contract the trader might experience. This is different from in stocks where a trader operating on margin is actually borrowing money to be able to purchase (thus own) more stock than they could have otherwise, much like a home-buyer takes out a mortgage. The stock margin is basically a collateralized loan.

No Ownership Means Lower Capital Requirements
Since a forex broker isn”t actually exchanging EUR for USD when a customer goes long a lot of EUR/USD, it doesn’t need to have 100,000 EUR on-hand (putting aside the whole matching up of customer positions brokers do on the back end). It’s not like a stock dealer which actually has to have the capital (or sufficient lines of credit) to own the shares it’s making a market in.

That’s why forex brokers can offer such high leverage ratios.