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).

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.

Reader Questions Answered

Is the Japanese Yen a Safe-Haven Currency?

Frequent trading question-asker Rod is back with another one. He sounds worried that he’s asking a foolish question, but it’s hard to get better and more knowledgeable if you’re afraid to ask when something confuses you. Fortunately for me, his question isn’t too hard to answer. 🙂

Hi John,

I know, you will slap me for this, but I have to ask: I don’t get it, why is the Japanese Yen still a safe-haven currency? To put it similarly, why is the market still in love with Japanese Government Bonds?

Is there no credit risk in JGBs? With 200% Public Debt-GDP?

As always, thank you.


This question is clearly motivated by the big gains the Yen experienced Thursday as the stock and other markets were coming unglued and a serious risk aversion/flight to quality move was afoot.

What Rod has done, however, is forgotten something important – the carry trade. A considerable amount of yen has been borrowed and exchanged for other currencies (the Aussie being a favorite given the exchange rate differential) to be invested there. What Rod has viewed as a flight to quality to the yen is in fact a reversal of the carry trade.

The carry trade gets done when one currency can be had for very cheap (like the JPY) and the markets feel comfortable with the level of volatility and prospects for positive returns. As investors and traders get more relaxed and complacent about things they continue accumulating carry positions, forgetting about the risk side of things – rather link traders who stop thinking about how much they could lose and focus too much on how much they can make. When something happens to snap them back to reality, they start cutting back their exposure. This could be either from them worrying about the returns on their invested funds or concerns about the impact on their positions of a turn in currency exchange rates.

At this point the carry traders are nervous about their investments and are reducing risk. That means selling stuff they are holding, moving out of the currency they have switched into and back into the one they borrowed. That means selling stocks and other instruments and converting their AUD and other currencies back into JPY. When it happens en masse, as it has been of late, the JPY pairs get hit hard because of all the yen buying.

This is not a flight to quality run into the Japanese currency. It is simply traders and investors paying back yen-denominated loans. This is a get flat move, not one positioning market participants long the yen. The flight to quality was actually into the dollar and US Treasuries.

Trading News

The Dominant Players in Forex

I see the question all the time about where prices come from in the forex market and who drives them. The answer is that it comes from the market makers in the inter-bank market. Want to know who the big players are there? Here’s the current ranking as per Euromoney (hat tip to Clint at BabyPips).

Source: Euromoney FX survey FX Poll 2009
Source: Euromoney FX survey FX Poll 2009

According to that same survey, the daily volume of forex trading breaks down like this:

  • Western Europe 50.19%
  • North America 26.98%
  • Asia 14.54%
  • All others 8.39%

Here’s something most folks probably don’t realize, however. According to a Financial Times article posted today, about two thirds of the $3.2 trillion in daily forex market transaction volume done each day is derivatives (see Most Active Forex Currency Pairs). That’s heavily in swaps. The focal point of that FT article is on the potential impact of new legislation requiring derivatives to be cleared through central clearinghouses.

It’s worth noting that the only bank in the ranking list above that does retail forex trading business is Deutsche Bank, which has the dbFX platform. The way I understand it, DB is a major liquidity provider to retail forex brokers. So the answer to the question of who is making prices in the forex market is Deutsche Bank.

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.

Trading Tips

An example of what can really drive the markets

Yesterday was a pretty interesting day in the markets. And I do mean “markets”. Most people will probably be aware of the large decline in stocks. Fewer folks are aware of what happened in the fixed income (interest rate) market. Actually, that’s where the real action was. The Dow lost nearly 200 points, but that’s not nearly as dramatic as it sounds, even when you add in the two down days prior it’s not that big a deal. We’re just so used to low volatility that it seams like a lot. In days gone by, that kind of action was much more commonplace – up and down.

The bigger volatility was in interest rates. The 10 Year Treasury Note yield jump 16 basis points (1 basis point being 1/100th of a percentage point or 0.01). That is a substantial one-day move! Actually, early this morning it was up another 12 basis points from yesterday’s afternoon’s levels, though as of this writing it’s since come back down some. This is the real story.

There’s been a kind of capitulation. For reasons only they know, some major players in the market were of the view that the Fed was going to cut rates this year. In the last few days, though, thanks to some good economic data, they’ve finally dropped those expectations. To top it all off, Bill Gross who runs PIMCO, the world’s largest fixed income fund management company actually publicly turned bearish on the US fixed income markets yesterday (meaning he sees higher rates ahead). That helped to push rates across the board higher.

Here’s the interesting part, though. Guys I work with who cover different facets of the rate market described to me a scenario in the mortgage market that was very similar to that which took place back in 1987. Those who recall that time period might be aware that so-called portfolio insurance was one of the major causes for the sharpness of the Black Monday violence. In essense, portfolio insurance was a strategy by which portfolio managers hedged their portolios by selling futures short in a kind of delta hedge. The problem was that as the market went down the managers were forced to sell more and more futures to maintain their hedges, creating a kind of cycle.

Something similar was going on in the mortgage market yesterday. Hedging strategies there were causing the same kind of cycle to take place. As rates rose (prices fell), portfolio managers were forced to sell to keep their hedges in order, push rates higher still, causing more hedge selling.

Naturally, the rapid rise in interest rates spooked the equity markets.

These are the sorts of situations regulators and institutional market participants fear. It was just this sort of thing that cause the downfall of Long Term Capital Management (LTCM) and some folks have their eyes open to see what funds or investment banks might have taken a major blow to their capital thanks to recent events – something from which they might not be able to recover and which could have a carryover impact on the markets.

Something to think about.

Reader Questions Answered

Understanding the different types of market participants

“…market behavior is the sum total of the actions of all of its individual participants and disciplines and timeframes.”

That’s a quote from Markets in Profile. I mention it here because sometimes new traders forget that fact. I’ve responded to the question of why anyone would buy in to a market that is clearly moving lower, or some variation thereof, numerous times. If we all traded in the same timeframe and for the same reasons, then the question would be valid. More than likely, it would also make for a very difficult market to effectively trade.

The fact of the matter, though, is that traders operate across a huge range of trading timeframes. There are the scalpers who work on the extreme short end of the time scale, holding trades for seconds in some cases. At the complete opposite end of that spectrum is the likes of Warren Buffett, who will buy something with the expectation to hold it for years. Most of us fall somewhere between.

I can understand why new traders sometimes don’t quite see that. There is such a focus on relatively short-term trading that sometimes the longer-term participation can get overlooked. Understanding that there are folks operating on different timeframes helps to clarify why someone would be buying when prices are clearly plunging. What is clearly a short-term downtrend could be a great buying opportunity for a long-term trader.

Here’s another thing to be considered. Not all participants in the markets are speculators after profits. Think about it for a second. Companies issue stock. That’s selling. They sometimes do share buy-backs, and many do market purchases for employee stock plans and whatnot. You wouldn’t call that speculation. Those are just business transactions. There are a great many businesses that make trades in the market to hedge their business exposures, be that interest rate risk, the cost of their raw materials, even the price of their finished products in some cases.

Perhaps the most active of non-speculators is actually the group of market participants referred to as market makers. These are the folks most responsible for providing liquidity by taking the other side of buy and sell orders. They don’t do it to take a position on the direction of price, but to make numerous small profits by earning the spread between where they are able to buy (at the bid) and sell (at the ask/offer).

It really is the confluence of all of these various participants that drives prices. Understanding that can go a long way to helping one see and comprehend the patterns of price behavior.