Guest Post: "Pirates, Arbitrage and The Silver Flash Crash", by Viking Analytics
Our friends and subscribers at Viking Analytics have written an interesting article regarding last week's sudden, 10% drop in the price of Comex Digital Silver.
Most everyone here at TFMR saw or heard about the "flash crash" in Comex Silver that occurred at 7:06 EDT last Thursday evening. With theories abounding as to how and why it happened, we thought we'd post this commentary for discussion.
"Pirates, Arbitrage and The Silver Flash Crash"
by, Viking Analytics
One of the quotes that guides my investment and trading philosophy is attributed to Benjamin Graham:
In the short run, the market is a voting machine. In the long run, it is a weighing machine.
- Benjamin Graham
I usually think about this quote with the second sentence in mind. “In the long run, the market is a weighing machine.” As such, I look for occasions when commodities and stocks have diverged from fundamental or benchmark values. After a 25-year career in energy and commodities, I look for ways to profit from those fundamental divergences. But, that is a topic for another article.
In this article, I want to focus on the first sentence: “in the short run, the market is a voting machine.” I believe that this sentence provides some insight into the recent "flash crashes" that we have seen in tech stocks, gold and most recently, silver.
Here is the one of the problems with the “voting machine” market in the short-run: there are entities who have the ability to stuff the ballot box and profit from nano-second moves in the markets. Perhaps especially during times of limited liquidity, the market "voting machine" can easily become an "arbitrage machine."
Silver Flash Crash
As has been widely reported, the COMEX silver market (owned and operated by CME Group) "flash crashed" from a high of $16.07 to a low of $14.34 before recovering to close at $15.90 over a 5 minute trading block of 8,000 contracts. These 8,000 contracts amount to 40 million notional ounces of silver, which is 4.4% of annual mine supply traded in 5 minutes!
Becoming a Pirate
One of my favorite quotes from film comes in one of the modern renditions of Peter Pan in the movie Hook. Peter Pan (played by Robin Williams) has left Never-land, and has become a swashbuckling investment banker. Wendy, now much older, goes to Peter Pan to let him know that he is needed in Never-land to once again battle the pirates. Upon seeing Peter’s newfound enthusiasm for profiteering at the expense of others, Wendy is astonished. She says, “why Peter, you’ve become a pirate!”
While I have not become a pirate, I have found that it can be occasionally profitable to think like one. In a game theory analysis of the commodity markets, I try to think like a pirate would think.
If I Were A Pirate . . .
Before we get to our pirate flash crash strategy, let's look at a recent bid-offer stack for the iShares Silver Trust (SLV). In this example, there are almost 400,000 bids to buy SLV at 14.91, and almost 110,000 offers to sell SLV at 14.92. We can see bids and offers above and below these levels. Most retail investors have the ability to see this bid-offer stack in the stock markets, and the same kind of bid-offer stack exists in the futures markets.
If I were a pirate (I am not), having the means to do so (I don't), I would evaluate the bid-offer stack of my target commodity, and during times of illiquidity (like 4am EST on a Monday, or 7pm EST on a Thursday), I would set up limit purchase orders 5% to 10% below the current price (for example), and then place a sell order that hits every bid in the bid stack. At key technical trading levels, I will have the added benefit of triggering known and unknown stop loss orders.
The cascading effect of the flash sale, combined with the known and unknown stop loss sale orders (designed to protect long positions and/or profit from a new downtrend) would ideally cause price to decline to the place that I had established my purchase orders. In my perfect pirate world, the short orders that I had created to hit every bid would be covered by the purchase limit orders that I had created below.
This pirate activity can of course be optimized by HFT algorithmic computers that have a form of market price omniscience, being fed continuously with the bids and offers, and oftentimes the stop loss data as well.
Five minutes later, price recovers almost to where it was before, and I would have arbitraged the bid-offer stack, making millions from my market omniscience in an illiquid market. I am not a lawyer, and I have no comment on the legality of this activity. I can only assume that the activity is legal, but perhaps represents a serious market inefficiency.
Who Loses In This Flash Crash?
The losers from the flash crash are the retail and other investors who do not have the same level of information and market-moving ability as others, and who have attempted to protect their long positions with stop-loss orders.
I have copied a couple of tweets from this morning that elaborate on this point. First of all, I must say that I am impressed that CME Group responded quickly to adjust and correct some of the orders made during the flash crash period. Whether CME was “fair” in the allocation of fills is not for me to decide.
One trader reported that he had a long position in silver futures, and had established a protective stop loss order at $15.80/oz. Unfortunately, stop loss orders are sometimes only triggered if there is an actual bid or offer at the exact level of the stop loss order. In this case, the trader’s stop loss order was not filled at $15.80 because liquidity in the market had vanished when the bid-offer stack was raided. When the market adjusted a nano-second later, the next quoted bid was used to fill his stop loss order with a sell at $15.00. As a result, his protective stop loss order was originally $0.80/oz lower than what he had set. An $0.80/oz loss on one futures contract in silver is worth $4,000.
Fortunately for this investor, CME Group corrected adjusted his order to a stop loss at $15.56, so he only lost $0.24/oz more than he had anticipated with his original stop order. But that $0.24 still amounts to $1,200 lost in a nano-second on a single futures contract.
After the dust had settled five minutes later, if this trader had not had the protective stop order of $15.80, he would have retained his long contract at a value of $15.90. In this case, the retail investor was easily fleeced by a 5 minute down-up spike in the price of silver.
We have attempted to alert readers to this kind of activity before, but it is of course complex and takes some contemplation to follow along. This example above is a more detailed example of what I attempted to explain in one of my prior articles: Trading JNUG and NUGT? Play Blackjack Instead.
Because this kind of stop-running activity can occur in all markets, in my trading I try to focus on the end-of-day closing price and set mental stops, not actual stop loss orders. This requires more screen time and discipline. During times of high liquidity, stop loss orders might be good to have. However, it is important for retail investors to know that some or most of their stop loss order data is sold to firms who have the ability to profit from that information.
Finally, thinking like a pirate helps me to understand where the pirates might be steering the pirate ship. I ask myself, “if I had vast resources and more perfect information, how could I arbitrage the market tomorrow, next week or next month?” I am currently studying the very deep and influential options markets in COMEX gold and NYMEX crude oil, and have developed tools to calculate where the “sweet spots” or “price magnets” are located. If I were a pirate, I would seek to capitalize on the fear and greed that I can induce into these markets, and sell volatility at key support and resistance areas. But, that’s just me.
I share this kind of research with my Seeking Alpha subscribers, as we seek to navigate the rocky shoals of these markets together, and hopefully avoid the pirate ships along the way.