Rooting around in what’s behind price and volume, we’re reminded of a movie scene.
Remember in the Coen Brothers flick “Fargo” where our hero (heroine), pregnant cop Frances McDormand, catches bad guy Peter Stormare running the wood chipper? He’s feeding it a chunk of… Anyway. If you haven’t seen the film, imagine dropping a block of wood into a chipper, which gouts masticated lumber molecules. IROs and execs, this is what’s happening to your shares. Trading systems are spraying order flow like wood chippers. In effect, orders to buy and sell shares are the block of wood and mathematical algorithms are the chipper. You drop your order into the machine, and it grinds the volume into tiny pieces and sends it to many platforms.
You can only see this activity if you survey your volume over time – say, five days – and observe how 400 shares goes to Jane Street, and 25,378 shares hit Direct Edge’s passive electronic market maker, and 5,685 shares flash past ITG’s Posit, and so on.
Understanding speculative trading can tell you a great deal about the nature of money in the markets. By our measures, since December, speculative trading is a nearly a third of volume, much higher than in the past and the biggest single force behind share prices. Speculation is volume driven principally by trading tactics, not investment objectives. A year ago, Speculative volume ranked third, trailing big Primes serving large institutions and hedge funds, and order flow matching up automatically at Electronic markets like Archipelago, Level, and the National Stock Exchange.
While rational investors do use algorithms – you can’t function in today’s markets without mathematics, because conditions and prices change each millisecond – continuous algorithmic buying and selling does not offer value investors the most supply at the best price. And while investors committing dollar-cost-averaged money to achieve growth at a reasonable price can get efficiency from algorithms, if conditions, prices and availability are constantly changing, they soon surpass their trading-cost parameters.
So what kind of money is feeding the gigantic chipper spraying deconstructed volume everywhere? Short answer: transient money often predicated on market neutral trading tactics. Translating to actual language, it’s money moving throughout the day from one thing to the next, hoping to preserve capital while turning a nickel or two along the way. It’s easier to mitigate risks with dispersed order flow than concentrated positions, and it’s quicker to yank 1,000 pieces simultaneously than one very big, long sell order through the shrinking knothole of a bad equity market.
Plus, registered investment advisors must be engaged in protecting and enhancing clients’ interests. That’s true whether they’re a bedroom-run futures commission merchant or the chief investment officer of a sovereign wealth fund. In current markets, these folks have determined that it’s better trading frequently in equities, derivatives, currencies and bonds, than deploying resources across time and asset-allocated equities.
Why do these conditions exist? One word: Washington. Speculators often point up the weak links. So if they abound now…what’s that tell us? If the markets don’t like what we’re doing…why are we doing it? But such is the zeitgeist of the times. And IROs and executives, for the next year or more, you’re wise to understand the ebb and flow of speculation in your equity market. Knowing what’s going on is the cornerstone of value, relevance and peace of mind.
Margaret E. Wyrwas - Knight Capital Group, Inc. (Nasdaq: NITE)
Senior Managing Director, Corporate Communications & Investor Relations
Equity Analysis™ subscriber since March 2007
"In global markets driven by automation, changing market structure regulation and dynamic investment objectives, today's investor relations professionals require new data points in order to remain relevant and add value in their company's quest to reduce its cost of capital."
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