Tools, Techniques, Essays and News that will help you pick the best CTAs, Hedge Funds and Alternative Investment managers. No nonsense. No excuses. No easy answers.
The Protocols of the Elders of Wall Street Conspiracy theories have a long, if not honored, Wall Street history. On the one hand, many people believe that the market is controlled by the Arabs, the Jews, the US Government, NYSE specialists, floor traders or—my favorite—the Illuminati.These beliefs are not limited to noninvestors. I used to get calls from brokers who clamed to understand the way the Elders think, and claimed further that they could use this knowledge to make me money.
More, there is a small investment literature on how to make the Elders make you money. One trading advisor has written several books on how NYSE specialists manipulate the market. He also advocates a charting method, which has, as far as I can see, no logical connection with NYSE specialist’s behavior, but which will, he claims, allow you to anticipate their moves.
On the other hand, exchange representatives have repeatedly told me that no one controls the market. According to these officials, the markets and, especially, the exchanges are perfect or almost perfect examples of price discovery and of Adam Smith’s invisible hand.Most of the time they are right, of course, or we would all be out of jobs. But considering the published history of the markets, such statements are breathtakingly dishonest.
Fire fights Consider one of many, many examples. In late November 1994, hedge fund manager Michael Steinhardt bought $500 million of “knock-in” put options on Venezuelan Brady bonds from Merrill Lynch. (A knock-in option is a path-dependent option. Once the price of the underlying security touches the knock-in point, the option is effectively in the money. It does not matter what the underlying security’s price does after that.)By early December, Merrill Lynch was selling bonds, presumably trying to keep the price of the bonds below the knock-in level, while Steinhardt was buying, presumably trying to push the price of the bonds to the knock-in level. On December 9 alone, as much as $1.5 billion of Venezuelan Brady bonds (of $6.5 billion face value) changed hands. This does not sound like price discovery to me. This sounds like a firefight.
This example is atypical in the sense that each side knew the other side was gunning for them. “Greg,” a former coworker of mine, tells a more typical story.Greg claimed to have been a broker for several years for a certain well-known American/Swiss market manipulator. According to Greg, he would get an occasional call in the evening and someone would say, “Silver will close tomorrow at $9.57. Do you understand?”
It would then be Greg’s job to make sure silver closed at $9.57. The next night someone else would get the call. Greg eventually moved into the manipulators organization. He said the manipulations were planned months in advance in excruciating detail. Even after they were shot, the victims rarely knew who shot them. Sophie Ni, Neil Pearson and Allen Poteshman’s recent work “Stock Price Clustering on Option Expiration Dates” presents an excellent and, in many ways, still more typical example. This report can be downloaded free from http://papers.ssrn.com/sol3/papers.cfm?abstract-id=519044. Poteshman and Pearson are professors at the University of Illinois at Urbana-Champaign, which probably means that Ni did all of the work.
The literature is replete with several works devoted to the effect of options on the underling securities. Neither the theoretical, nor the option introduction nor the option expiration literature has shown that options have any clear and significant effects on the behavior of the underlying securities.It is surprising, therefore, to find strong evidence of manipulation in Ni’s paper. But then Ni is looking where, to the best of my knowledge, no one else has looked.Ni and her professors looked at the price behavior of optionable stocks (stocks with listed options) over the period 1996–2002, and found that such stocks tend to expire at prices near one of their option’s strike prices with suspicious frequency. This statement is not as vague as it might seem.
Ni’s paper has a chart of the percentage of optionable stocks closing within $0.125 of an integer multiple of $5.00. The chart shows the percentages from 10 days before expiration to 10 days after.On expiration day, just under 8% of the stocks close within $0.125 of an integer multiple of $5.00.On no other day is the percentage higher than 7.5%. This difference turns out to be statistically significant.
$9.1 billon A half a percentage point is a fairly subtle difference. Option buyers are hardly likely to notice.Nevertheless, this allows some options to expire without value that should not. Ni estimates that this represents a capital market “shift” of at least $9.1 billon per expiration date. If someone is manipulating the market then this “shift” is theft.
Ni’s paper has two important parts. The first demonstrates that price clustering around integer multiples of $5.00 is in some ways “unnatural,” or at least unexpected. Ni shows that the available data do not support other possible descriptions.For example, “Do prices naturally tend to close on integer multiples of $5.00 on all Fridays rather than just on option expiration Fridays?” Ni shows that they do not. Her demonstrations here are clear, easy to understand and valid.
In the second part Ni uses logistic regression to show that other possible explanations, such as the possibility that price clustering is a side effect of option sellers using of delta hedging, are not supported by the available data. There are a number of subtle ways this kind of analysis can go wrong. I found her demonstration convincing. If Ni has found a real phenomenon—and I believe she has—this suggests two things. First, hedge fund managers and investors can sometimes buy optionable stocks at a slight discount by putting buy orders on the appropriate exercise price on the last day the option can be exercised.Second, the regulators have not yet leveled the playing field. As one market sage put it many years ago, “We are in an economic con game and prudence has its place.”
An early version of this article appeared in MARHedge.
Comments and Critiques
"If your mother says she loves you, check it out." --Old reporters' motto; also our motto. Copyright (C) 2005, 2006, 2007, 2008, 2009 Fred Gehm. All rights reserved.