Interesting article about MMs and volatility:
Cramer Rewrites 'A Volatility Nightmare'
By James J. Cramer
1/15/00 1:01 PM ET
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This piece struck home for many of the market makers on Nasdaq who owned up to me, confidentially, that I was spot on. We have really hit some sort of weird moment in Nasdaq-land, as a combination of factors has meant that individuals are routinely able to beat the market makers. When these rules were in place many people, including yours truly, complained to the Securities and Exchange Commission and Congress that the new rules would ruin liquidity and drive up volatility. All of the nightmares are now coming true. By automating a market that was distinctly person-to-person and eliminating market makers' ability to protect themselves, we drove the best of them right out of business. I don't think that working on a Nasdaq desk would be anything but a sentence in red ink hell. You can't possibly make any money for your firm. But you could lose a fortune for it. Because we have taken away the incentive for liquid markets, we have destroyed the functionality of the Nasdaq. This piece addresses that dysfunctionality and adds many of the thoughts that you have provided in the interim.
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Volatility nightmare. Instead of the dot-coms calming down and trading with more precision and in smaller increments, the opposite has occurred: Everything is now trading like a dot-com. (Wow, when I said everything, I didn't think it would include Intel (INTC:Nasdaq - news), which acted like the quintessential dot-com, charging 13 points on the last day of trading.)
Look at the points put on in the semiconductors and the semi-equipment stocks. Or check out the action in Compuware (CPWR:Nasdaq - news), which was down 4 in regular trading and is now up 4 after a failed bear raid. (That was a bizarre situation. I call it a bear raid because a bunch of people spread nasty rumors about Compuware missing its quarter. I don't know how this stuff gets started, but one thing is for certain: These days if you start a rumor it's going to be picked up by a wire service or by television. I've never seen a period where everything, no matter how false or unsubstantiated, gains immediate credence. Some Web site says some company is going to get into the S&P 500 and the wires pick it up like it's gospel. Another site says the whisper number for Yahoo! (YHOO:Nasdaq - news) is 20 cents and it gets reported. Where are the truth police?)
Sun Microsystems (SUNW:Nasdaq - news) and Nortel (NT:NYSE - news) are going nuts on the hardware side. And last week Procter & Gamble (PG:NYSE - news) and Bristol Myers (BMY:NYSE - news)shocked to the upside. (I confused the issue by including listed stocks. They have less liquidity than they used to. But the specialists are still in control of the markets, unlike the market makers who no longer do what they used to.)
What the heck is going on?
We left the office today stunned at the ranges that all stocks are now trading in. These are frightening ranges for those of us who like to control our risk (and, as a hedge fund manager, that's my key variable). We love it, of course, when they go up, but the ride down is too hard to hedge against. I'm shaking my head here, wondering whether the dot-coms have infected the rest of the market with illiquidity.
(Let's go into this risk control issue, as I think many of you missed the point of what I do and how I have set up my company. My goal is to make as much money as possible with as little risk as possible. When I started I didn't understand risk. I thought that all that mattered was pedal to the metal. Wrong! What matters as a professional money manager who has to make money in good times and bad -- I don't get paid if I don't make money -- is EXPOSURE. You have to be sure that your exposure is at a minimum when the market gets hammered and at a maximum when the market ramps. This week in my chat someone asked me how I could be a bull if I were 50% long. The answer is that when the market took a header two weeks ago I rushed in $150 million. But when it snapped back 8% immediately, I took it off the table. My goal is to have as much money in when I think it is right. But as soon as the coast is no longer clear, I can't hang around. It would take only a couple of years of not making money to put me out of business, because I can't pay people, so risk management is everything to me.
I look at my company as if it were a retailer. I want to have the maximum amount of merchandise on hand to sell at the right time, and the minimum at the wrong time. At the same time, I don't want to lose certain positions. A lot of people derided me this week for being long Yahoo! during a period when I thought it might go down, but I don't want to lose my core Yahoo! position. And when it got down to the 350s, I bought a little more. I want my minimum Yahoo! position on right after it reports, because insider selling always occurs after the quarter reports. But as the earnings season drags on and people see that Yahoo! had the best quarter of any Internet company, I will want the position to get bigger.)
Perhaps, and I am still working on this thesis, what has happened is that the market makers in the Nasdaq simply have ceased to try to make orderly markets. They are solely acting as agents buying stock and selling stock for customers, without positioning a thing. If someone wants to buy Oracle (ORCL:Nasdaq - news), she goes to a market maker and the market maker, rather than stopping her on the stock and working the stock in, just goes out and lifts all of the offerings. The market maker wants none of the risk of the trade.
(To refresh, in the old days, a market maker used to work an order. You wanted 15,000 Oracle? He shorted you 5,000 and then he tried to work the stock in over time. Now he doesn't short you anything; he is losing too much on that 5,000. He just goes in as an agent and buys whatever is available from others.)
(Here I'm going to crib directly from a market maker who described why this occurs. His letter to me started like this: "I am glad that you have voiced concerns about the volatility and lack of liquidity in the Nasdaq stock market and I understand that you have suffered enough frustration to step away from actively trading in this market. Part of the problem is the Actual Size Display Rule. The implementation of this rule allowed market makers to decrease their size commitment from the Special Order, or SOES tier size, generally 1,000 shares, to 100 shares. If I were to receive an order to buy 10,000 shares, in the past that was pretty much an automatic execution for the customer. I would short the customer the 10,000 shares and it would take at most 10 trades to cover or buy back the position. Now it could take me as many as 100 trades -- and many price levels -- to cover that position by taking the stock."
It gets worse, the market maker went on to say: "Factor in the daytraders who see the stock in motion and jump in for the ride pushing the stock further." That's how you get those crazy jumps that we never used to see. Everybody is just feasting on everybody else's order. We have total equality, which means that the little guy gets the same execution as the big guy. But it also means that the big guy can't really do anything because the little guy can break it up. It has, in a sense, turned us all into little traders. )
Suffice it to say that if you thought that parts of the market were not for the squeamish last year, you ain't seen nothing yet. (Of course, what's happening is that market makers are not only dropping out from making orderly markets but are simply lifting stocks up and moving them down with every order. I now buy stocks in 1,500 and 2,500 share units for all but the biggest stocks. Anything larger and I will move the stocks a couple of bucks. Until I realized how bad things were I routinely berated my traders for moving the stocks of multibillion dollar companies with 5,000 shares orders. I can name 30 multibillion dollar companies that I can move 5 points on an order of 15,000 shares. Surely that's not what was meant when the government cracked down on these market makers a few years ago. Surely that's not good news for the American capital markets. )
The flaw here is that it still doesn't explain how listed stocks became so illiquid. That's going to take some digging, but I bet that the listed market makers at the big brokerage houses are just as unwilling to make orderly markets, too. (I have no answers as of this writing, but I know that no multibillion dollar company on the NYSE can be jerked around like one on the Nasdaq.) |
