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We have spent the last two weeks dissecting the two major causes of the infamous 22% one-day drop in October 1987 and how those two causes are exponentially bigger factors in markets today.
Now, are you ready for the really bad news?
It's about the liquidity myth, the story that says the market's mechanical wheels are well-greased.
It's not just a myth… It's a total lie.
Sure, there's liquidity when markets go up, when it's not needed. But when things go south – and they will – the myth will be revealed for what it is.
What most people believe about liquidity is a lie convened by conspiracy.
Here's how the new portfolio insurance game and ETF arbitrage are going to unmask the frightening truth about market liquidity and seize the wheel of fortune…
Welcome to Your Nightmare
While regulators were sleeping on the job, Wall Street remade the two principal causes of 1987's catastrophic one-day crash – remembered as Black Monday.
First, portfolio insurance, the external kind, the kind you buy to insure your portfolio won't tank in a crash, the kind that became a hot Wall Street product in the 80s, isn't what the Street's selling today.
What replaced it is something everyone's supposed to feel more comfortable with: internal insurance.
Your portfolio's self-insured if it automatically rebalances itself when bad stuff happens or, if you're a passive investor, your internal insurance rider says to ride crashes out because stocks always go back up.
For big portfolio managers, the need for external insurance has been replaced by risk parity, volatility-targeting, and rules-based quantitative portfolio management game theory.
The problem is, the game they're all playing is the same game based on volatility.
When volatility spikes and triggers wave after wave of sell orders, everyone's going to find out they measure volatility the same way. They're in the same positions, and they're all rebalancing by selling the same things with spiking volatility into the same sinking market.
Second, passive investors, whose internal insurance is predicated on stocks always rising historically, who without knowing it count on index arbitrage to keep their ETFs from coming unglued, are going to find out that "historically" is time relevant and that arbitrageurs will hammer their ETFs and stocks.
So, when panic strikes, the supposedly passive investing crowd will become active, and everyone's going to find out that ETFs aren't magic boxes; they're stuffed with the same stocks everyone else's ETFs are stuffed with, and the same stocks that everyone's in.
And arbs are going to be front-running them down in waves.
The Frightening Unintended Consequences of Modernized Markets
A couple of decades ago, it used to be that selling, as bad as it could get, was more orderly on the way down, even if the way down was 12.5 cents, or 50 cents, or a dollar or two at a time, time after time.
That's not the case anymore.
Two things happened to change the way stocks trade:
- In the mid-1990s, ECNs (electronic trading networks) challenged the NYSE, the AMEX, and the Nasdaq. These new trading platforms paid traders to send, buy, and sell orders to them, instead of routing them to traditional exchanges. Traders and investors spread their orders around, reducing the number of shares to buy and sell at different price levels at every trading venue.
- After April 2001, all listed stocks traded in the United States could trade in increments of one cent. Before that, stocks traded in minimum increments of 12.5 cents. Decimalization narrowed bid-ask spreads, but also made it harder for specialists and market-makers to make money. Narrower spreads increase the risk of taking one side or another as a liquidity provider.
The unintended consequences of these modernizing events are:
- Orders to buy and sell are spread around to competing trading venues, reducing depth and liquidity at each of them.
- Depth and liquidity are thin everywhere, so investors don't leave big standing orders on anyone's books anymore.
- All specialists and market-makers at the exchanges and trading venues don't see big order flow; they aren't incentivized to trade for themselves and don't provide liquidity like they used to.
Enter the HFT dragons.
About the Author
Shah Gilani is the Event Trading Specialist for Money Map Press. In Zenith Trading Circle Shah reveals the worst companies in the markets - right from his coveted Bankruptcy Almanac - and how readers can trade them over and over again for huge gains. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.