Investment Capitalist

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Dear Investment Capitalis followers, please forgive the “forced” history lesson regarding recent headline grabbing events transpiring with Netflix (NFLX) as well as the broadr markets in general, and I hope you don’t construe this as an indication I’m downplaying your intelligence. Hopefully, you’ll see the data on this article before it become stale, but there are powers that think you, the reader, require additional hand holding than I would have thought. So as a bow of respect to them, I give you a more instructional analysis of said events. In January, Investment Capitalist covered Netflix in depth when the stock was in the low $70′s, calling it a risky but high probability/high reward buy recommendation. The culprit was short term market inneficincies combined with possible corporate downtalking of the stock price to allow the company treasury to purchase stock recently exercised by employees, thereby preventing a dillution to earnings. We took the events which led to Netflix being mispriced in our opinion as buy opportunities because of an intimate familiarity with their business model, their deeply entrenched market position, recent corporate decision from the CEO that alhtough made many customer angry, were obvously designed to better position Netflix for a future where streaming content would be the norm and the DVD would go the way of the cassette tape. We cautiously advised getting long at an almost 60% discount to recent prices at the time, into a company whose has an outnding business model and an almost prescient view of the long-term. A company with the courage to ignore the short-term quarterly hit they knew they would take in order to position themselves for a much different long-term business landscpape where broadband video streaming would make DVD rentals in the mail go the way of the cassette tape. Because as you know, they raised prices on their DVD membership plans but left their streaming content membership prices unchanged.

As a Global Macro Trader, the rear view mirror always provides insight into the future because as it does everywhere else, history tends to repeat itself because human nature repeats itself. That repitition may manifest with a modern twist, but the single overwhelming fact is empirical evidence regarding election years. If you combine this empirical data with the March 2009 “super-bottom” in stocks, you’ll realize the path of least resistance for stocks are up. If you recall, the massive one-day reversal of 2009, which covered 1,700 Dow points in a single trading session may no longer be relavent from a traders perspective, but combine it with Federal Reserve behavior during an election year, you’ll reliaze the winds are blowing towards higher stock prices and more lax fiscal and monetary policy, at least until post elections. This gives Trader’s the knowledge they won’t be fighting the Fed during 2012 if they remain on the long side of stocks. The only major concern I hope everyone understands is that liquidty has yet to return to the levels they once were before the 2008-2009 meltdown. However, with the right tools at your disposal, you can overcome these minor challenges if you trade heavy size, and if you don’t, well you needn’t worry about this issue as it doesn’t concern you.

For the former group, it starts by taking full inventory of the technology at your disposal, designed to either give you an edge or prevent you the firepower to access liqudity on a level playing field with larger, more sophisticated firms employing sophisicated algorithmic strategies and even more sophisticated execution algorithms. And no they are not one and the same. One advantage discretionary traders using customized execution algorithms have over those shooting from the hip using “hot keys” to gain a feeling of technological superiority over whatever they think is competing against them is the dominant but rarely used ability to quickly step in and provide liquidity at a time when liquidity is scarce. Scarcity produces an opportunity for risk and the analogy is simple. The major wirehouses will accumlate vast inventories of stock during major market panics, as we witnessed during the one-day 1700 point swing in March of 2009. After plunging 1000 points, a 700 point recovery into the closee put “sealed” on the idea of one-day reversal. The inventory of stock to sell was exhausted, and sensing this, the short positions began to cover to book their profits and the bulls jumped in to make doing so quite difficult, while also trying to catch the revesal, as we did. Large, institutional traders will execute when they can, not when they want. Remember that and you’ll save yourself some stress. It took a great deal of patience, perseverence and courage to wait for as long as it took to get the green light without permitting your instincts from taking over and trading for the sake of trading. An unfortunate reality for almost every “day trader” I know. They live and die by their “daily performance” whereas Global Macro practitioners only care for their quarterly and annual performance. Although we’re masters of our trading platform and use it better than any daytrader when the time calls for rapid fire market making and execution in mutliple stocks, we are not inclined to trade just because we’re sitting infront of our array of monitors with buying power at our disposal. We know that a 3-5 day move, if caught correctly without the stress of having to crawl out of a deficit, will product monumental gains with the potential of making one’s year. Why suffer the stress and the defeatist mentality that comes with it by trading during the market’s “back and fill” environments, or whipsaw action caused by a lack of market participants for whatever reason?

Here’s a quick lesson for you newbies, who need this more than veterans, on how 21st century Market Makers and Specialists operate powerful arrays of automated algorithms in their market making activities. Automation enables a single trader to make markets in an obscene number of stocks never before possible by high touch trading. During a major volatility spike in all sectors, correlations that cause all asset classes to trade almost in total synch, or as the industry jargon likes to say “correlations spike to one”, trigger risk alarms that force the automated algorithms to go “dark”. Automated market making has a built-in safety net to generally shut down when Sigma (volatility) breaks 5, correlations spike to 1, or when a trader hits a market maker hard and fast to get them lopsided. Those chaotic moments are trading nirvana for experienced traders who know their execution platforms like extensions of their body, much like master musicians. I’m not referring to simple “hot keys” which went out of style in the late 90′s and are often defaulted to settings which cost the trader a lot of money in execution fees to the benefit of their firm. This is why I think Proprietary Trading firms are recinarnated bucket shops. On the other hand, it may have been your first experience or for whatever reason you were caught on the wrong side of a violent 1700 point single day range. If you blew up, consider it a blessing (as hard as that sounds). The best traders have had their share of blow up’s and have felt the pain deep in their gut.

Back to the point I’m trying to make if readers are given an opportunity to understand, because I firmly believe the Seeking Alpha reader is a sophisticated reader and doesn’t need things put in “layman” terms and unfortunately, some non-trader types think that’s the only way an article should be written. Regardless of the fact that a 12 year hedge fund veteran is the one
sharing his insights. Whether you’re at a major fund or a reputable proprietary trading shop, both offer powerful technology which enables the trader to launch dozens of baskets to simultaneously neutralize a heavy beairsh bias under such extreme conditions while also acquiring long positions at the same time. Most manual traders will do each half individuall. By that I mean they will cover their short positions first, perhaps even using a large long position in the Spyder’s (SPY) as a partial hedge while they do so, then they’ll switch over to accumulating long positions in stocks they havne’t been monitoring but buying as symbols pop in their head because they know this is a rising tide that will lift the marke. Not an ideal way to trade if you’re a professional. There are multiple strategies, involving derivatives overpriced due to spiking volatilility and an aversion to risk (e.g. selling naked puts rather than buying long). Using these baskets, which are fed through customized execution algorithms creates an environment best described by using a shot-gun to hit all market centers showing liquidity in a way without causing markets to run away from you because with correlations at 1, you need to concentrate on fewer stocks and larger sizes, or a huge list of stocks with smaller sizes. It’s the dollar amount you’re exposing, not what you’re buying. Because under these circumstances, the market’s in all stocks will move in tandem.

But to reverse a huge trading book from short to long within minutes without allowing annoying and opportunistic predatory algorithms running prices away from you is what traders live for. An entire year of doing nothing is worth a week where you produce a 6, 7 8 or figure profit on paper. This is what the disciplined trader waits for, this is Trading Nirvana. The unskilled, undisciplined trader who just happened to be in the right place at the right time will generally give back on average 50% to 80% of their profits, while some give back all of their gains and then some because they trade from a position of anger, a feeling of fighting to regain what was theirs to begin with, and an overall irrational mindset. Regardless of how much you made, if you fall into this trap, the best service you can do for yourself is walk away, and although it’s easy to write, I know from experience it’s almost impossible to do. Long-term success rides on your ability to bank windfall gains without any temptation to keep going at full throttle when the action rapidly diminishes. Most traders become careless following very quick and very large gains. They tend to fly off the cliff going full throttle in fifth gear. What you need to remember, the rule I live and die by is when you’re waiting for and prepared to act the moment such an event occurs (because the blood and fear or more quantitative data sets have given you indications) and generate significant gains due to your readiness,you’ve just crossed the finish line. The amateur thinks the race just began at that point and trips over themselves giving their gains back as fast as they made them during the ensuing back and fill action that causes major damage to day trader’s books. Trying to navigate in choppy waters is just money for your broker and the automated market makers back online to drive short-term, fast money traders insane with “liquidity seeking” behavior. Only traders will understand this, not editors, not teachers, not subscription newsletter writers who need to produce trades to keep their subscription base. Imagine a subscription service saying “no trades for the next few weeks because the market is too choppy and we just booked monster gains”. It’s unlikely the latter statement is true about the gains being booked, but the former statement will result in a rapid drop off in memberships. Are you on one of those members? If you are, tread very very carefully.

Why do experienced traders walk away following huge profits due to a sudden volatility/correlation spike? We all know such events are followed by equally rapid regressions in volatility and liquidity as stocks search for price equilibrium.

Because we are always at our most vulnerable following a period of tremendous profitability.

Professional traders must have the tools, confidence and mental discipline to stay calm and properly navigate a multi-sigma event of unprecedented proportions; profit as effectively and efficiently as possible from the event, then go “flat” as we say on the floor within minutes, knowing it’s time to play defense mainly against one’s own weaknesses. Adrenaline charged traders caught in a daze of euphoria caused by windfall gains will lose focus and hand back those gains due to a lack of patience and discipline to exploit high probability opportunities. Only veteran traders will understand this, non traders judging the editorial value of this material will not get what I’m saying in the slightest bit. Much like my Graduate School Economics Professors never understood and always asked me to intervene during sections covering market inefficiencies and how to exploit them, as well as to refute the formerly widely held belief out of the University of Chicago that market’s are rational. The latter is quite easy to refute.

Gains, no matter how large and how quickly accumulated, will vanish in seconds when a skull crushing reversal kicks in to retrace 70% of the cascade sell-off. Those heavily short into the cascade use the opportunity to close out and possibly reverse their direction extremely fast during a momentary sea of liquidity. Significant bottoms experience tremendous volume spikes but a large chunk of that volume is comprised of major institutional buying. The ensuing few days exhibit a rapid withdrawal of liquidity. When I was younger, we were trained to hit and hide. Stay in the tree’s until you have near certainty then jump in aggressively and jump back out to bank your profits.. With proper execution, preparation and an almost instinctive understanding of the technology at your disposal, giving it all back should never be a problem.

I used to have a mentor who was the greatest stock-picker I had ever worked with, but as I ultimately surpassed my mentor, as is the goal for all students of a great trader, I realized he was the sloppiest trader I had ever seen. With only a 7 figure line, the footprints he left when he executed a trade were the size of an elephant, as if Fidelity was in there buying millions of shares! The idea of “information leakage” never kicked in with him, so his executions resembled a buyer at the NYSE using a bullhorn to announce they were executing a large buy order and getting scalped by all the floor brokers. I was on the same platform as he was. He had access to the same tools as I did. But he didn’t use them. It was always a hot key to buy and a hot key to sell, both at market, both with a single click and very little brains. Instead, by using dozens of baskets, each containing 10-12 stocks in conjunction with strategic execution tactics, the trader can reverse, load up, get flat or neutralize market beta (i.e. directional exposure) within minutes. When short a large book because the market’s in a cascade sell-off, and then fear a bone crushing reversal is developing, the most obvious action is not the correct action. If you try to cover your shorts with no concurrent long orders in other stocks, you feed the squeeze that’s about to pop your head off. Instead, you simultaneously work to get long and cover your shorts by maximizing the platform’s capabilities.

Remember, when correlations are at 1, you don’t need to expose yourself with dozens of positions. You can buy a few generals that have enough liquidity to let you take blocks without moving the stock and gain enough exposure in a few names vs buying dozens of names. Simple enough right? You wouldn’t believe how many so-called traders have no conception of correlation, sigma or neutralizing one’s beta. Most don’t have to care because they’re running small amounts of money, but there are those running enough money where this matters!

Using your tools, skills and training to systematically and tactically cover your short positions and increase your long positions on pullbacks until your exposure is pointed in the right direction is critical. Smart, capable traders write naked puts on stocks that display signs of severe exhaustion to capture the inflated volatility in premiums in addition to getting long the stock with leverage at a time when leverage should be aggressively deployed. There’s a time for all the leverage you can get, and there’s a time when you’re not even 30% deployed, instead sitting on cash. Even if it seems like an eternity, it actually happens within minutes before the market realizes supply is exhausted, with nothing left to sell or borrow. Those few seconds, or minutes are your edge: when liquidity is greatest in the market just before vanishing, as reflected in those skyscraper volume bars during 15 minute reversals (or pick your fast time frame).

The rest of your success as a trader is whether or not you understand the market’s micro-structure and stay on top of fluid, constantly changing rules. Always be aware of charges and rebates from ECN’s for adding or taking liquidity and when major market crosses take place in the dark pools. Some ECN’s are natural dark pools like the Nasdaq itself, and a plethora of other constantly evolving elements that comprise the market’s “micro-structure”. Knowing how to pick stocks and how to customize your execution algorithms to suit your trading style are only half the battle. The rest requires a “better than average” understanding of the global macro picture along with an almost intuitive familiarity with the market’s micro-structure. If you don’t know what “market micro-structure” is, have never heard of it, or have heard of it but haven’t the foggiest clue about where to keep close tabs on it, you have only until your next losing day to start learning.

Part II will focus on a top-down analysis from a global macro perspective with an election year thrown in. The empirical evidence pertaining to Presidential election years is considerable and easy to find. I’ll also do a follow up to the long recommendation on Netflix which was covered extensively at Investment Capitalist in late December/early January. The trade was screaming out at you if you understood a couple key items: How corporate treasuries conduct stock buybacks to offset massive employee stock options that vest and are simultaneously exercised; and of course, how the micro-structure of the market behaves in such cases. Tuesday, January 26th and the Wed. January 27th both proved to be extremely profitable days for holders of Netflix stock from the low $70′s, and also an opportunity to bank gains from 50% to 80% in a few weeks. Of course I’m still holding a fairly large net long position but I’ll be trading around it at all times and have an early target of $150. That’s a natural ceiling and a good area for the stock to rest, back and fill tight stops or shake out weak hands, and build a good base to potentially use for the next leg up. I am a long-term bull on this stock and buying my entire line in the low $70′s while banking gains and rebuying those shares at even slightly lower prices gives me a cost basis way below $70, thus allowing me the benefits of patience and tactical maneuvering in the market. I also see the stock conducting a split this year if it approaches $200 again, or even breaks it. Based on recent action, the stock shows it can jump over $25 to $55 in a very short period of time. As another internet high-flyer, the risks are there but so are the rewards. Beyond what’s printed in this article, their’s not much hand holding I can do, nor the patience to be told by individuals with no trading experience what trader’s need to hear. I’ve put in too much time and gained too much respect to have to. But if you wish to access advanced market analysis, you are invited to sign up for Investment Capitalist, which is a free, highly actionable, and infrequently posted market research blog.