Tweet Fear

Last Tuesday at approximately 1:00 pm EST, a Tweet from the Associated Press (AP) Twitter account read as follows; “Breaking: Two Explosions in the White House and Barack Obama is injured.”

Within a space of three minutes, US $136.5 billion of the S&P 500 index’s value was wiped out. The S&P 500 index fell more than 14 points. Sources from AP and the White House quickly dismissed the report as false, and within a minute of that, markets recovered all of the lost ground.

The short term shock and awe raised more than a few eyebrows; it brought back memories of the flash crash, provided further evidence about the skittish temperament of the financial markets, emphasized the downside of trading on unsubstantiated rumors and highlighted the importance that social media plays in the instantaneous dissemination of news.

What did not receive as much attention was the rapid erosion of specialist bids on hearing the rumour! At the heart of an exchange are market makers and floor specialists who match buy and sell orders presumably maintain tight spreads between the bids and ask prices and generally provide liquidity for various financial instruments.

The rapid sell-off on Tuesday had more to do with the evaporation of specialist bids rather than a significant spike in large sell orders hitting the market all at once. In short the specialists and market makers pulled their bids after the first tweet and reinstated them at much lower prices.

Investors with hair triggers entered market orders that were executed at prices that were in some cases were well below the previous trade. Mind you most of these hair triggers were pulled by high frequency traders whose orders were originated by computers using algorithms that track among other things flash news from social media sites.

That bids evaporated may be the most important lesson to gleam from this event as it lays the foundation for what is to come. I say that because the specialists’ action this was a rational response to a set of known circumstances.

Professional market makers and specialists are well aware that high frequency trading is the single largest contributor to daily trading activity in the US markets. While these same floor traders may not have the specifics that drive high frequency trading decisions, they certainly have a peripheral understanding of the algorithms. At least they know enough to get off the tracks when a high frequency freight train is bearing down.

That is one of the basic tenets of efficient market theory. At the core of efficient markets is the assumption that there is no free lunch. If a trading system becomes too successful – which most believe is the case with high frequency trading – other market participants will take steps to mimic the strategy and over time will eventually price out any excess return. I suspect in the fullness of time, it will become virtually impossible to earn excess returns with any short term trading strategy.

That does not mean that one cannot create wealth in the financial markets. Far from it! In an efficient market mean reversion plays a role… which is to say markets and individual securities will experience short term ebbs and flows that go beyond rational expectations but over time those same markets and securities will gravitate to a value that is predicated on reasonable fundamentals.

The degree to which a security ebbs and flows – i.e. the security’s inherent volatility – is determined by short term sentiment which, by the way, is priced in the options market. A classic case study of this theory being put into practice can be seen in the price action of Blackberry.

From an intraday high well above $45 per share, the stock have fallen 66% to close on Friday at $15.25. At $45, most would now agree that Blackberry had gotten ahead of itself being priced as a company where there was little competition. That’s not rational as there comes a time when technology companies must deliver new products in order to remain competitive. Without that investors begin to re-value shares using other metrics. That can be a very painful shift that Blackberry investors have witnessed firsthand over the past six months.

With growth slowing, most analysts and longer term investors see Blackberry as a value play. The question is what value do you place on the company which is another way of saying what value should the company rest at when mean reversion takes root? The answer to that hinges on your time horizon.

This is where options can play a role by helping us determine a range of reasonable outcomes given longer term metrics that take into account mean reversion. For example, the Blackberry January 2014 15 calls (these are the at-the-money options) are valued at $3.00 (based on Friday’s bid ask spread). The Blackberry January 2014 15 puts were valued at $2.85 as of the close of trading on Friday.

If one were to buy both the January 2014 15 call and 15 put the total cost would be $5.85. At this point you would not care whether the stock rallied or sold off. If it rallied the calls would profit if is sold off the puts would benefit. This behavior is what determines an implied trading range.

We get to an implied trading range by simply adding and subtracting the total cost for the call and the put from the 15 strike price. In this example, Blackberry has an implied trading range of $9.15 $15 strike price less $5.85 cost for the Blackberry straddle) to the downside and $20.85 ($115 strike plus $5.85) to the upside.

If you are bullish on the outlook for the company, you would opt to hold out for the upside potential which in this case implies a target above $20 per share sometime between now and January 2014. If you were bearish, than the longer term downside target is around $10 per share. The trick with mean reversion is to stay invested long enough to see the fruits of one’s labor.