Web’s Weekly Roundup&

Who’s On the Other Side?September 12, 2015

Presenter: Web Begole@MarketWebs

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Web’s Weekly Roundup

• Analysis of /ES (S&P 500 Futures) and forecast (BEARISH)

• Analysis of /CL (Crude Futures) and forecast (BEARISH)

• Analysis of this market…..

• Who’s On the Other Side? Supply & Demand in the Market

/ES Futures (S&P 500) YTD 2015

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Opening Price: 2026.25Current Price: 1952.25

High: 2114.25Low: 1819

O/C Change: -74.00pts (-3.65%)H/L Range: 295.25

Notable Pattern:On Wednesday there was a fairly impressive rejection of Septembers value area, as we continue to trade just below it now.

Forecast:My eyes are glued at this level, because we are in value for the yearly chart, I have firmer confidence we’ll sell off soon to the 1838.50 level as we continue to make our way down to 1808.50 before the end of the year.

Returning into value this month could call for a move all the way up to 2094.50

All eyes on the Fed on Thursday…

/CL Futures (Crude) YTD 2015

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Opening Price: 60.33Current Price: 44.78

High: 64.75Low: 37.75

O/C Change: -15.55 (-25.77%)H/L Range: 27

Notable Pattern:The bounce off the 2009 Low Tick has maintained for now but as we’ve re-entered September’s value area, things aren’t looking strong for a recovery in oil prices. The blue line notes we are trading beneath the 15 year trendline and finding resistance there.

Forecast:I certainly think we’re heading to 41.34, but we may not break that 38.91 level again this month.

DIA – QQQ – SPY

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IWM – TLT – GLD

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Looking Ahead

• Overall:

• Everything seems to be in a holding pattern until Thursday / Friday. Next week is setting up to be an exciting closer….

For the /ES – Look for the Fed announcement on Thursday, will they raise rates or wont they, and regardless, what will be the reaction?

For /CL – Look for more from Washington, sanctions on Iran are likely to be lifted soon regardless of the bickering on the hill. Also note

that while some smaller members of OPEC are nearly screaming for price intervention by the group, OPEC has quietly stated its

intentions to bring yet more production online going forward.

• Looking at these charts, and from what I understand of what is going on in the world, I think there are more scenarios under which the

market will continue to sell off, but ya never know!

Who’s on the Other Side?

A discussion of Supply & Demand in the Market

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Who’s on the other side?

• I’ve been asked a lot recently – If China is selling US Treasury Bonds, who is buying them?I don’t have a direct answer for that… but it lead me to another question…If I want to sell something, who is buying it from me?Conversely:If I want to buy something, who is selling it to me?

In addition, one thing we’re always looking to know is: Is the pressure in the market to the buy-side or the sell side? We want to know what direction the market is going! At AlphaShark we often talk in terms of “Paper is buying X” or “Paper is selling X”… and the question always comes up “For every buyer there’s a seller, so how do you know??” That’s what we’ll discuss today.

• Therefore, I will spend today talking about Supply & Demand and what it means in the markets.We’ll discuss this in two ways:

Equities – because in some metaphysical sense, this is a “physical” tradable thing and therefore has a limit to how much exists in the world.

Futures / Options – Because these are only “paper”, these are contracts for which supply can be theoretically limitless.

We’ll also talk about two kinds of participants:

The investor – we’ll call this participant: Joe Mainstreet

The professional – we’ll call this participant: Jane Wallstreet

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Who’s on the other side?

• Let’s start at the beginning…. Micro Economics 101

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Supply

Demand

Quantity

Price

Supply Side:If you are a producer of Widgets, it costs you money to produce widgets, therefore it is at a loss-cost for you to produce more widgets than the market will bare (ie: more than there is demand for them)You want to know two things:1) How many Widgets should I be producing?2) How much can I get for my Widgets?

Say a Widget costs $1 to produce,

Above 5 Widgets, the demand isn’t there, so the price would have to be lowered to meet demand. Ex: Could sell 8 Widgets for $2 minus $8 in CapEx = $16 revenue and $8 in profits.

Below 5 Widgets, the demand is far higher, you could get a better price and have less cost because you only produce 2 Widgets!Ex: Could sell 2 Widget for $8 minus $2 in CapEx = $16 revenue and $14 in profits.

At Exactly 5 Widgets, you’re meeting Demand.Ex: Could sell 5 Widgets for $5 minus $5 in CapEx = $25 revenue and $20 in profits.

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Who’s on the other side?

• Let’s start at the beginning…. Micro Economics 101

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Supply

Demand

Quantity

Price

Demand Side:For the only 1 Widget in existence, the price “demand” is willing to pay is immeasurable.For the requirement to buy 10 Widgets, “demand” may find they have no use for more than 5 and so the price they’re willing to pay for a package of 10 is very little per Widget.

But what changes demand side? Participants!

If more people come into this market and want to buy, they’ll outrun supply, so the price moves up.

If people leave the market, the supply is higher than the demand and price will move down.

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Who’s on the other side?

• Let’s start at the beginning…. Micro Economics 101

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Supply

Demand

Quantity

Price

On the topic of Participants, what happens when more join the supply side?

Maybe you’ve found your equilibrium supply/price levels, but what if a competitor joins your market – importantly, they’ve seen what you’re making and they want the same income! – dealing with the same demand curve?

The new equilibrium price lowers because the demand is finding supply throughout the market, the supply curve shifts to the right and suddenly your seeing lower prices, revenues, profits.

The only natural thing that can save your prices, is an increase in demand….

We’ll get into this another time, but a CARTEL could collude to establish a price floor that could also lead to saving prices…

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Who’s on the other side?

• So what does this mean in the markets? Let’s talk about Equities first….

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Supply

Demand

Quantity

Price

We can replace “Supply” with “Sellers” and “Demand” with “Buyers”

If sellers suddenly have reason to sell with abandon, what happens? It’s the same as competitors coming in, the “supply” of easily bought equities increases and therefore the price decreases.

What happens if buyers suddenly have reason to buy with abandon (because prices are lower!)? It’s the same as participants increasing on the demand side, prices increase as the demand for the supply increases… they only start to decrease again as supply increases….

And why would supply increase again? Because prices are higher! Think about this in market terms…. After these iterations, suddenly more supply comes in to sell at what used to be the equilibrium level… This is why we have cycles or “retracements” in the market.

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Who’s on the other side?

• I want to take a pause here and talk about Cartels…

• There’s the Evil version – ex: OPEC, which in the past has set the price floors I mentioned before (though recently, OPEC has been setting price ceilings, but that’s due to macro-economic political reasons) – which sets prices through mutual collusion.

• Then there’s the unintended version… the market price of a security – where there are so many participants on one side of the market (in this case, the buy side) that there is a market-enforced high price... The NBBO (National Best Bid / Offer). It might for reasons I’ve discussed previously be above the demand curve. But the buyers will eventually “run out of bullets” and the demand curve will fall faster than the NBBO. When this happens, if market participants want to sell a mass quantity of stock at a higher price than the demand will bear, there needs to be a “buyer of last resort”.

• “Buyers of Last Resort” are also known as “Liquidity Providers” – they work in the opposite direction as well. These are the pros, the Jane Wallstreets. They will buy/sell at the market price – even if it is outside of demand – because not only is it their purpose but they simply hedge against the position.

• Say Joe Mainstreet wants to dump 500k shares of AAPL at 114 – the current NBBO – but there aren’t enough buyers at that price level. Well, Jane Wallstreet will look in her darkpool and try to match a buyer. Failing any darkpool buyers at that price, Jane Wallstreet – charged with the job of providing liquidity – will buy those 500k shares from Joe (at some discount for taking on his risk, perhaps she’ll buy them all for a few ticks below the market’s best bid), and hedge them. She will immediately sell as many shares at the same price as the market’s liquidity will provide (unless Joe Mainstreet has already done this part) so Jane is only responsible for the liquidity that didn’t exist before.

• If demand rises to meet her level of buying, Jane will close her position and remove her risk, if they don’t, she will continue to hedge the position.

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Who’s on the other side?

• Since I mentioned the scary word “darkpool” I’d also like to take a pause and discuss something here…

• Say Jane Wallstreet bought Joe Mainstreet’s 500k shares within Jane’s own darkpool. The retail investor is trained to believe this is a bad thing because the market can’t see where the demand is – that Joe just dumped a huge amount of shares! But let’s think through this:

• Jane is now long 500k shares that she has hedged, she didn’t necessarily want to be in the position but she’s safe within it because it is hedged. But because it’s not a position she wants, she will begin to start selling her shares on the lit market.Remember, Joe Mainstreet couldn’t sell all of his shares on the lit market because there wasn’t enough liquidity at the price he wanted. Therefore there still isn’t enough liquidity at Jane’s price either, but Jane has the benefit of time and hedging on her side. What she will do is start selling her shares whenever she can get a risk-even price for them. Because of her hedge, and the likely premium she got from Joe Mainstreet, she can afford to sell shares at a slightly lower price and not all at once.

• So the lit market (that the retail investor sees) will see selling pressure from Jane Wallstreet instead of Joe Mainstreet. It makes little difference in the actual market aside from keeping the market in a certain equilibrium without undue extreme price movements – this is the point of liquidity providers.

• So what IS bad about darkpools? Well Joe Mainstreet (or large hedgefunds or prop-firms etc) looking to sell large amounts all at once will be seen by HFT algos within the darkpool, those algos will immediately go out to the lit market and start the price movement in the same direction (by absorbing liquidity) before the big order has a time to be completed… thus front-running and thus reducing the advantage of being able to use the darkpool for liquidity. In short, the HFT/darkpool problem is more a problem for those placing very large orders all at once and or anyone placing a market order.

(I never want to ever place a market order!!!)

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Who’s on the other side?

• Coming back to equities, let’s talk about liquidity extremes….

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Supply

Demand

Quantity

Price

What is hard to see in the previous slides is that the supply&demand curves are ALWAYS moving in the market. This is what leads to price discovery and allows all participants in the market to know where the current equilibrium value of an underlying is. However, these curves can do some really strange things at times…

Say everyone who owns a stock believes it is worth more than it is currently worth, no one will bother selling. Say also that at the current market price, everyone who is desiring or able to own it owns it already…

Price goes up, trading volume goes down. As volume goes down, fair price discovery starts to diminish. Occasionally a new buyer may come in and buy at a higher price, but the overall demand can’t really match it.

So what can be done to bring things back into a healthy-price-discovering market? Well if it’s an equity, the company can issue more shares and add to the supply, lowering price.

Or the stock can split, reducing the price but also reducing the demand (as the current market demand also splits with the stock price). What this does however is shake up the sentiment in the market – is the split a good thing or a bad thing? What does it mean for the company? – and it lowers the barrier to entry for new demand participants.

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Who’s on the other side?

• There’s another vastly different type of liquidity extreme… Gold…

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Supply

Demand

Quantity

Price

Gold is one of the purest micro-economic underlyings to talk about… it has only one purpose in life, to have and to hold value. Not to mention, it is a finite resource where supply can’t be manipulated like I just mentioned.

This leads to a strange case where Supply and Demand curves – in essence – flip.

As the price of gold rises, so does demand, and the available supply to buy diminishes. As it falls, so does demand, and the available supply to buy increases.

What this causes is a liquidity crisis in waiting – If the price of gold goes up (say because of macro-economic turmoil) there becomes less to buy and the market becomes illiquid causing a feedback loop of increasing prices until the value has reason to fall…When it falls it falls very quickly because demand fell as well and now everyone holding gold wants to liquidate as quickly as possible before the value drops quickly.

What’s important to note here, is that Equities can act the same way in a bubble, where the market price is determined not on book value of the company but rather it is determined under the perception that an equity has no other purpose than to have and to hold value….

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Who’s on the other side?

• There are so many more topics to discuss in this way, but I want to bring it back to some simple points for digestion:

• A stock chart is nothing but the historical end-result of the constant movements of the supply & demand curves. While technical analysists (myself being one of them) live by the belief that previous movements in supply & demand can determine to an extent their future movements, there are problems with this belief. It is not necessarily false, but it is not necessarily true either. There are many factors outside a single stock/commodity/future/option that can influence the movement of the curves perhaps even into a surprisingly erratic way.

For example, a healthy investment market will value an Equity based on the company’s book value, future returns, innovative potential, etc. and the stock will act in the ways we first talked about because of the investment cost of Joe Mainstreet – he doesn’t want to lose his money by buying a bad company. Putting his capital into a company presents (outside of potential margin payments, taxes, etc) an opportunity cost because that capital cannot be used elsewhere. Therefore he will trade on what be believes the value should be, regardless of what the market says it is.

However, if the market finds itself in a “bubble” condition, the market may value an Equity in the same way it values something like Gold, where the price of the underlying is no longer directly associated with the value of the company but rather speculative conjecture about where the market might value it in the future… Bubbles can be created when the cost (opportunity costs and margin payments etc) to Joe Mainstreet has reduced. (To wit: 0% Interest Rates)

• When supply & demand curves are in their “normal” state, the equilibrium value (where the two meet) is easily maintained and will naturally always gravitate to be traded at that price.

When they are in the “flipped” state (like the bubble condition) the equilibrium price is very difficult to maintain and the market will tend to resist that level in highly volatile ways.

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Who’s on the other side?

• Yet another type of extreme liquidity…. Futures or Options…

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Unlike equities and gold, Futures and Options are nothing more than contracts/agreements made between market participants. Because of this there is (theoretically) infinite supply. All one needs is a participant on the other side to enter their contract.

That’s difficult to chart because the concept of “quantity” is driven by the demands of both buyers & sellers, so a whole axis of the chart gets all mangled.

But I can talk about it in an anecdote form:

Take the S&P E-Mini futures for example, these contracts are merely an agreement between two parties for which profit/loss will be settled at the end of every day based on the settlement price of the future. Again, there is no limit to how many there can be… in fact there can be way more futures contracts open than there is actual number of shares within the entirety of the S&P by some infinite multiple…. This leads to an inherent problem…

Say you want to sell 1000 /ES futures, and at the moment there’s no one else who wants to buy that many. In steps Jane Wallstreet again to get your back – and keep the market somewhat stabilized. She’ll take the other side of your contract and buy those /ES futures. How does she hedge these? Well the immediate and most direct hedge is for her to go and sell 500 shares of SPX…. Or piece it out and sell the proper number of shares of each equity in the S&P….

So what happens if everyone who has a long portfolio of S&P stocks decides on the same day to hedge their portfolio 1:1 with /ES futures? Suddenly there is massive selling pressure in the /ES, and if everyone is selling, the only one buying is Jane Wallstreet, who is hedging by selling the actual equities in the market (assuming there are enough out there to sell… she will have to borrow to sell them short) and the actual equity market starts to fall… Notably: what was intended to be a hedge just became a self-fulfilling necessity.

So, if you can imagine for a second the first development of algorithms along with the development of “modern portfolio theory” led to a few computers turning on and crunching their numbers for the first time in history, and concluding that some major portfolios need to be hedged and quickly…. Suddenly an onslaught of /ES futures are sold, perhaps even more than there was actual equity in the market. Jane Wallstreet shorts and hedges as much as she can, but there’s a physical limit to how much can be hedged…. Eventually an external force needs to step in to restore calmness and confidence in the market…

If you haven’t guessed yet: This is what happened in 1987.

Who’s on the other side?

• Yet another type of extreme liquidity…. Futures or Options…

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So what saved the market in 1987?

Well here we have yet another thing that’s hard to graph. But essentially what was required was a rising in the speculative buyers demand curve by a new participant willing to buy the /ES contracts without a hedging them by selling the correlated equities. This then allowed both the futures AND the equities to rise together again. The confidence this showed in the market allowed more buyers to buy either futures or equities or both at what became “discount” prices.

What allowed risk takers to enter the market? Well some saw a good opportunity and were simply willing. Others were helped by external hedging (ie: assistance from the Fed) which lowered the “cost” as we’ve discussed before.

The ability to hedge /ES futures with /ES options helped matters as well.

But remember, options are contracts too, if you’re buying calls from Jane Wallstreet, she will hedge them by selling the underlying. Again, what is necessary is an opposite party willing to take the risk without hedging.

All in all, for the market to move upwards in a healthy and sustainable way, transactions like we’ve discussed have to be done so with confidence and without the hedge. Hedging leads to a zero-sum game that allows movement in the market (a good thing!) but a net zero impact in the market (a bad thing!)

Who’s on the other side?

• So where to conclude all of this….

• Well, why is the market a weird and chaotic place? All the reasons we’ve discussed today.

• What’s the take away for the individual investor? – There’s a lot to digest here, and this is only barely the tip of the iceberg in how the market fully works.– Try to have an opinion of your own on the type of market you face… are you in a value market or are you in a bubble market?– Some hints to answering the above is to evaluate the “cost” of investing both for yourself and for everyone else in the market…. If they’re hedged or if

their cost is artificially low, you may be looking at a bubble market. If the cost is high (or perhaps one may say if the cost is fair) then we are more likely to be in a value market.

– Value markets are easier to evaluate, look at the fundamentals of the company, is it going to improve or worsen over time?– Bubble markets are more difficult to evaluate, prices can rise or fall very very quickly and only the market participants have any influence over it.

• One final thought – because I can’t shut up –– In a value market, the “cost” of trading is higher for short sellers because they have to pay margin and have other carrying costs, therefore in a value

market, the short sellers are more likely to hedge (leading to the net zero-sum impact) while long buyers are less likely to hedge (leading to the net-plus impact)

– In a bubble market where “costs” are reduced short sellers have a rare advantage of being able to short with less cost and therefore will tend to take advantage of the environment and short without hedging (leading to a net-negative impact) while long buyers also have less cost, they’re also facing higher volatility as price does not like to stay in equilibrium and will be more likely to hedge (leading to a net-zero impact)…

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Q & A With Web