Ho John Lee's Weblog

…start with a large one.

This weekend’s news that JP Morgan will take over Bear Stearns for around $2/share is astonishing. Last Friday BSC closed at around 30. A week ago it was around 60. A year ago it was around $150/share. So in a year the shares are down by 99%, and even the bargain shoppers who got in on Friday are down by something like 85%, based on today’s close.

Global financial markets are linked more closely than ever. Here’s a crib sheet of a few markets of interest and their opening/closing times in Pacific Time (US West Coast).

There are often interesting interactions at major market open and closes, especially during the overlap between the US market open and European market close. In addition, US index futures, particularly the ES (S&P 500 e-mini futures) also trade nearly around the clock, closing only for daily settlement between 4:15 and 4:30pm US East Coast time (plus weekend and holidays).

Note that many Asian markets have morning and afternoon sessions, and close for lunch. Different countries also observe differing practices with respect to Daylight Savings Time, so the relative timing may change seasonally. You may find it useful to check with a World Clock for the current times. Also remember that Asia begins it’s week on Sunday evening in the US, and is closed for the week by the time it’s Friday in the US.

A cautionary tale gets added to market lore. This is going to make a good movie at some point…

In one of the banking world’s most unsettling recent disclosures, France’s Société Générale SA said Mr. Kerviel had cost the bank €4.9 billion, equal to $7.2 billion, by making huge unauthorized trades that he hid for months by hacking into computers. The combined trading positions he built up over recent months, say people close to the situation, totaled some €50 billion, or $73 billion.

Mr. Kerviel is no trading legend who let a transaction get out of hand. He was a low-level trader in the bank’s “Delta One” desk in western Paris, earning about €100,000 ($145,000) a year. His job was to make bets on how large European stock indexes would move, according to bank officials. His expertise was trading baskets of stocks such as the Euro Stoxx 50.

At $7.2 billion, this loss is larger than than the estimated 2006 GDP of 65 of the 183 countries tracked by the World Bank. It’s just about the entire output of Cambodia ($7.193 billion), and greater than the combined output of Seychelles, Liberia, Grenada, Gambia, Saint Kitts and Nevis, Saint Vincent and the Grenadines, Samoa, Comoros, Vanuatu, East Timor, Solomon Islands, Guinea-Bissau, Dominica, Micronesia, Tonga, Palau, Marshall Islands, São Tomé and Príncipe, and Kiribati ($6.846 billion).

I’ve noticed that the news coverage keep reporting “fraud”, which is apparently true (he made up fictitious trades with outside partners of the bank), but it mostly sounds like internal risk controls failed in more than one place.

Of course, if it had gone the other way and turned a profit, we never would have heard about it.

Looks like no one was impressed by Bernanke’s non-intervention on Thursday and the Bush/Paulson send-everyone-800-bucks stimulus package. US markets are closed for Martin Luther King Day, but the rest of the world is open, and down hard. DJ futures are showing something like -520 for tomorrow’s open, around 11586. The NYSE circuit breaker rules don’t kick in until a 10% move (1350 points), which would be somewhere around 10740. (The thresholds get reset every quarter.)

Don’t think we’ll see that tomorrow, but the way things have been going recently, it’s not out of the question. I wouldn’t be surprised to see a last-ditch central bank intervention tomorrow morning before the open, either. I think they missed their chance on Thursday, but I also don’t think the Fed has the luxury of waiting until the official FOMC meeting January 29 for their next move.

Fed chair Ben Bernanke appeared before the House Budget Committee this morning, giving a prepared statement, then taking questions from the panel members. Aside from the content of his comments (growth is slowing, we’re not in a recession, some quick economic stimulus would be good), I always find it unsettling to see and hear the questions from our elected officials on the budget committee, as they tend to make speeches posing as questions, that sometimes border on the absurd. Basically, they pretend to ask questions, and the Fed Chair pretends to give answers.

One congresswoman had Ben Bernanke confused with Hank Paulsen, (former head of Goldman Sachs, now Treasury Secretary) in a prepared question asking if the bankers who caused the credit market problems would repay their bonuses and salaries to the American people. You’d think at least her staff would be able to keep track of who was at Treasury and Fed. Ben probably wishes he had the bonuses she wanted him to repay.

The short term trading question tonight is whether we see the widely-expected “surprise” rate cut premarket tomorrow to ambush the index option traders before the open, like the discount window cut before the August 17 options expiration. Unlike equity options, US index options mostly settle based on the opening trades on expiration day. Futures are creeping up overnight, in case. But they already pulled that trick once, and everyone is watching for it, which means that even if they do it again, it won’t work as well as last time.

2008 so far: S&P down 9.2%, DJ -8.33%, Nas -11.51%

Update 01-19-2008 09:15 PT – The confused congresswoman is Marcy Kaptur currently on her 13th (!) term as US Representative from Ohio.

“CEO of the Princeton Economics Department”. At least he has a sense of humor.

Another day, another subprime-related fiasco. Today GE Asset Management announced that one of its not-quite-money-market short bond funds, the Enhanced Cash Trust, took a loss from subprime holdings, and is offering customer redemptions at 96 cents on the dollar. Normally these funds are considered to be a higher-yielding version of a money market fund. This would make you pretty unhappy if you were looking for 5%-ish stable returns while waiting for the stock market to settle down.

Along these lines, here are British comedians John Fortune & John Bird chatting about the state of the banking system, Northern Rock, and subprime in another interview of “George Parr, investment banker” from last month.

See also: Subprime crisis explained, by British comedians

This afternoon I was in the audience at the CNBC Fast Money show, which was taping on the road at the Computer History Museum. Many of the attendees were customers at Charles Schwab, which is holding a local workshop for active trading clients this weekend. People seemed to be in good spirits despite today’s down market.

In addition to the cast of Fast Money, we had Paul Otellini from Intel, who brought along a UMPC and a silicon wafer. Also making an appearance was the Trading Goddess, although I may have been the only one who recognized her handle during the Q&A session.

The Computer History Museum has an interesting collection of preserved techno-rubble. In the past, I’ve worked with a remarkably large number of the items displayed in the exhibits. I also enjoyed the Cray-1 sitting out near the entrance.

John Fortune & John Bird explain the subprime crisis, in a talk show interview of “George Parr, investment banker”.

Here’s a graph of the open interest in Sep07 SPX options. Unlike your typical equity option which settle based on opex Friday’s close, most index options settle based on the opening value of the S&P 500 index on expiration Friday.

This leads to interesting dynamics like last month, when Ben Bernanke cut the discount rate just before the market open on Friday. A lot of fund managers went to bed Thursday with good looking option positions that got crushed Friday morning when S&P 500 components gapped up at the open.

Thursday SPX cash closed at 1518.75. I come up with around 1490 for max pain. (“Max Pain” is the settlement value that will result in the lowest aggregate value for the open contracts at expiration.) This, and the big run up since the unexpected 50bps rate cut on Thursday, suggest a lower bias going into tomorrow’s open, which we would see in the futures. ESZ7 (December S&P futures contract) closed Thursday at 1531.75.

Part of what makes the index options settlement interesting is that the settlement value is based on the opening trades in each of the components, and they don’t all open at the same time. It takes a huge amount of money to move the entire market around, but you can jack the futures up or down, along with selected issues in thin premarket sessions to induce a higher or lower opening cross in your preferred direction. I don’t generally attempt to take a trade based on max pain alone, but it can be useful to know where some pricing anomalies may occur. On SPX, the institutional-sized interest tends to fall at multiples of 25, i.e. 1475, 1500, 1525, which is easily visible on the graph. If the opening price gets moved to a strike, there can also be an opportunity to fade the gap, as the trade gets unwound.

The rate cut on Tuesday resulted in a lot of excitement and probably an overdone level of buying. So there are some other reasons we might see prices come in on Friday. However, it looks like the “Bin Laden Trade” (many, many Sep07 SPX 700 puts) isn’t going to expire in the money.

Barry Ritholtz points out the new community sentiment feature, part of the new front page for Yahoo Finance.

Stock message boards are a fascinating place to scan through from time to time, containing a mix of informed, uninformed, and sometimes deliberately misleading posts. On average, the post volume and prevailing sentiment is probably a good contrary indicator. Part of what makes stock message boards interesting is the sheer volume of misdirection and general noise. At the same time, there are a smaller number of board posters that contribute more than blind cheerleading or bashing their chosen stocks.

I spent some time a while back looking at trying to automate the process of scanning the Yahoo Finance boards for “informed” or otherwise actionable message flow, but concluded that the project wasn’t worth the effort unless I was working for Yahoo. Some of the process I was considering would have been to determining a reputation value for messages and contributors, partly based on historical outcomes and partly based on user-generated ratings. The last revision to the finance message boards incorporates a simple rating system, but what I was looking for was the ability to see the ratings from a trusted set of users, and the ability to rate the posters, and perhaps their likely context (long term holder, swing trader, or intraday trader). The other piece would have been to implement some backtesting on the various sentiment indicators to see whether it had any trading value at all.

The sentiment indicator is being generated by Collective Intellect, which says:

Using proprietary algorithms, Collective Intellect’s Media IntelligenceTM service filters and ranks bloggers and posts, so you only see the most credible sources of information — and only when it’s relevant to your trading strategy.

I think it’s much easier to deal with analysis of the financial bloggers than the stock message boards and chat rooms. It will be interesting to keep an eye on how this new feature works out.

I take a week or so away from the markets and look at what happens…

The preface to Oscar’s e-mail this morning summarizes the current sentiment pretty well.

“Caution: This Next Trade is Not for Widows or Orphans”

Bear in mind that he’s a short term futures trader, so if you’re a buy-and-hold investor, none of this matters to you. You might enjoy his daily video commentary though.

The Budget Graph poster is a visual depiction of the United States Budget. The online pan-and-zoom browser is fun too. If you want a general sense of where the money goes, this totally beats plowing through the official federal budget documents.

Both CNBC and TheStreet.com have separately reported problems with their respective stock trading contests.

The CNBC contest site apparently had a coding flaw that allowed traders to open an order entry window before market close, then wait until after hours to actually enter the order, which would be executed the closing price.

The more interesting comment from CNBC is this:

In addition, there have been allegations that one or more contestants may have engaged in illegal market manipulation to affect actual prices of stocks represented in their contest portfolios.

With a million dollars at stake, this seemed like a plausible scenario even before the contest started. It’s unclear to me whether “illegal market manipulation” here actually means “illegal under contest rules” or “illegal under SEC regulations”, but it seems quite feasible.

Along similar lines at TheStreet.com, which offered $100,000 in their contest:

The final results of the game indicate that players employed trading strategies to achieve returns that could not be duplicated in the real world, thereby depriving other contestants of an equal chance to win.

I don’t know why these large contests don’t just partner with a retail brokerage that already has a paper trading (“demo”) mode instead of building their own. Wouldn’t solve the market manipulation problem though.

See also:

• BusinessWeek – CNBC’s Easy Money
• Insufficient volatility to win
• Not bad for real money, but not enough for paper trading

Since last February’s market gymnastics, I regularly take a glance at the wacky Shanghai market in overnight trading to see if that particular financial asteroid will be landing in the morning. This evening I noticed that the free quotes on the US Yahoo site lag the quotes on the China Yahoo site:

Here’s the Shanghai market as seen on the US site:

Here’s the Shanghai market as seen on the Chinese site:

In both cases, they’re free, delayed quotes, and are correctly time stamped. I never noticed that the overseas Yahoo sites provide more current data for the local markets before, though. Now you can all impress your non-trading friends with your nearly psychic ability to call intraday turns in the Shanghai market.

It appears I didn’t win the CNBC stock contest, ending up at +30%. The leading portfolios were something like $4-5MM, so there is a huge spread in that top 2% bracket.

I’m currently in the top 4% at 14746 in the CNBC contest. Oddly, they don’t publish the portfolio values on their website, but did show the current portfolio values and standings on TV last Friday. The top positions are clustered around $2M, or a total return of around 100%. It would be interesting to know what the distribution of 1-week returns looked like. That’s probably the best opportunity for placing at this point.

In either case, I haven’t hit any 25% to 50% movers, which looks like a prequisite for placing in the standings so far.

It’s hard to find high volatility stocks that are likely to move up in this market. I made a little progress on the CNBC stock contest, but this is going to be a lot lower tomorrow when they update the results (seeing how the markets had another abysmal day). It would be a lot more interesting if you could take short positions. Everyone would probably be in NEW and LEND.

As an aside, the rules for the trading contest apparently don’t prohibit multiple accounts owned by the same person. Consequently, someone named “Nancy Beaumont” has entered hundreds of portfolios. By the rules, they can only win once, but having multiple high-volatility portfolios in the running significantly improves your chance of ending up with one or two successful outliers, sort of like buying multiple lottery tickets, but with much better odds. At the moment they’re occupying 8 of the top 20 rankings.

CNBC is running a stock trading contest starting today, with a prize of one million dollars for the best performance by May 25th. Signing up is free. Each participant gets a notional $1,000,000 to trade. There are a few non-obvious rules:

• All trades are priced at end-of-day – no intraday trades, and no GTC limit orders.
• No ETFs – this means no indexes, countries, sectors, or commodities, and no inverse trades
• No mutual funds – again, no indexes, country, sector, commodity, or inverse vehicles
• No options, futures, or other derivatives
• Minimum market cap of $500 million as of the starting date – this is probably to keep people from winning by manipulating a thinly traded microcap stock.

In order to win this type of contest, you pretty much have to treat it like a free lottery ticket and make your selections accordingly. There is no risk-adjusted return to consider, and no downside to taking extreme losses. So on a short timeframe, and in a long-only US stock portfolio, you’re looking for something highly speculative that’s going to move a lot.

Before I read the rules, I was thinking that with a million real dollars at stake, someone would game the system by thrashing a microcap issue back and forth, but the $500MM market cap requirement makes it harder. Not out of the question, but probably not worthwhile for anyone in a position to control the stock price.

Since we can’t trade the easily manipulated microcap stocks, I’d look for low float, heavily shorted small cap stocks that have some positive opportunity for event or news driven movement. Some general areas to look:

• Biotech development companies that have regulatory approval or conferences coming up
• Despised companies that are potential buyout candidates
• Disaster / event driven companies, such as avian flu, anti-terrorism, or whatever you can think of
• Fad driven trades. Last year it was ethanol and energy drinks. It might be ethanol and alt-energy again this year

These are all exactly the opposite of good investment or trading approaches, but the contest has a binary outcome – either you win or you don’t. By taking on extreme levels of portfolio risk, you’re trying to increase the variance of portfolio returns during the contest period, in hope of coming up with the highest outlier by the end.

A contrarian approach might be to stay in cash or very conservative stocks, and hope that everyone else makes speculative bets that crash and burn.

Hmm. I just looked at the rules again, and they also have $10,000 prizes for each week’s best 1-week return. This actually increases the incentive for finding a more-or-less binary, news-driven trade each week (such as earnings, court ruling, regulatory approvals). If it works out, your portfolio goes up. If it goes down, it doesn’t affect your 1-week return for the following week.

I was going to run a scan for this over the weekend, but perhaps I should try to dig something up for this week in case something works out.

Needless to say, this isn’t how one should invest or trade with real money.

Got a relatively weak bounce today after yesterday’s excitement.

Here’s a look at today’s market heat map after the close. There’s a lot of green, but this was pretty unenthusiastic.

I wasn’t too impressed with John Thain on CNBC today explaining yesterday’s weirdness with the NYSE trading and reporting systems. The official story seems to be that the systems that compute the DJIA got backlogged with transactions, and separately an internal messaging system for floor traders also got backlogged, so they’re upgrading their servers. Today they had to delay closing a number of stocks to allow transaction queues to clear at the end of the day. Thain mentioned a volume of over 20,000 msgs/second. This is all plausible, but not reassuring. It sounds like something that would happen to a growing e-commerce site, not one of the world’s largest stock exchanges. I wonder how much reserve throughput they can actually deploy. If we get a “real” market crash, they’re going to have to handle a lot more than the 2.4 billion shares they traded yesterday.

Update Thursday 03-01-2007 0616 PST – Premarket looks pretty messy this morning so far.

Today was a notable down day for most investors. This is a snapshot of the WSJ’s market heat map after today’s close, as monochromatic as I’ve ever seen it. (Update – see TraderMike’s recap of the intraday trading.)

It’s interesting to observe that diversification across asset classes and markets didn’t help you today. All 30 Dow stocks closed down. 99 of 100 Nasdaq-100 stocks closed down. Nearly all of the S&P 500 closed down. Oil, gold, and other commodities closed down. Emerging markets closed down. Basically, equities and commodities got sold, and the proceeds went to cash and bonds. (Update – here’s the summary from today’s Worden Report: “Zero Industry groups advanced while 239 declined. There was one winner in the Nasdaq-100, two in the SP-500 and zero in the Dow. HalfPoint+ Movers were seven against 2174. The Leadership Index was 34 versus 2228.”)

One nominal trigger for today’s selling was a 9% drop on the Shanghai exchange, but there have been any number of reasons to be concerned and raise a little cash for a while.

In general, diversifying an investment portfolio across asset classes and markets reduces overall risk for an equivalent level of returns. This works because the price behavior for different markets is supposed to be relatively uncorrelated over time. Lately, disparate markets have been more correlated than in the past, mostly going up. Today the risk was clearly to the down side, making it likely that your investment portfolio closed lower today, unless you were in cash or bonds. (I’m pleased to have reduced my trading positions in India and China over the past couple of weeks.)

Another unexpected systemic risk exposed today was in the odd behavior of the NYSE around 3pm. The new hybrid (electronic and open outcry) trading system was apparently getting backed up due to heavy order flow this afternoon. The DJIA appeared to gap down by 180 points when the backlog was cleared. Anyone trading intraday off a NYSE data feed probably had some problems. (Update – here’s TraderMike with more detail)

I think the price action today is overdone, but I’m also happy to have exited many of my positions in India, China, and other emerging markets over the past few weeks. This is a good time to think about where to invest after the dust settles, or focus on short term and day trading. (Some of you may be interested in using the Ultra and Ultrashort ETFs.)