Wednesday, July 29, 2009

The Magician

This post will explain probably the most influential mechanism of stock manipulation. Long before anyone would have written the control function for the stock market or created the necessary neural network or other algorithm(s) needed to calibrate the behavior of a sci-fi trading computer, it was recognized by many that the stock market is just as fickle as public opinion would be if we had hundreds of simultaneous presidential elections going on. We try, through appreciation of human accomplishments won through logical faculty, to make rational evaluations of trading opportunities, but inevitably our social mechanics and primal nature filter in. Just like pundits and anyone with anything to gain in the political world, there are always players spinning their wheels cloak-and-dagger style, behind the cape of uncertainty and faith in the general legitimacy of society, working hard to push the right buttons at the right time to get the herd moving in some direction they can capitalize on. Collectively, this influence can be represented as the arch-rival of the chaotic cow, the magician.

Let's start with a brief introduction to social behavior. Assume you want something and recognize that lots of other people want the same thing. A viable strategy is to identify whoever looks like a strong player and follow their lead. Apply the reasoning to a cave man scenario. While on the day's group hunt, you and your party are slowly creeping up on [insert large tasty dangerous animal]. Suddenly, one of you raises up and starts running at one of the creatures. The signal hadn't been given. The guy is breaking consensus. Do you
A) rush in with him?
B) hold back, tie him to a tree after he's scared the prey off, and try again one short?
What if the guy doesn't look like your above-average hunter? Is he probably out on a limb for his ability? Now, suppose the guy is well regarded as an expert at pre-emptive cave/kung-fu. Even though the leader might not have seen the opportunity, you generally expect that this guy does. In the first case, you probably don't follow. In the second, you probably do.

Back to financial markets, are there any arenas where the elite players and gamblers mix? The answer is yes. Instruments with elevated risk and reward exist in the form of derivatives, namely stock options and futures. Stock options essentially allow you to buy the profit potential, short or long, in exchange for risk. Stock options only have a certain window of time available within which that profit can be won. This has a price, known as the time premium. Futures operate much the same way. Increased risk, increased return. Because these instruments are very volatile and dangerous, it's usually expected that big plays in the derivatives markets are made by expert players showing their hands. The reasoning is that bad plays go south, so bad players go bankrupt or get out fast.

Now, lets say that the you're a major institution or large investor and you feel/determine that there is a little bit of a wound up spring in the market if a technical pattern builds at a certain point, and you want to capitalize on that movement. You could A) get lucky or B) shove the rugby pile with a large play. Since everyone is always watching the market, all plays are visible, and one of the places that gathers a lot of attention is derivatives. A frivolous move on the derivatives market will become very costly very quickly, but making a very aggressive play that shows up in the derivatives markets is easy. The market sizes are small and the reactionary trading habits are greatly amplified. The feedback happens so fast that you can ping the spread with a single order and suddenly watch the market readjust like hyenas in a flinch-fight. One order, and the whole thing starts rearranging.

Because frivolous plays are costly, it's expected that frivolous derivatives exchanges don't happen to a large degree. However, if you're a well capitalized trader with a large position in a stock, that frivolous trade becomes cheap, and then you send the whole pack of hyenas mad in one direction. Better yet, just like our pre-historic cave hunters, the regular traders will pick up on the unusually activity of the "experts" and follow suit. If the move was made at an appropriately susceptible position, then the flurry of activity will probably be enough to push the needle over, and lo and behold the market will go in that direction, with full technical support.

This is the power of the magician. In between the boundaries of chaos, the chaotic cow is powerless, disorganized, and fickle. The magician is calculated, precise, and utilizes the emerging patterns in disorganized chaos to create self-propagating movements through technicals. How often does this happen? Ask Jim Cramer. This link goes to an interview that also aired on John Stewart's infamous clash with the poor Cramer.

The next post (barring another market update) will focus on the limited influence of the magician. Possibly an illustrated guide to the struggle that brews between the cow and the magician. Get on my RSS to be sure and catch it.

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