Pirates, Arbitrage, and the Silver Flash Crash - Viking Analytics

by Viking Analytics, Sprott Money: One of the quotes that guides my investment and trading philosophy is attributed to Benjamin Graham:

In the short run, the market is a voting machine. In the long run, it is a weighing machine.

- Benjamin Graham

With this quote in mind, I look for occasions when commodities and stocks have diverged from fundamental value, and seek to profit from that divergence. Often, the divergences can last longer than anyone might expect. But, that is a topic for another article.

In this article, I want to look at this quote in a specific and practical way, and apply it directly to the recent "flash crashes" that we have seen in tech stocks, gold, and now silver.

Graham says, "in the short run, the market is a voting machine." Here is the one of the problems with that true statement: there are entities who have the ability to stuff the ballot box and profit from nano-second moves in the markets. At certain times of limited liquidity (or otherwise), the market "voting machine" can easily become an "arbitrage machine."

Silver Flash Crash

As has been widely reported, the COMEX silver market (owned and operated by CME Group) "flash crashed" from a high of $16.07 to a low of $14.34 before recovering to close at $15.90 over a 5 minute trading block of 8,000 contracts. This many contracts amounts to 40 million notional ounces of silver, 4.4% of annual mine supply traded in 5 minutes!

Peter Pan Becomes a Pirate

One of my favorite quotes from film comes in one of the modern renditions of Peter Pan in the movie Hook. Peter Pan (played by Robin Williams) has left Never-land, and has become a swashbuckling investment banker. Wendy goes to Peter Pan to let him know that he is needed in Never-land. Upon hearing about Peter Pan's new job, Wendy is astonished to see that the boy hero Peter Pan is now playing the part of a real-life pirate.

While I have not become a pirate, I have found that it can be occasionally profitable to think like one. In a game theory analysis of the commodity markets, I try to think like a pirate would think.

If I Were A Pirate . . .

Before we get to our pirate flash crash strategy, let's look at a recent bid-offer stack for the iShares Silver Trust ( SLV). In this example, there are almost 400,000 bids to buy SLV at 14.91, and almost 110,000 offers to sell SLV at 14.92. Most retail investors have the ability to see this bid-offer stack, and the same kind of bid-offer stack exists in the futures markets in addition to the stock markets.

If I were a pirate (I am not), having the means to do so (I don't), I would evaluate the bid-offer stack of my target commodity, and during times of illiquidity (like 4am EST on a Monday, or 7pm EST on a Thursday), I would set up limit purchase orders 10% below the current price (for example), and then place a sell order that hits every bid in the bid stack (and triggers known and unknown stop loss orders at key technical levels).

The cascading effect of the flash sale, combined with the known and unknown stop loss sale orders (designed to protect long positions and/or profit from a new downtrend) might cause price to decline to the place that I had established my purchase orders.

All of this can be optimized by HFT algorithmic computers that have a form of market price omniscience, being fed with the bids and offer data, and oftentimes the stop loss data as well.

Five minutes later, price recovers almost to where it was before, and I would have arbitraged the bid-offer stack.

Who Loses In This Flash Crash?

The person who loses in this flash crash is the retail and other investors who do not have the same level of information and market-moving ability as others, and have attempted to protect their long positions with stop-loss orders.

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