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Governments Still Have Not Learned from Past Mistakes

May 18th, 2010 Comments off

Governments Still Have Not Learned from Past Mistakes

original article written by Net Advisor

Germany Panics.
Probably one of the worst moves a government could take to financial markets is to initiate limitations on the ability to have a flowing, liquid market. Germany did just that.

Germany banned naked short selling in the country’s 10 most important financial institutions. The news caught markets off guard sending Western stock markets lower (Source: Reuters).

The idea is to protect Germany’s 10 biggest banks from their stock price from falling. Obviously the German government did not pay attention to what happened when the U.S. government did the same thing in 2008. The trading limitations, and eventual temporary ban on short selling altogether on certain leading financials decreased liquidity to the market and the bank, and all other stocks in general sold off anyway.

The news also helped send the Euro to a four year low against the U.S. Dollar (Source: Reuters). Clearly, the markets are sending a message that governments do not understand that when you decrease liquidity to the market it produces a negative effect. If anyone had forgotten this event in 2008, maybe looking back less than two weeks ago to the Flash Crash.

What the U.S.’s SEC did not understand in 2008 is that you can try and restrict trading, try and control a market that has been functional for over 200 years, and if you start changing the rules of the game, many investors won’t want to play. The result of these buyers and sellers moving to the sideline reducing trading volume, and liquidity to the markets. Thus when someone does come in and want to buy a stock they often may pay a higher price and a seller wanting to sell may often pay a lower price.

The spread, the difference between the bid (sell price) and the ask (buy price) can widen (Chart A). The result of that says that the market maker or specialist who is trying to create an orderly market is suddenly the one in the middle taking on all this new risk. In order to reduce some of the risk, the market or specialist widens the buy and sell price, raising the cost to buyers and receive less money to sellers. I am sure the government would love to go in and tell market makers they can’t do that. Too bad.

If the government did that, the market makers would just pull their bids and exit the market, thus leaving fewer people to make a market. When you have enough market markets doing this, what happens is you create a panic scenario. People want to get out. It’s like playing hot potato. If you own stocks, and you suddenly realize that you can’t sell, what is the stock worth? If there are no buyers to buy your stock, the stock plunges, and you don’t may not want to be the last person holding on an asset that is plunging in value. This is what happened in 2008, and this same issue contributed to the May 6th Flash Crash, and has happened at times of panic and uncertainty.

CHART A: (click on graphic to enlarge)

The above chart is a snapshot of live data taken from 05-06-2010, The “Flash Crash.” It is an example of what can happen when liquidity vanishes from markets. Buyers run, sellers panic and they try to get whatever they can for their investment. Market makers and specialists widen trading spreads or simply exit the market. Thus no one can buy or sell, and any orders re-routed to the few remaining market markets send massive volatility to the underline security. (Read more, SEC Rule 606: “order routing rules.”)

Notice in Chart A:

  1. Most of the Bid (sell prices) are $0.00, meaning if you want to sell, you may get nothing on a market order, maybe 1 cent, which did happen with some stocks on the Flash Crash.
  2. Also take note of the Ask (buy price), where the most of the ask prices are $200,000 or higher noting the “…” after 200,000. Compare this with other prices in the Ask price column, and notice the extreme range in price.
  3. Now take a look at the “Last Trade” in the blue column. The Last Trades range from $13.70 to $24.21 depending on which option contract was trading. Also notice in this same blue area that “Tot. Volu..” = Total Trading Volume, was 16 (contracts traded), thus virtually no one was buying.
  4. Now notice on the right side of Chart A, the black columns. These are the sellers. Take note of the Bid and Ask prices here also ranging from $0.00 to $200,000 or higher noting the “…” after 200,000.
  5. There were only two contracts in the black columns that had posted “real” bid and ask (Sell and Buy) prices. Note however the spread (difference) between the bid (sell) and ask (buy) prices are huge on a percentage basis. If you take a look at the center of the chart called the “Strike” then go down to where it shows “95.”

Now look to the right of “95” and notice the corresponding Bid (1.14) and Ask (3.50). There is over a 300% difference between the buy (ask) and sell (bid) price. Translate this to your everyday stock. Can you imagine buying Proctor & Gamble when the last price was say $30. If you wanted to sell the stock, the bid price was $10.00, and if you wanted to buy the sock the ask price was $90.00.

At times of high volatility, one should consider using LIMIT ORDERS to specify a price you are willing to buy or sell at. If one does not enter a limit order, and just places a regular standard market order, when spreads are like this, one could often get royally screwed on a buy or sell. That is why it is important to understand what type of order one should enter into the market when buying or selling. It is also important to know what the spreads and trading volume in like in the security one is looking to buy or sell.

At times of high volatility, one should consider using LIMIT ORDERS to specify a price you are willing to buy or sell at.

Next: Chart A Continued:

  1. Also notice the spread price in the same black column for the 100.00 and 101 “Strike.” The spread on the 100 Strike is almost 5 times the difference from the bid and ask. The 101 “Strike” is $0.00 Bid and $3.85 ask. These are huge spreads.
  2. Now look at the “Tot. Volu..” (Total Volume) in the black column. Notice there are a ton of contracts trading (these are the sellers).
  3. As a side note for those not familiar with options. The “Open Inte..” is “Open Interest.” This is the number of contracts that are currently being held and have not yet closed out of their position by any number investors, traders, funds, etc.

I tried to use the above chart as an example of what can happen when liquidity dries up in the market. Prices can become more volatile, and panic can set in. This can happen not just with options, but with stocks, commodities, futures, real estate or any investment.

As if we did not have enough government meddling with the stock market again, President Obama’s “FINREG” (Financial Reform) legislation also contributed to the market sell off on 05-18-2010 (Source: Reuters).

Goldman Sachs indicated to their clients that the current FINREG bill “could shrink banks’ normalized earnings per share by 20 percent.”

— Source: Reuters

It seems evident that the move by major global governments to over regulate financial markets is not creating any stability in them, and that is what government needs the most – stable financial markets. Without stable financial markets credit can become tighter, and innovation, and job hiring can slow dramatically (Source: CNN). All of this was witnessed in the fall of 2008 and during the Great Depression. Hopefully governments have learned from those lessons, but as of today, they don’t seem to get it.

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