Intermarket Arbitrage

Category: CM Commentary & Opinion, Tim Quast, AC Whats New, AC RSS
Source: Tim Quast

Seeing the Dow and the Nasdaq inversely correlated at times today – one up seven-tenths of a percent and the other down 65 basis points – seemed good reason to write on what we call “intermarket arbitrage.” While also a good name for a rock band, it's a term for trading simultaneously in multiple markets to create divergences in major market measures.  

This widespread activity is an unintended consequence of both SEC rules like Regulation National Market System designed paradoxically to reduce arbitrage, and algorithmic trading for spreading out orders. Smart participants exploit limitations (the antidote -- more caveat emptor, which results in less such gaming – is ignored, as politicians, bad doctors, misdiagnose the patient again).  Imagine running back and forth topside a sailing boat until the vessel is rolling and you’ll have an idea what happens. 

It can work like this: suppose you’re a large trader with Credit Suisse as prime broker. Utilizing Credit Suisse’s algorithmic tools you send buy orders for all 30 Dow Industrial components to different liquidity pools.  You specify larger trade sizes and deeper liquidity pools, knowing that these parameters will slow the trades down some.  You then sell twice that dollar amount of Nasdaq composite issues using another algorithm. You keep your Nasdaq trades small, routing volume to fast platforms like Bats, Lava Flow and Direct Edge.  If other traders respond to your presence in order books, the indices begin moving in different directions as sellers follow your fast selling, and buyers follow your slow buying. Then you reverse your tactics, selling into the Dow momentum you created and buying into the Nasdaq dip.  You pocket profits predicated on speed and location, not gaps between individual securities. 

On behalf of clients we observe this sort of activity in both isolated instances where traders game the liquidity of a single stock by trading on multiple markets at varying speeds simultaneously, and in scale where volumes reflect macroeconomic plans that have nothing to do with our client’s business or liquidity. 

“Thanks a lot, Quast,” you say.  “What am I supposed to do with this information?” 

We hope you set yourself apart in the IR chair with coolness on a higher existential plane (so to speak).  As Paul Harvey used to say, listen to this now:  These conditions will prevail into the foreseeable future (though markets will in the next days or months begin a long slide).  Why will trading like this continue? Because value becomes more convoluted each day, and regulators are still hung up on shorting, an anachronism far behind current tactics.  So if you haven’t found a way to understand the dynamics affecting your equity, we advise you to either find one or make one up (a little humor there – we always stand ready to help, affordably and indispensably). 

Reminder: It’s options expirations week. LEAPS (see link below), which are long-term options for hedging risk, converted Monday the 11th, and these hedges were off target again.  Index puts and calls expire Thursday and Friday. Volatility swaps lapse the 20th.  Traders have added opportunity to arbitrage risk resets around this two-week spread.  These may not affect your price, but they will almost certainly ripple who’s in your equity and why – things you won’t see in just price and volume. 

Bottom line: This is not a time when rational investors set prices. 

Have a good week,

Tim Quast

Managing Director

ModernNetworks IR LLC

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