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A sharp drop at the tail end of January was followed by a nice rally to start the first half of February. The market has recouped most of those losses sustained in January. Pundits praised a resilient market and claimed investors seeking long-term capital appreciation knew market depreciations were buying opportunities. However, most traders sifting through the data might tell you a different, more ominous tale.
Changes in wealth occur every second, but most investors can tolerate the micro-sized events. What most investors tend to ignore is the strength in those changes, and this conviction is measured in volume – the amount of shares traded in a given day. It is how one can “read between the lines” and assess the conditions of overall sentiment. Low volume indicates less conviction in the direction of the market, and that is what we are currently witnessing. Volume generates confidence that allows the market to maintain a positive cash flow creating rises in stock valuations.
Let’s use an example to understand the theory. Imagine I was the CEO of a public company called Vacuum Inc. and you owned some shares. On a typical day, the amount of shares traded is 10 million. However, over the past month, the volume has declined to only 4 million, yet the shares are up 5 per cent. What does this mean? Why should an individual care about liquidity?
Low volume suggests that there is less conviction in the direction, as we stated earlier. There could be a number of reasons why the strength of the rise is questionable. Perhaps, big money has maximized their allotted positions on Vacuum Inc., or they have funds tied up in other parts of the market, or demand is reduced due to business concerns. Whatever the reason, it can suggest a negative trend.
Let’s take this example to the extreme. Let’s say volume was 100 per day for the last month with the shares rising 5 per cent. This would indicate that a small group of traders, perhaps even just one person, was propping the value of the shares by buying and selling between themselves. Now, for investors ignoring the variable of volume, the rise in equity appears good. Vacuum Inc. has just increased your overall wealth, but the underlying issue of low volume should trigger red flags. The elevated price of the shares are not an accurate assessment of valuation. There are other variables one could examine, such as buy orders through market depth, to verify unrepresented strength, but under normal conditions, one would assume that liquidity is minimal, so if shareholders decided to sell and volume rose back to 10 million, we may eventually see large drops in price. The price you receive per share is the accurate value of the stock.
The reduction in stock volume represents a fundamental change in investor and trader behaviour. With economic conditions muted, this limits growth of participants in the stock market. Since the stock market is essentially a zero-sum game, debateable by many scholars and professionals, it requires continuous net positive cash flow into the market to create long-term wealth. Investors already in the market looking to sell in the future may find that drops in liquidity are not beneficial, especially since most trades created throughout the day are executed by institutions.
Another reason investors need to care about liquidity is that it stabilizes markets. A system that has a billion shares trying to buy and sell will create less volatility than a system that has just thousands. Spreads between the highest buyer and the second highest buyer can be huge. Imagine yourself selling a home to just a pair of shoppers. One offers $400K and one offers just $350K. Your options are limited. But imagine your home having bids from a dozen people, well suddenly, the price received to sell if the top bidder backs out might still be closer to your asking price.
Concerns on volume have been a discussion for the last few years. As US markets continue to reach all-time highs, some wonder where investors are. With a lack of investors participating in the stock market's rise, many question the validity. This chart, from July 2013, shows a significant down trend in trading over the last half-decade, courtesy "The Wall Street Journal."
And if we examine the archived data directly from the NYSE here, we see the same information being upheld in the chart above. Some may say that a rising market means fewer shares are traded at higher prices, however, what we do see is that this is not true. In fact, the dollar volume has also decreased.
It's hard to imagine the stock market's volume being reduced to mere thousands per company, or millions per exchange, but the underlying issues that could lead to such a scenario should be educated. The biggest culprit to wealth is not falling prices as some believe, but in fact liquidity. Without the ability to participate or sell in any kind of market, what motive is there to buy a company whose shares might take days to withdraw from?
As a hockey player, when you're in the offensive zone, the last thing you should be worried about is the performance of your goaltender, but that is how the Edmonton Oilers had been playing the first half of the year.
You see, Dubnyk was having one bad season. He was the fault of the Oilers losing ways. Defendants explained that the Oilers poor play was the reason, and that Dubnyk was a mere victim of such defense. But these people can not deny that he was unable to make timely saves if his career depended on it. Case in point the game against the Toronto Maple Leafs on October 12, 2013. The Oilers led five different times throughout the game and gave up a goal in the final minute on a weak wrist shot. The team would lose in over time.
Twice to my recollection, Dubnyk allowed a goal from the blue line that should not have gone in. One, a harmless dump-in from the blue line, and the second, a seemingly routine save that slipped through his nine hole (blocker and pad). In any given night, a hockey fan could use such an opportunity to bite into his hot dog or take a sip of his beer, but not if Dubnyk was in net.
The Oilers poor defense was magnified exponentially because of poor performances by both goalies. And many indicated that it did not matter who was in net, the Oilers would still allow 4 goals a game.
Enter Ben Scrivens. Since his acquisition on January 15, 2014, the Oilers are 5-4-2 and have allowed three goals or more just three times, once in an OT loss. That's unreal hockey for this team. His first appearance was not so good. He allowed four goals to the Wild and it was "proof" it did not matter who was in net. And then, two games later, the goals-allowed stopped.
It's not that Scrivens has done anything to fix the glaring problems that face the coaching staff; there is a lot of work that has to be done. It's that the players believe that Scrivens, and Bryzgalov, are going to make that one additional save that could be the difference between no points in the standings or two. And that changes the dynamics of every player.
Jack Michaels and Bob Stauffer of 630 CHED are proponents of the concept that this team's good goaltending has led to significant offensive chances and overall play. The pair mentioned during the post-game after the New York Rangers (Feb 6, 2014) contest that the Oilers were playing substantially different and it was all due to confidence in their goaltender. The ability to activate the defense and try high-risk plays indicated that they knew their goalie was capable of forgiving their mistakes. It might not make sense to a casual fan, but the reality is that a team needs to have faith in every aspect before all strengths can develop and emerge, even if they are not the most elite.
Imagine for a moment a simple restaurant with five average employees. One is in charge of each of the following: utensils, beverages, appetizers, entrees, and dessert. The first employee plates the tables and moves on to the next one. The beverage provider does the same thing. But there is a weak chain in the appetizer employee. He is often late to deliver, mixes them up, or forgets them altogether. Now, a good supporting team would most likely grab that appetizer with the drinks, or explain that it will be delayed. However, if this occurs on a consistent basis, it throws off the timing and chemistry of a well-run restaurant. Now, the waiter in charge of entrees needs to make sure the appetizers have been served or the beverage employee has to spend additional time apologizing in advance for a delay. This simplified example of assignment translates across every job, including sports.
If a receiver can not catch the ball, a quarterback will have to focus else where instead of utilizing the entire field. If a short stop is slow moving, the third base man might have to shift left, giving room to his right. If a doubles tennis partner knows his server will double fault, his close-net strengths will be moot. A team needs confidence in their mates so that they are not distracted by weakness and can focus on strengths and create opportunities. People act differently when they can not rely on others.
I had a lot of trust and faith in Dubnyk to start the year, but as the days progressed, I realized that he was the problem. Richard Bachmann came in to face the Kings one game, and he faced two shots in the final minute of the game that forced overtime. They were point blank shots no more than six feet from the crease, but he made that one, no, two, big saves that changed the game. I remember my brother and I yelling, "Dubnyk would have let those in." This game occured October 27, 2013. The Oilers would lose in a shoot out but earned a valuable one point.
And that is how all the greats are remembered. Some times people forgive average statistics if they make the extra save, or the field goal, or the walk-off home run, or that clutch buzzer beater.
After the Olympic break, we will see if my theory holds true. The Oilers have technically gone above .500 in a stretch from late November to early December which also lasted 11 games. However, I firmly feel that the Oilers have significant confidence in their goaltending and should earn them an extra four wins by the end of the year. I would argue that three of the Oilers last five wins were courtesy of great goaltending, including that 59-save shut out. Those four wins might not sound like a lot, but the Toronto Maple Leafs have the worst shots ratio and have 11 more wins than Edmonton. The Ottawa Senators and Washington Capitals also have porous defenders and are above .500.
Had the Oilers won 5 additional games or sent more close games to extra time in the last 60, they would be right up there with the Canucks and Coyotes. In professional sports, there is such a fine line between winning and losing and some times it takes very little to turn things around.
The performance of global equity markets to kick off 2014 has been a painful one for investors. In a sign of things to come for the year, January's direction as an almanac is accurate 80 per cent of the time. This means that 2014 could be a down year.
Volatility, especially downward, comes in bunches. That's what history tells us, so the next few weeks could see severe selling. Big money is leaving the market and for good reason. The rise has been attributed to fed stimulus, but that is winding down, and the earnings reports of big names and market leaders have been unable to turn the tide. So what actions can an investor take without worrying about their portfolio and wealth?
The simplest thing to do is to sell your holdings. But for long-term holders, this might not be practical. They may be in dividend-reinvestment programs and would appreciate the slight drop in valuation. Others may want to always be participated in the market for any eventual rally. Or perhaps investors don't want to realize any tax gains until retirement, especially if they are planning to get back in the market. This is where the option market comes in, and why I have always been an advocate for it.
The endless array of strategies that exist in just two products should persuade many investors to get a basic understanding of how they work. The covered call can introduce monthly or weekly income immediately in cash so any taxes owed at year-end can be simply withdrawn from the account. But covered calls are only half the answer. Today we are going to introduce the married put.
Let's say you have owned Google (GOOG) shares for 5 years now, buying after the market crash of 2008 and you bought 100 of them for $380 a share ($38,000). Those shares today are worth $1,137.50 each ($113,750). Well, cashing in would create a capital gain of $75,750. But you truly believe in the stock, so if you sell today and bought a 100 shares in a few weeks at roughly the same price, you would still owe taxes. Instead, you can essentially lock in that $1,137.50 price without having to worry about the movement of the market for the next several weeks using a married put strategy.
The strategy is implemented by selling a covered call and using those premiums to purchase a put. Let's say a trader wants protection until the end of February, they would find February 28, 2014 options and sell the call for at least $28.80 a contract ($2,880) and buy the put at the same strike price costing at most $29.80 a contract ($2,980). The overall cost of the "insurance" is at most $100. The reason for this is because we sold at the bid (highest shown buyer) and bought at the ask (lowest shown seller), which in reality, is the worst case scenario and better fills often exist.
So, here's why it works. Let's say today is now Feb 28 and the shares fall to $1,100. The covered call would be worthless, and the trader would NOT exercise his option, but simply sell it for about $37.50 ($3,750). This would create a profit on the put option of $770. The profit on the call is the entire $2,880. A net profit of $3,650. However, the shares of Google have fallen $37.50, so the equity value has dropped $3,750. The total loss of equity is $100, the cost of the option.
Let's use a table to demonstrate this.
| Date | Google Value | Cash | Equity |
| Feb 3 mid-day | $113,750 | $0 | $113,750 |
| Feb 3 close | $113,750 | -$100 | $113,650 |
| Feb 28 close | $110,000 | $3,650 | $113,650 |
