Archive for September, 2008

An Ugly Day on Wall Street

By trader7757, 30 September, 2008, No Comment

Yesterday was one of those days you could throw out all that you knew about trading and just watch in amazement as 900 billion dollars evaporated into thin air. As you are all probably aware of by now, the market reacted violently to the house repudiation of the bailout bill and dropped an unprecedented amount. As you can see on these charts, some of the bars were 50 pts long, so I had to switch over to 1 min bars from 3 minute bars just to stay in the game. It was like riding a bucking bronco and I stayed very conservative and only took a few trades, and then only traded one contract, yesterday was a good day to lose a bundle or make a bundle if you were in an aggressive mood. Myself, I stayed conservative. I am sure there are others that would have done differently. As you can see, the market started down as the votes were being tabulated on the bailout bill, but I worried that a large block of yes votes may surface and the market would gap up, through my stops and cause a catastrophic loss. So I settled for a few scraps here and there and ended up +18 at 1 contract. Which isn’t all bad, but looking all that was on the table, it was not what could have been done, just the same, I was happy with my trading.

In a panic market like this, support and resistance were not reliable, nor were any oscillators, at least not with any consistency. It was trading off the cuff, which is not really my style. It was a day that the market romped out of control. I would look for more of this in the coming days as the bailout bill works it’s way to the Senate and then probably back to the House. It should provide some interesting financial pyrotechnics.

Wow! Check out the length on some of these 3-minute bars

By trader7757, 26 September, 2008, No Comment

ESZ8

As you may have been reading throughout the course of this blog, we try to enter trades at the +100 and -100 points on the CCI, depending upon whether or not you are going long or short. We try to exit when the slow stochastic diverges from the direction of our trade. Of course, these are just general rules of thumb, as we also take into consideration the available pivot points, support and resistance and price action.

Of course, the best laid plans can be made useless when volatility reaches a point where the three minute bars may stretch from 5-11 bars, making almost impossible to stay in a trade, no matter which direction you think the market is moving. And that was the case today….it was like trying to surf in a hurricane….the waves were just too big to ride. So you are reduced to guessing which way the market may take off, which is a situation that I will participate in…proper investing goes from being a systematic artform to a binary outcome guess.

The reasons for today’s, and most of the past weeks, volatility is rooted in the continuing financial shake out in the banking system, with Washington Mutual the casualty of the day. I would expect more bank failures in the coming weeks, as we are just now going through the deleveraging process caused by the securitization of mass quantities of these subprime and Alt-A mortgages. As you might expect, Congress has dithered away valuable time in a hotly contested bail out plan….a plan that has been replete with all sorts of pageantry and theatrics as members of congress grandstand for popular acclimation by the masses. In the whole, it has been a pathetic demonstration of our democratic deficiencies. We will overcome it all, though.

More of the same in the futures markets….

By trader7757, 25 September, 2008, No Comment

ESZ8 09-23-08

As has been the case the last couple of weeks, the market yesterday was searching for some direction. Once again, I had to widen my stops to stay in a trader as the volatily was substancial.
Looking at the chart, it appears to be any easy one to trade, but the was not the case for me yesterday. The morning session took maximum concentration to be profitable.

I would expect the markets to remain volatile until the bailout bill is hashed out and presented for a vote. Of course there is not shortage of opinions on how the crisis might be handled, but nothing definitive has emerged from the talks yet….although I don’t think anyone n Congress misunderstands the dire situation we are in.

A technical explanation on Hold to Maturity pricing from Calculated Risk.

By trader7757, 23 September, 2008, No Comment

reprinted with permission from CalculatedRisk

Hold-to-Maturity Pricing

by CalculatedRisk

An interesting question is why do Bernanke and Paulson believe the Hold-to-Maturity price is higher than the current market price for MBS?

One possible explanation is market failure based on information asymmetry. Mark Thoma explores this question: “Hold to Maturity” versus “Fire Sale” Prices

Let me try to give a defense of paying above current market prices (in a devil’s advocate sense). For markets to function according to competitive ideals, full information must be available to all market participants. When information is lacking, or when it is asymmetric, the outcome is inefficient relative to the full information outcome.

The nature of these assets – their opacity as it has come to be called – makes full information unavailable. I’m not sure how asymmetric information is, people holding the assets don’t know themselves whether a particular asset might blow up and lose it’s value or not, but there is some degree of asymmetric information in these markets (a standard lemons problem).

This is market failure due to lack of full information, and asymmetric information to the extent it does exist, is depressing prices.

In this case, I don’t think the information is asymmetric because both buyer and seller are aware of the characteristics of the MBS. There is uncertainty regarding future house prices (and MBS performance is related to house prices), but that isn’t a market failure.

Professor Thoma also links to Professor Kling: Hold-to-Maturity Pricing

Suppose that you owe $110,000 on your mortgage, due in one payment a year from now. The “hold to maturity price” is that $110,000, discounted back to the present. At an interest rate of 10 percent, the price is $100,000…..NOT!

The fair price depends on the probability that you will default. If there is a 50 percent chance that you will default, the fair price is more like $50,000.

The probability that you will default depends on the distribution of possible paths of future home prices. Along paths of falling home prices, defaults are much more likely than along paths of stable or rising prices.

It’s hard to know how home prices will behave, but right now if I were pricing the risk (something I used to do for a living, unlike the key decision-makers in this bailout), I would include a lot of paths where prices go down. That would make the “hold-to-maturity” prices of the mortgage securities, properly calculated, pretty low in many cases.

First, this analysis assumes 100% loss severity in the event of default. If there is a 50% chance of default, half the time the mortgage will be worth $110K discounted back to the present. But if the borrower defaults, the value will not be zero since there is a recovery value on most mortgages. Kling apparently assumes a loss severity of 100% in the event of default (perhaps he was thinking of a 2nd mortgage), but a more normal severity would be around 50% or $55K discounted back to the present. So in this example, and using a 10% discount rate, the mortgage would be worth $100K * 0.5 + $50K * 0.5 or $75K at present.

But I think this might provide a clue to the pricing disparity: because of the uncertainty in future house prices (and MBS performance) potential buyers are probably using a higher discount rate than Bernanke / Paulson. Typically the higher the standard deviation of the potential outcomes (higher risk), the higher the discount rate. So even if investors view the future price the same as Bernanke/Paulson, they might view the NPV as much lower. In addition, the cost of capital is higher for private investors – also impacting their discount rate.

Perhaps Bernanke / Paulson believe that aggregating assets will lower the risk. Usually when you aggregate assets, the overall volatility decreases. This is almost always true for holding a group of stock (the beta on the S&P 500 is lower than the beta on most stocks in the S&P 500). But if the assets are all impacted by one parameter – in this case future house prices – aggregating assets does not lower the risk.

This would make a great question for Bernanke tomorrow. Why does he believe the Hold-to-Maturity price is higher than the current market price? Is this because of some market failure? Or because of different discount rates? Or some other reason?