VIX Futures (Don"t) Breakout: a Slinky"s Story of Epic Failure

Volatility Index Futures (VX)

 

VIX futures spiked up to 13.47 during the session before reversing 12% lower and closing back down at 11.88.  Today"s 13.47 intraday high was just:

• 0.03 lower than the 11/15 swing high of 13.50, which is...


• 1.15 lower than the 10/25 swing high of 14.65, which was...


• 3.85 lower than the 9/05 intraday spike up to 18.50, which was...


• 0.50 lower than the 8/29 intraday spike up to 19.00, which was...


• 0.75 lower than the 8/11 swing high of 19.75, which was...


• 0.45 lower than the 6/29 intraday spike up to 20.20, which was...


• 1.75 lower than the 5/18 swing high of 21.95, which was...


• 1.55 lower than the 4/17 swing high of 23.50

 

 

 

Drawing trendlines from each Lower Low provides future resistance at several levels.  After another failed breakout attempt, the only thing noteworthy for VIX bulls is that the Super RSI™ has registered consecutive bullish divergences as the RSI has made higher lows while price has made lower lows.

 

 

 

A good way to get an early "heads up" that VIX futures may be ready for a true breakout is to draw the trendlines on the RSI"s plot values.  We can see that the RSI value is turned up and poised to break above the trendline from the August highs, but true confirmation of a long-term VIX bottom will require a break above the trendline connecting the two major swing highs from 4/17 and 8/11. 

 

 

Check out Fibozachi.com to learn about modern technical analysis and trading indicators that actually work.

Muir: "People Are Going To Be Wiped Out" By Short-VIX ETFs

Back in August, we highlighted a story in the New York Times about a former manager at Target who decided to try day trading with $500,000 he had saved up. Over the following years, he turned that into $13 million by following one simple strategy: Shorting volatility every time it spiked.

As MacroVoices host Erik Townsend points out, that strategy has worked for many retail investors over the past eight years. And in a brief “postgame” interview with the Macro Tourist Kevin Muir following a longer interview with Francesco Filia, a fund manager at Fasanara Capital, the former explains how many investors don’t understand the risks associated with shorting volatility, as well as the possible repercussions if exchanges and brokerages don’t take the appropriate steps to limit this.

Townsend begins the discussion by asking Muir about a chart he created of the VXX - the long-VIX ETF - which, because of the low-volatility environement, has repeatedly split leading to unbelievable wealth destruction.

Going back to 2009, the price of the ETF has gone from $120,000 a share to just $35. And while a sudden spike in volatility could see it surge, with so many investors on the other side of the trade, it"s worth considering what might happen if they couldn"t pay.

It’s frightening. And I don’t think enough people are – well, there are some – but I don’t think that enough people are really considering all these things. And I think that guys like the Interactive Broker chairman, that are taking proactive steps to make sure that there’s enough margin, we need to see more of that. We need to see more people saying, hey, wait, this is actually a very, very scary instrument that has a lot of risk in it.

 

I watched a Real Vision interview with John Hempton from Bronte Capital, and he talked about phoning up the infamous Target salesman guy, the fellow that quit his job as a Target manager to trade XIV and all the VXX products, and he turned his 1/2 a million bucks into 13 million bucks. The part that really scared me about it was that John phoned him up and he was expecting to talk to this very sophisticated guy, and his basic takeaway was that, although he had a lot of buzzwords, and he understood kind of what the products represented, he didn’t really understand his true risk.

 

And I think that there’s just a myriad of people out there that are trading these things that don’t understand that. The more people that wake up and realize this, and stop playing this game, the better off we’ll be, actually.

Brokerages have caught on to this, Muir says. Interactive Brokers, one of the largest online brokerages, is now asking retail investors to post between 300%-400% margin when they short certain VIX contracts – because brokerages recognize that one sharp drawdown in the S&P 500 could blow millions of short traders out of their positions, potentially leaving thousands of customers with massive negative balances that could threaten the brokerages’ existence.

Erik, you’re absolutely correct. And Interactive Brokers, one of the largest electronic brokers out there, realizes the risk. If you look at the way that they’re margining these products, they’re margining them completely different than what the exchanges and everyone else say is the proper amount.

 

So if you look at the VIX futures, the front month is $6,200 – the exchange minimum is $6,200 – which works out to roughly 50% of a contract. The next month is $4,000, which works out to 30% of a contract. And the far months are $2,500, which works out to 17% of a contract.

 

But if you go to Interactive Brokers and you want to sell this VIX contract short, you have to put up 300%–400% of the contract. Because they’ve looked at it and they’ve realized that if the S&P has a 10% down move, which isn’t out of the realm of possibility, that the VIX could spike up to 37 really easily. And people are going to be wiped out if that happens.

Should the VIX suddenly spike, the repercussions of such a move would be further complicated by the billions of dollars sitting in various VIX-linked ETFs. Because individuals sellers would probably disappear from the market in such a situation, the ETF market makers would find it nearly impossible to hedge their positions, potentially triggering the dissolution of the funds, or even the collapse of some of these firms.

There’s $1.2 billion of the XIV, which is the short ETF. There’s $1.3 billion of the SVXY, which is another short one. These are staggering numbers.

 

In my days, when I was on the institutional desk, we had this big – I did index arbitrage, and we used to go out and buy the baskets and sell the futures. One day the risk manager came to me and said, if you had to take this position off (because we had accumulated this big position) how long would it take you? And who would do it?

 

And I said, the reality is that there’s nobody. You know, we were the biggest player in the market and there was nobody that was going to take this off of us. The only way was to go all the way to expiry.

 

Well, the reality is that these numbers are way bigger than any market player can absorb. And, if we get a situation where – as Francesco says, all it’s going to take is a return of the VIX from its current level of 10 to its average level of 18 or 19 to wipe out these products.

 

I guess that’s the point that I want to make: If you’re actually owning these things, you should be aware that all it will take is a move of 80% and then they’re going to wind down these products. So the XIV, when it moves up, if all of a sudden VIX goes from 10 to 18 in a day, they’re going to wind down that product.

 

And what’s going to be really scary is the amount of VIX futures that is going to have to be bought, because they’re short all those VIX futures and they’re going to have to buy them back.

 

And I just don’t know who’s going to sell it to them. For the first time – for a long time, I didn’t view this VIX as that big a deal, and there were some smart guys like Jesse Felder that were going on about it – I just think that it has been taken to a level that is becoming increasingly worrisome. And it actually could create a market dislocation in itself.

 

And what is it Warren Buffett says? What the wise man does in the beginning the fool does in the end. Well, VIX, at this point, we’re hitting a point where if you’re actually continuing to bet on it you’re going to be in the fool category.

 

Because it’s not going to take much to have a big spike that wipes a lot of people out. And it’s actually very, very worrisome.

Of course, it would take a large intraday move to trigger a truly catastrophic spike in the VIX. But at least one analyst, Bank of America’s Michael Hartnett – whose work we have cited here – believes there could be a 1987-style crash in the early months of 2018. Hartnett’s reasoning? The bearish positioning seen at the beginning of 2017 has completely flipped. Investors’ long positions are larger than they’ve been in years.

And as we’ve repeatedly pointed out, with volatility and volume so subdued, hedge funds have remained overwhelmingly short vol, fearful of missing out on even one tick of the torrid rally for fear of pissing off their clients.

One things for certain: Given the market’s already dramatically overextended rally, the day of reckoning is coming. The only question is will it be a steady decline, or will it happen suddenly?

Given the incredibly stretched nature of positioning, the latter scenario, Muir and Co. believe, seems far more likely.

* * *

Muir"s discussion begins just after the hour mark:

 

Why We"re Buying Physical Gold with a $1700 Target

Originally on marketslant.com

For What it is Worth: We are buying Gold in our small family fund. This is a trade, not an investment. Potentially a much longer term trade for us than normal, possibly a 12 month hold as opposed to our 3 day positions. We are buying physical in quantities that will not need to be sold if we are wrong, thus no leverage. We will also be swing trading gold with an upward bias as our indicators dictate below $1260 or above $1306.

Target  picking is risky in an asset whose value is largely based on sentiment and prone to being "jawboned" into its proper place. But we believe for various reasons that if Gold does not pierce $1260 spot, its chances of a rally topping between $1450 and $1700 are strong over the next 12-18 months. The wide target range reflects the emotional factor in Gold"s behavior far outweighing supply, production costs, and its lack of fundamentals to measure using tools like EBITDA, PE, and cash flows. And our own analysis is corroborated from several different disciplines from whom we did not seek out to rationalize. It"s a trade, that"s all. But it"s a very good and very rare risk reward trade. it has set up right now. Further, it will either be violently and decisively confirmed (or negated) above $1306 or below $1260.

Why are we sharing this? That same question should be asked of Ray Dalio, Jeff Gundlach and others who announce they are bullish on Gold after they have  bought. Our own position is not relevant to the market overall and we do not need to market our tiny positions to create an exit strategy a la George Soros.  The premise for the trade happens so rarely its worth writing about, if for no other reason as an exercise in outsourcing our self-discipline on the trade. 

Vince Lanci for SKG

vlanci@echobay.com 

Here is how  we came to be this way.

Step 1: Volatility is Coiling

When trading short term periods, intraday and intraweek, we use a volatility system for alerts to incipient movement. We risk 1 to make 2 and move  on when wrong. It works about 50% of the time. it is net profitable. And best of all, positions that are in limbo are closed expeditiously. This is after all a volatility system. No vol, no position. It"s been cited here many times in the past. When it is right, it is very right. when it is wrong, you are out. Past posts and a 25 year track record of use bear this out from our active days.  The bottom of this post goes into more detail on its use.

What we never did at Echobay or its predecessor fund CIS Energy, was use it on long term charts. We certainly looked at them, but only for bias in shorter term trades.  Last month we took a serious look at our VBS algorithm on a monthly chart. Here is what we found:

Updated from : Gold Macro Analysis: A November to Remember

Gold has a  tremendous risk reward setting up above $1306 or below $1260..... which way from there is not known but can be handicapped once either number is breached

for a nexplanation of VBS see bottom Appendix

Step 2: How Equity Funds Play Gold

Portfolio managers at large equity funds who have contributed here anonymously use systems that advise them when being in cash as opposed to long stocks is prudent. What is also known is that funds like these  punt gold positions with their discretionary in-house money for fun.

They use similar systems for entry and exit, and never risk much in their positions. Gold is a hobby to these guys. As a result, they like to buy and walk away with long term trade orientations and firm stops. This means using long  term moving averages to avoid noise. We know this is true.  And here is an example of how that type of positions is implemented:

 In a recent interview a vocal critic of the Gold industry explained why he was buying Gold

…Gold is poised to close above its 12-month moving average for the second straight month. Going back to 1970, the average monthly return for gold following a close above the 12-month moving average is 1.47%. The average monthly return following a close below the 12-month moving average is -0.15%.

If you used the simplest of trend-following methods, investing in gold when it was above its 12-month moving average, and going to cash when it is below, the results would have been far better than just buying and holding gold. He continues:

The chart below shows when you would have been invested in gold and when you would have been out. Granted, prior to GLD, this could only have been done with futures contracts, or gold bullion, with the former adding a degree of leverage that I would not have been comfortable with, and the latter adding a degree of paranoia that also would have made me uncomfortable.

Full post : Vocal Critic Explains Why He is Buying Gold

About Physical vs. ETF: While we agree with the rationale behind GLD vs futures if you are trading and not investing, we feel for multiple reasons the physical gold market is going to open up and become a serious competitor to ETF allocations within 12 months. Specifically, blockchain products are coming,  and if properly implemented as a pipeline, owning physical gold not held in trust by a GLD custodian will be as easy as clicking a mouse. You will buy and sell physical Gold that will be yours and verified via the blockchain system.

So for us, physical gold now has the benefit of increased  liquidity on the horizon, which means increased transactions and exposure. Which ultimately means decentralization of the Gold market from a few large firms to grass roots stackers, owners, and value preservers. We view emerging technologies as putting physical assets in a position to  have their true value unlocked. Whether that be the tea farmer in India who can"t currently get a loan on his land due to government rules, to Silver whose value is somewhat disconnected from its  price. The effect will not be unlike when a private company goes public. Accessibility and liquidity creates safety and increases demand. Owning physical metals is like owning a beneficiary of technology down the road.

Monthly Chart Through July 2017 using the 12 Month MA described above

 

Step 3: Optimizing the Simple 12 month MA Tool

by optimizing the MA with one factor we back tested greater successes when in trades. Conversely, we were also in less trades. On balance it was a wash. But right now the employed filter says the 12 Month MA has bigger upside than the average if profitable at all. A rare chance to buy close to the level the fund punters did with a statistical chance of greater profits than the  1.47% monthly average  generated by the original backtest.

Updated and Optimized by the Author

 

The chart below shows the hypothetical results from each of the 30 exits following an entry (going back to 1970). Using these rules would have resulted in a loss two-thirds of the time. But as you can see, the losses have been relatively shallow, not exceeding 10%, while the gains have been good to extraordinary.

Step 4: Using VBS for Confirmation of Direction

Simply put: If we get a VBS signal trigger when $1306 trades, a decision must be made to add, sell, or hold based on the data that comes with the signal. If we get one on a $1260 print, the same must be assessed. 

 

Step 5: Actions

1. We are buying Gold now based on the "Fund Finder" signal with a monthly stop out below the yellow line in that chart above.


2. $1306- we will consider adding a shorter term amount in a rally if the monthly VBS is triggered higher


3. $1260-  we will consider either adding physical, or selling paper Gold for swing trading purposes if the VBS is triggered lower.


4. Per #1- we will close or hedge the first physical purchased on a monthly settlement below $1244 - the wide berth on monthly exits necessitates no leverage 

 

Bonus: Moor Analytics comes to a similar conclusion from a different perspective.

Moor Analytics: Gold Downside May Finally be Exhausted

Within the overall bearishness I noted that a possible area of exhaustion for this move down from 13624 comes in at 12732-644.  We basically held this, but with a $1.6 violation, and rallied to 13084 before rolling over and rejecting from it again (although this time down the 12628 was simply support, not exhaustion)

And Michael"s most recent weekly report of Nov. 10th

Via Moor Analytics:

I would note that we broke above a well-formed macro line in the week of 8/7 that came in at 12629. The

break above here projects this upward $183 minimum, $501 (+) maximum—the maximum to be attained likely within 9-12

months. This line comes in at 12357 today. I am late to the game on this, but we were only $18 from the original breakout

when I mentioned this, and have a lot of room to go in the projection.

 

Appendix

 

What is VBS?

• Volatility Based Risk Reward Generator

+ Originally developed as an alert to when the risk of being short implied volatility is larger than being long it, and vice-versa

+ It is a probability model that handicaps risk reward

+ As a by-product of its original purpose, it gives risk/reward scenarios in market direction. 

+ Due to its accuracy in predicting volatility expansion, directional applications are right or wrong quickly and is very useful in efficient use of capital

 

How VBS Works

• Time is precious, Price is noisy, Volatility is less so.

+Volatility is less noisy than price, therefore more reliable as an indicator. 

+Volatility cycles more cleanly and  can be seen to "inhale and exhale" when viewed graphically with Bollinger Bands

+VBS is based on several relationships between historical and implied volatility  across different time frames

+ It can  be applied by traders on any time frame

 

VBS and Direction

• It doesn"t predict price, only speed of movement

+It gives non-directional alerts and was initially developed for optimizing option portfolio risk.

+While not predictive directionally, VBS gives as a by-product excellent risk-reward setups for directional plays

 

VBS Process

• Radar, Alert, Trigger, Entry, Exit

1. Radar- VBS generates 2 prices, one above and one below current prices for a "breakout" in market volatility 


2. Alert- One of the prices is breached and closes its bar/ candle beyond that price level.


3. Trigger- Real volatility will expand
   
   • Market direction does not have to continue in the direction the price in #1 was broken
   
   
   • volatility based risk- reward prices are generated for directional use. I.E. Risk 1 to make 2
   
   


4. Entry- using the  VBS risk/ reward generated levels, a decision is made to either go with the directional trend, against it, or do nothing
   
   • The trigger gives 2 bites at the apple if the trader so desires.
   
   
   • In "first way, wrong way" scenarios reversal levels are generated (N.B.- our preference is to not play the reversal and have left money on the table in favor of the trauma of being "chopped up". if compelling, we have used options to remain in the game on reversals)
   
   


5. Exit- is either from a stop-out, a profit capture, or a time limit
   
   •  Stop-Loss- are generated by VBS and adhered to religiously. Profitable trades trail stops higher based on expanding volatility
   
   
   • Profits- exits can be subjective, we prefer taking 90% of position at target and leaving a tail if the VBS is not signalling Vol is overbought
   
   
   • Time Exit- trades  that are neither profitable  nor stopped out are exited  in 3 bars/ candles. The signal is designed for quick confirmation / rejection of the trigger
   
   

Good Luck

About the Author: Vince Lanci has 27 years’ experience trading Commodity Derivatives. Retired from active trading in 2008, Vince now manages personal investments through his Echobay entity. He advises natural resource firms on market risk. He pioneered and executed the Nat Gas EOO arbitrage trade of 2006 to 2008, netting over $90MM for a NYC hedge fund before retiring. Over the years, his expertise and testimony have been requested in energy, precious metals, and derivative fraud cases. Lanci is known for his passion in identifying unfairness in market structure and uneven playing fields. He is a frequent contributor to Zerohedge and Marketslant on such topics. Vince contributes to Bloomberg and Reuters finance articles as well. He continues to lead the Soren K. Group of writers on Marketslant.

vlanci@echobay.com 

Black Monday 2.0: The Next Machine-Driven Meltdown

Authord by Ben Levisohn via Barrons,

In the rise of computer-driven trading, some hear echoes of the stock market’s 1987 crash. Beware the feedback loop...

Black Monday. Although the event to which those two words refer occurred 30 years ago, they still carry the weight of that day—Oct. 19, 1987—when the Dow Jones Industrial Average shed nearly a quarter of its value in wave after wave of selling.

No one in living memory had seen anything like it, at least not in the U.S., and in the postmortems conducted to understand just how the Dow managed to drop 508 points in one day, experts found a culprit: so-called portfolio insurance, a quantitative tool designed to use futures contracts to protect against market losses. Instead, it created a poisonous feedback loop, as automated selling begat more of the same.

Since that day, markets have rallied and markets have tumbled, and still we marvel at the unintended consequences of what, in hindsight, was an obviously misguided strategy.

Yet in the ensuing years, market participants have come to rely increasingly on computers to run quantitative, rules-based systems known as algorithms to pick stocks, mitigate risk, place trades, bet on volatility, and much more - and they bear a resemblance to those blamed for Black Monday.

The proliferation of computer-driven investing has created an illusion that risk can be measured and managed. But several anomalous episodes in recent years involving sudden, severe, and seemingly inexplicable price swings suggest that the next market selloff could be exacerbated by the fact that machines are at the controls.

“The system is more fragile than people suspect,” says Michael Shaoul, CEO of Marketfield Asset Management.

THE RISE OF COMPUTER-DRIVEN, rules-based trading mirrors what has happened across nearly every facet of society. As computers have grown more powerful, they have been able to do what humans were already doing, only better and faster. That’s why Google has replaced encyclopedias in the search for information, why mobile banking is slowly replacing bank branches, and why—someday—our cars will be able to drive us to work. And it is also why Wall Street has embraced computers to help with everything from structuring portfolios and trading securities to making long-term investment decisions.

In the years since 1987, huge strides have been made in understanding what drives stock performance and how to apply it to portfolio construction. At first, researchers focused on “factors,” such as a stock’s volatility relative to the market—known as beta; whether a stock is large-cap or small—the size factor; and whether it is cheap or expensive—the value factor. More recently, the use of factors has proliferated to include many others, such as quality and momentum. (The latter involves buying the best-performing stocks and shunning the worst performers.)

Quantitative investors understood early on that betting on stocks based on their characteristics - and not the underlying business fundamentals of a particular company - was a good way to outperform the market. So good, in fact, that many fundamental, or “active,” money managers now use quantitative tools to help construct their portfolios and ensure that they don’t place unintended bets. Nomura Instinet quantitative strategist Joseph Mezrich says that 70% of an active manager’s performance can be explained by quantitative factors. “Factors drive a lot of the returns,” Mezrich says. “Over time, this has dawned on people.”

Has it ever. One result has been the rise of indexing and exchange-traded funds. The ability to buy an index fund based on the Standard & Poor’s 500 - effectively a bet that large companies will outperform small ones - made the need for traditional fundamental research and stock-picking unnecessary. Since then, indexes and ETFs have been created to reflect just about any factor imaginable - low volatility and momentum among them. Some funds even combine multiple factors in a quest for better performance.

As a result, an increasing amount of money is being devoted to rules-based investing. Quantitative strategies now account for $933 billion in hedge funds, according to HFR, up from $499 billion in 2007. And there’s some $3 trillion in index ETFs, which are, by definition, rules-based. The upshot: Trillions of dollars are now being invested by computers. “We’ve never seen so many investment decisions driven by quantitative systems,” says Morningstar analyst Tayfun Icten.

That’s quite a change from the 1980s. If you wanted to place a trade 30 years ago, you picked up the phone and called your broker; your broker called the firm’s trader; the trader would ring up a specialist, the person in charge of running trading in a given stock; and the trade would be executed. The process was slow, cumbersome, and inefficient. As computer technology advanced, machines gradually took most of these steps out of the hands of humans. Today, nearly every trade is handled by an algorithm of some sort; it is placed by a computer and executed by computers interacting with one another.

The entity handling trades isn’t the only thing that has changed in the past 30 years. Trading now occurs in penny intervals, not fractions such as eighths and 16ths. While that has made it cheaper for investors to buy and sell a stock, pennies made trading far less lucrative for market makers, who historically profited by playing the “spread” between the highest bid to buy and the lowest offer to sell. Consequently, market makers have been replaced by algorithms programmed to instantaneously recognize changes in liquidity, news flow, and other developments, and respond accordingly. At the same time, the proliferation of exchanges helped to lower trading costs but also created a fragmented market that can make shares hard to find during dislocations.

Most of the time, none of this matters. If you want to buy a stock, you boot up your computer, log in to your brokerage account, and place an order that gets filled almost immediately. The fee you pay is so low that it would have been unimaginable 30 years ago. The system has worked well for individual investors, and will continue to do so—as long as nothing goes wrong.

BUT MISTAKES HAPPEN.

In 1998, the “quants” at Long-Term Capital Management, led by Nobel Prize winners Myron Scholes and Robert Merton, nearly caused a massive market selloff when the hedge fund’s highly leveraged trades, based on quantitative models of expected market behavior, suddenly lost money after Russia unexpectedly defaulted on its debt. The damage was magnified by the borrowing that LTCM had used to supersize its bets. Only a bailout organized by the Federal Reserve prevented the broad market from plummeting.

In August 2007, a selloff occurred in quantitative funds that would become known as the “quant quake.” To this day, no one knows what sparked the selling, but once it began, computer models kicked in, causing further selling. Humans added to the mess as risk managers looking at losses dumped shares. Funds specializing in quantitative investment strategies reportedly suffered massive losses: The Renaissance Institutional Equities fund was thought to have lost nearly 9% early in that month, while Goldman Sachs ’ Global Alpha suffered a double-digit decline.

The impact on the market wasn’t huge - the S&P 500 dropped just 3.3% during the first two weeks of August - but the event demonstrated what happens when a trade sours and too many funds are forced by their models to sell at the same time. It was a wake-up call for quants, who have since created more-sophisticated systems to reduce the kind of crowding that led to the selloff.

More recently, problems have been caused by algorithms that are supposed to provide stock for investors to buy, or buy when investors sell, creating liquidity. On May 6, 2010, the S&P 500 dropped 7% in just 30 minutes, as bids and offers for stocks moved far away from where stocks had been trading, in some cases leaving bids down as low as a penny and offers as high as $100,000.

Again, no one knows what caused the sudden decline. Investors had been on edge because of an unfolding European debt crisis, but that alone seemed unlikely to have triggered the flight of automated market makers. The U.S. Commodity Futures Trading Commission blamed the swoon on fake orders placed by a futures trader, while the Securities and Exchange Commission fingered a massive sell order in the futures market allegedly placed by a mutual fund company seeking to protect itself from a potential downturn. That order, it argued, had been handled by a poorly designed algorithm—yet another reminder that an algorithm is only as good as the inputs used by the people designing it.

While the rout was over quickly, and the S&P 500 finished the session down a more modest 3.2%, the episode raised concerns about the potential for computerized trading to exacerbate selloffs.

REGULATORS AND EXCHANGES have made changes since then, but so-called flash crashes continue to happen, even if they are no longer quite as disruptive as the 1987 selloff. On Aug. 24, 2015, for instance, the Dow dropped almost 1,100 points during the first five minutes of trading. The selloff was spurred by a plunge in China’s stock market, which led to a drop in Europe. All of this happened when U.S. markets were closed, which meant that investors turned to the futures and options markets to place their trades.

Chaos prevailed when the stock market opened: Only about half of the stocks in the S&P 500 had started trading by 9:35 a.m.; a quarter of the Russell 3000 index was down 10% or more intraday, and many large ETFs traded far below the value of their underlying assets. Algorithms, sensing something amiss, simply stepped back from the market. Once again, the S&P 500 recovered much of its sudden loss, but savvy market observers detected eerie echoes of an earlier era. In a much-read note at the time, JPMorgan strategist Marko Kolanovic cited the feedback loop of selling and compared it to the Black Monday selloff of 1987.

Flash crashes have not been limited to stocks - or even crashes. On Oct. 15, 2014, the price of the 10-year Treasury note soared, causing yields to tumble 0.35 of a percentage point in mere minutes before quickly reversing. The SEC blamed the increasing role of automated high-frequency algorithms for the sudden move.

The most recent scare occurred on May 18, when the iShares MSCI Brazil Capped ETF (ticker: EWZ) dropped as much as 19% in a single trading session before closing the day down 16%. To put that move in perspective, the Brazil ETF’s worst single-day decline at the height of the financial crisis in 2008 had been 19%. While there was bad news in May—reports that Brazilian President Michel Temer had been ensnared in a corruption scandal—that seemed insufficient cause for such a precipitous decline.

Shaoul, of Marketfield, attributes the Brazil ETF’s plunge to a combination of factors, including the growth of passive investing, which has made it easy to buy and sell an entire country’s market with the press of a button, combined with computer-driven trading.

“There was no way of knowing what was a human being pressing a button, or a computer pressing a button,” he says. “But it generates the potential for sudden spikes in volatility that come out of nowhere.”

The Brazil ETF recovered its losses fairly quickly. By the end of August, it was trading above its May 17 close.

U.S. markets haven’t suffered declines like that, but have experienced numerous “fragility events”—sudden one-day declines—during the current rally, says Chintan Kotecha, an equity derivatives strategist at Bank of America Merrill Lynch. But because stocks have been in a bull market, there has been little follow-through after the initial selloff. As a result, some quantitative strategies reposition for more volatility, but none arrives. Kotecha attributes the lack of follow-through, in part, to central bankers’ continued bond-buying, which has provided much-needed support for the markets.

Follow-through was all the market had in 1987, as selling automatically triggered more selling. To some observers, the risks of a similar scenario are growing. One particular area of concern: volatility-targeting strategies, which try to hold a portfolio’s volatility constant, and risk-parity strategies, which attempt to equalize the risk in a portfolio among bonds, stocks, and other assets—and sometimes use leverage to do it. When volatility is low, these portfolios can hold more-risky assets than when volatility is high. But as soon as volatility rises—and stays high—these types of funds will need to start selling stocks and other assets to keep the risk of their portfolios at the same level. If they sell enough, volatility could spike higher, leading to even more selling.

“ The PROLIFERATION of COMPUTER-DRIVEN INVESTING has created an illusion that RISK can be measured and managed. But several anomalous episodes in recent years involving sudden, severe, and seemingly INEXPLICABLE PRICE SWINGS suggest the next MARKET SELLOFF could be exacerbated by the fact that the MACHINES are at the controls. ”

In a market selloff, commodity-trading advisors similarly could exit their long positions quickly and look to short stocks, creating further selling pressure as they head for the exits. “Action leads to more action,” says Richard Bookstaber, chief risk officer at the University of California and author of The End of Theory, a book about financial crises caused by positive feedback loops.

PERHAPS THE BIG QUESTION is who might be left to buy. Warren Buffett once quipped that investors should be fearful when others are greedy and greedy when others are fearful, but the current market structure has turned that maxim on its head. Algorithms provide less liquidity in a downturn than a human market maker, who might be thinking about how to profit from a dislocation.

The rise of momentum and passive strategies has caused some $2 trillion to shift away from active money managers, who could be counted on to look for bargains as stocks sold off, says Kolanovic, the JPMorgan strategist.

“We think the main attribute of the next crisis will be severe liquidity disruptions resulting from market developments since the last crisis,” he says.

But most strategists acknowledge that such an occurrence isn’t a high-probability event. Much will depend on the cause of any disruption, as well as seasonal factors—stocks are more thinly traded in summer, for example. Also, computers aren’t the only cause of selling cycles; bear markets, after all, long predate machine-driven trading.

Quantitative investors argue that they have learned from past mistakes and are less likely to be leveraged or crowded into the same trades.

Moreover, regulators and exchanges have instituted rules that could help arrest a bout of unchecked selling, with trading halts imposed when the S&P 500 falls 7%, 13%, and 20%.

Maybe these precautions will work to stem a tidal wave of selling. One of these days—possibly soon, given stocks’ lofty valuation and the Fed’s plan to shrink its balance sheet—we’ll find out.

Gold: Take Profits at $1330, Beware the London Spoof

Update 12:45pm - if we do not hold the  $1312- 1310 area in spot there is a lot of trouble ahead.

The 60 minute is looking at an inflection point in the area:

 

 Breaking $1312 on the 60 minute chart puts us outside the  bottom band, and would likely increase all BBand widths implying accelerated downside movement, aka a reversal. Inflection point to say the least.

 Meanwhile the daily shows the same area as an outright negation of today"s momentum higher.?The Upper BBand comes in near $1312 currently. A settlement inside that adds fuel to the 60 minute chart above

Expect more profit taking if we get below this area. Pray some buyers have not gone to the market and are waiting for this dip to buy in. If stops exist, expect Commercials to gun for them here.

Take Profits Now

posted originally on marketslant.com

Big players like Soros and Druckenmiller use liquidity events to get out of massive  positions all the time. This is another example of where these types  may sell into strength. That does not mean the market will not continue higher afterwards. it does mean profit protection is mandated when gorillas like these are entering a room. If we do not close weaker today, beware the London Open for a large profit booking as the past has shown us. Many continue to call this a spoof,  and sometimes it genuinely is. We think Friday"s Comex activity was one to shake out momo longs and help commercials cover some shorts. But it is prudent to accept that some  of those big orders seen during London hours are genuine  profit taking by players not worried about $5.00  when  they are booking $55 in 2 months

 Yesterday, via Moor Analytics we gave you the road map ahead. Admittedly we did not think  it would happen so quickly:

August 21st : We wanted a bull flag

 We  wanted a bull flag to form starting with a selloff early last week, as opposed to the one at week"s end, and said as much on Aug 21st;

Ideally, over the next 3-5 days: we wanted to see Gold fill the Comex gap underneath, and in the process shaking out some weak longs and luring some shorts to pile in. First touching the $1285 area, close with a positive settlement on a lower day. Then we could see a nice orderly rally out of a bull flag. But so far that is not the case. Instead we have more buying at the top end of a range that has earmarkings of Friday"s behavior.

Aug 28th: We got the Bull Flag

Our time frame was good. Our order of events was not. The rally / dump 2 Fridays ago did spook us, but last Friday"s sell-off and rally undid that. The Comex gap got filled underneath as we wanted, and the market closed positive on the 25th, leaving a tail of sellers trapped below.  Happy to be wrong timing wise here about the momo money bailing.  

Michael Moor"s Next Steps:

From yesterday"s post

Paraphrased with our comments in italics

• Areas of possible exhaustion for this move up come in at 13143-237 and 13466-556 - We have moved through the first area of congestion overnight


• Take profits in the $1330- $1332 first time up, reverse on a break above with a $1336 target - Some profits  should be taken  on speculative portfolios long from  the $1285 area or lower. We do not think  trailing stops will serve specs well here.


•  Buy to cover shorts in the $1321 area first time down. - if you are getting short in the $1330 area with a $1332 stop, we like this advice


• There are multiple  resistance numbers that may be broken early, only to serve as accelerators  of profit taking on a re-piercing lower - This may be a strong hands to weak hands day

For additional information contact: Moor Analytics

Our 2 Cents

Comex Futures now have a Gap between $1317.80 and $1318.90. To those who ignore gaps as Gold is a globally continuous market, we get it. But to those who trade in one time zone, they remain relevant when applied consistently. We"d be hesitant to buy that gap if tested because of our own volatility based trading style, and would rather buy it upon a break under adnarally back through $1321.

Bollinger Bands show us that if one were playing the momentum game it is prudent to remain long until a settlement occurs  within the outer band. This comes  in currently at $1321 now, and is  consistent with Moor"s levels. Any breaking of that level, especially late in the day does not give us a good risk reward in which to buy. We"d rather  short in the gap  with a stop-loss and reversal set at  $1321 for a day trade. 

Today:

1. Take some profits near $1330-1332 if you were long from the $1285- 90 range


2. Take more profits if the area of $1346 is reached


3. Leave a tail in the form of long calls or a small position that wont kill  you on a $20 move lower overnight.


4. Buy $1321 area for a bounce back to $1328- $1330. Risk a $1317 print


5. Short here at $1325 with a buy stop on new highs with a target of $1301 ( do not take home  if  out of  the money on close)

interactive spot chart HERE

Gold is Goldilocks regardless of the next $50 move... keep the faith and let the momo guys create short term opportunities for you now.

Why Gold's Rally to $1299.70 Today May End Ugly Tomorrow

Pray for Rain?

• Gold has profit taking above


• There is a gap  below that "needs to be tested" for increased likelihood of a sustainable rally.


• Short term the market is overbought, and Friday"s buyers  are  out of the money already

via Soren K Group posted originally on Marketslant.com

Ideally, over the next 3-5 days: we wanted to see Gold fill the Comex gap underneath, and in the process shaking out some weak longs and luring some shorts to pile in. First touching the $1285 area, close with a positive settlement on a lower day. Then we could see a nice  orderly rally out of a bull flag. But so far that is not the case. Instead we have more buying at the top end of a range that has earmarkings of Friday"s behavior.

The sellers right here are commercials and large funds taking profits. And the sellers" stops to buy back are much higher (if they exist at all), than the stop-losses placed underneath from this headline-chasing momentum fund buying. Can we continue  higher despite our "perfect" scenario. Sure. Guys like Ray Dalio are showing no signs of back-tracking on their "risk-off" stances. But we are not buying here. We want the hot money to short Gold, not get long. And guys like Dalio are longer term traders with deeper pockets and more apt to tell us they"ve changed their risk-off and sold their Gold after the fact.

George Gero describes Gold nicely without judgment before the open:

Today gold is steady ahead of  summit of bankers including Chair Yellen, ECB Draghi and many more all of which may keep market watchers with one eye on headlines. Keep the other eye on open interest, more new longs.. Gold over 508,734 as we mentioned Friday on cnbc, copper 329335, silver 191783,and gold options on futures 1,144,348, all these indicate asset allocations returning to metals again. Stocks iffy and more political, geo political headlines await as we look for more 1300 area to come.

Gold is higher today, and that for us is unhealthy. It is the increase in OI that worries us. It is the momentum funds looking for more $1300 and buying based on headlines of:

 $1300 GOLD YAYYYYY! BUY IT NOW  BECAUSE YOU WONT GET A CHANCE TO EVER AGAIN that scare us. Friday"s rally brought new longs. Activity and info confirmed for us asset allocators bidding, but momentum funds chasing the price.

And based on that day"s close, some of them finished out of the money. If we do not close higher today, they may bail given their gnat-like tolerance in metals. Traders with a 6 month horizon may find themselves annoyed by the funds with a 6 minute horizon right here, right now.

We fear the supernova spike/reversal right here and feel the market is much more likely to extend higher on a more sustainable basis if it consolidates a bit here and takes out some weak longs. We prefer the market establish a base here. Higher now without closing above Friday"s high means the likelihood of  a significant sell off in 3 days increases. That fear would ratchet up  MORE if we took out Friday"s  high today but closed lower than the day"s VWAP 

via Vince Lanci:

The question is, do you want a $10 rally today, or a $35 rally over the next 3 weeks?  Its a matter of perspective and time frame. But less upside volatility now means more upside later. Better someone sell it in the hole this week than momentum funds trample each other getting in today.

The caveat as Michael Moor noted to us today is "Longs should not want to trade below $1282.90 intraday."

This is consistent with our Bull flag hopes. A break below that would almost certainly negate a flag formation and thus bullish sentiment.

Gold for December delivery is trading $1297.00 as we write  this, up $5.40 on the day

SPOT GOLD 1 MINUTE CHART

?

Real time interactive charts HERE

There is a gap on Comex charts between $1286.20 and $1283.50. The smackdown was expected on first penetration of $1300. The market may linger between the gap and recent highs  for 3 to 5 days creating a bull flag base for a higher push. Our opinion is that unless Gold penetrates $1314 rallies should be sold to book profits during this time. 

Alternatively, shorting rallies this week might be a good intraday play to capture swings as the market gyrates  between the gap and new high. Separately, and not necessarily at odds with our analysis, Michael Moor would prefer the gap be tested sooner rather than later in his summary below

We can see bitcoin profits being taken while hot money is buying Gold with that same manic ajax-snorting expectation of profits. And we do not like  it. 

As long as the market is between $1284 and $1306, we see rallies as a sale, and selloffs as a buy for the next 3 days. Sell it now if  you are booking profits. Then hope it breaks $1314 and buy back in.-  Soren K.

Moor Analytics

emphasis ours- Soren K.

Analysis written by Michael Moor 

Gold (Z) 8/18/17

On a macro basis:   The maintained gap higher on 7/18 left a medium term bullish reversal intact below that warned of higher trade for days.  We have seen $67.8 of this so far from (Q) into (Z) with a roughly $7 spread differential.  The solid penetration above 12417-21 warned of solid short covering in the days/weeks ahead, with a good likelihood of a run back up toward 12980 (+).  We have seen $63.8 of this so far, taking out 12980 on 8/11.

On a shorter-term basis:   The maintained gap higher yesterday left the short term bullish reversal warned about below, which warned of decent higher trade. We have seen $11.5 of this before backing off the high.  Decent intra-day trade below 12829 will negate this definitively.  Although this has not been negated, I warned to be out of longs for the time being if we broke back below the 12978-88 and 12954-60 areas, below which I would look for decent profit taking to come in—we have seen $6.3 of this so far.  If we leave a maintained gap lower intact above on Monday, this will leave a short term bearish reversal intact that will warn of decent lower trade, likely for days.  Decent trade below 12801 (+ 1 tic (10 cents) per/hour starting at 6:00pm Sunday) will project this downward $28 minimum, $34 (+) maximum based off a ‘well formed’ formation; but if we break below here decently and back above decently, look for decent short covering to come in.—likely back toward 12980 (+).   

All inquiries for Moor Analytic"s Professional research in the Gold and Energy markets please use contact info below

Anticipating "VIX Shock", Interactive Brokers Raises Volatility Margins

Even as the VIX has continued to plumb new all time lows, unable to rebound from the realm of single-digits where it has spent a record amount of time in 2017, warnings about a potential surge in the volatility index have been growing in recent weeks.

Last week, in a note looking at what may happen "if the VIX goes bananas", Morgan Stanley"s Chris Metli cautioned that it’s easy to become numb to the low volatility environment and the risks it presents.  While trying to pick a trough in vol has been a fool’s errand, Metli said that focusing on the risks resulting from vol being so low is not, and warned that low vol has produced a regime where the risks are asymmetric and negatively convex, so being prepared for an unwind is critical.  "This is not a call that vol is about to spike, but you need a plan if it does", he echoed many other similar warning issued in recent months.

Of course, while nobody can know when a VIX explosion could occur, Morgan Stanley explained what could catalyze such a violent rise in volatility, showing that "just" a 3% to 4% one-day S&P 500 selloff could result in a 12 point VIX surge, a relationship MS showed through the gamma in vol related products, where demand for VIX futures from three main sources could result in 100,000 contracts ($100mm vega) to buy in a down 3.5% SPX move.  For context VIX futures ADV over the last year is 230,000 (although has risen to as high as 700,000 in big selloffs).

For those who missed it, below we recap some of the salient points of what would happens if the S&P 500 were to fall 3.5% today, based on Morgan Stanley calculations:

• First, the VIX could rise as much as 12 points.  When volatility is low it tends to move a lot for a given change in the S&P 500.  That effect is likely to be exacerbated now because a) skew is steep (and VIX rolls up the skew in a selloff) and b) many players in the VIX market are short.  Taking these dynamics into account QDS estimates VIX could rise ~12 points for a 3.5% 1-day decline in SPX. Of course, a far smaller move in the VIX would be sufficient to result in massive losses among the vol-selling community according to previous calculations by JPM"s Marko Kolanovic.


• Just as concerning, if VIX futures approach +100% in a single day, there is a risk that the providers of inverse VIX ETPs cover the VIX futures that they sold to hedge the products.  This is because there is a mismatch in the hedge if VIX futures rise more than 100% – the inverse ETPs can’t go below zero (-100%) but the loss on a short VIX futures position can be more than -100%.


• For XIV (holding ~73,000 contracts short) the prospectus indicates that it will unwind if the NAV falls more than 80% intraday, with investors receiving the end of day value.  Given this is a known threshold, anything close to a +80% move in VIX futures would likely trigger buying (by the ETN provider and/or market participants) in anticipation of the unwind.  Note that because XIV is an ETN, investors receive the theoretical value of the index based on its rules, not what the provider actually trades.


• SVXY (holding ~37,000 contracts short) does not have a set threshold to unwind according to its prospectus.  That said VIX futures currently have a margin requirement of ~45% of notional for the average of the front two contracts, and any decline in value of the inverse ETPs to those levels could trigger a rapid forced unwind.   Note that SVXY is an ETF, so the NAV is based on the actual holdings of the fund at the end of the day.

• Adding to the pain – on days after the initial shock – would be the flow from annuity and risk parity deleveraging.  Both of those investors are slow by comparison to the VIX market – annuities will sell over several days, starting the day after a selloff.  Risk parity funds are more discretionary, and the supply could come over a matter of weeks.  But given high leverage resulting from the low vol environment, their potential supply is large and could prolong any downturn. Between all three vol players, a 3% drop in the S&P would result in forced selling of roughly $60 billion in one day, growing to $140 billion should the plunge accelerate to -5% intraday.

* * *

In a separate report also discussed here previously, Fasanara Capital"s Francesco Filia revealed what the "wipeout scenario" - one in which the VIX were to double from its current level in the 9/10 range to 18/20 - would look like for vol sellers. In a word, it would be an unmitigated disaster.

Our analysis shows that if VIX goes from 9.60 to 18/20 in absolute values (it was approx. 40 as recently as Aug2015), and stays there for 8 / 10 days in backwardation, VIX-based ETFs may stand to lose up to 55%. Short positions on long-vol ETFs can then lose up to 250% of capital with VIX at 20. Losses are higher in case of wider backwardation of the term structure of the VIX (i.e. front contracts trading higher than back contracts), or the longer VIX stays elevated while in backwardation, or clearly the higher it goes. For example, if VIX quadruples from here to 40, losses on a UVXY position would amount to a staggering 656%!

* * *

We bring up all of the above, because as Morgan Stanley said, "This is not a call that vol is about to spike, but you need a plan if it does" and at least one exchange is doing just that.

In a notice to clients sent out late on Friday, Interactive Brokers admits it is starting to get a worried about the recent VIX record lows and as a result after expiration processing on August 19, "Interactive Brokers will put into place greater margin requirements for Volatility Products."

While the IB notice had it usual dose of fluff and generic admonitions...

VIX has established new all-time lows over the course of the past month. The price dynamics of that product are such that it can have very large relative price increases over a very short period of time base on news and other market factors. In recognition of the special risk of sudden, large increases in market volatility, that is inherent in Volatility Products such as VIX, Interactive Brokers will put into place greater margin requirements for Volatility Products after expiration processing on Saturday, 19 August. 

... It was surprisingly clear in what the specific parameters of the anticipated move are, to wit:

IB"s margin policy will be to consider market outcome scenarios under which VIX might rise to a price of 18 (even when it is currently priced much lower) and under which the other Volatility Products could rise to proportionately similar degrees.

In other words, IB is starting to prepare for the day that the VIX doubles from current levels, which as Fasanara showed above, is sufficient to wipe out most vol sellers, and in the case of those with levered, naked volatility shorts, results in losses greater than 600%.

Who will be impacted:

If you have positions in Volatility Products that have risk in large upward moves of market volatility, then your margin may increase significantly.

Of course, since volatility is the "fulcrum security" of today"s reflexive market nature - does a surge in the VIX send stocks lower, or does a market crash lead to a VIX surge? - the very fact that vol-linked leverage is about to be aggressively cut first by one, then by many more if not all exchanges, as we head into the critical for volatility fall period, these warnings could create a self-fulfilling prophecy whereby the margin increases are the very catalyst that leads to a surge in volatility.

Whether that is what happens over the next two weeks remains to be seen. In the interim, IB said that "it will with immediate effect increase its Initial Margin requirements on Volatility Products to a degree consistent with the upcoming 19 August increases in Maintenance Margin."

What this means is that vol sellers will now have to pay up substantial additional margin (i.e. cash) for new short-vol positions, and that in two weeks, maintenance margins for legacy positions will be likewise affected. It also means that unless the short-vol traders have a generous amount of cash lying around, they will have no choice but to close out of existing positions, in the process sending vol, and VIX, higher if purely mechanistically.

IB also specifically cautions inverse vol sellers:

Some Volatility Products have "ultra" and "inverse" characteristics. Ultra products are expected to have greater daily returns than normal products while inverse products are expected to have returns that are of the opposite sign to normal products. It is therefore expected that an increase in market volatility will result in a decrease in the price of an inverse volatility product. As a consequence, for example, under the new policy the margin on a naked short call will increase for a normal product while the margin for a naked short put will increase for an inverse product.

This unexpected margin hike across the vol universe by Interactive Brokers (to be followed by its competition) is especially notable because one month ago Bank of America warned that the most dangerous moment for markets "will come in 3-4 months", or 2-3 months as of today, when the confluence of the adverse debt-ceiling negotiation, disappointing Q3 earnings, and the Fed"s balance sheet unwind all converge into one broad risk-off shock.

It is precisely this "event" that Interactive Brokers is the first to admit may have drastic consequences on the market.

IB"s full notice is below.

Dear Regulators: Do you Really Want to Stop Manipulation? Subpoena the Programmers

Why Do Silver and Gold Get Spoofed Lower? Because That"s Where the Stops Are.

via Soren K. Group for Marketslant.com

If you really want to root out manipulation, you must find intent. Intent is encoded in the algorithms themselves. The algos embody the conditions, tactics, and goals of the trader who designed them. They are his intent downloaded into a program. Do you really want to stop manipulation by predatory Algos? Then subpoena the programmers.

VBL EDIT- The  interview below with Daniela Cambone is merely one person"s opinion. But in a world where facts are the final arbiter of truth yet those facts are impossible to obtain, one must survive on his wits. That means using inductive means to asses a trading situation. We traders can only see the market"s behavior, not the intent behind it. Thus we trader types must decide to oppose, surf, or get out of the way of the market behavior we see. Professionals generally accept that and adapt. But the public is punished and taxed daily because of it.

When someone asks me WHY the market does what it does, that puts me in the position of guessing at intent of "Them". Markets are manipulated constantly. That does not mean that the Bullion dealers were "repressing Gold" or on a bearish mission. It just means that they, and the algorithms that succeeded them were finding the lower lying fruit in stops below the market, as opposed to above. Manipulation is agnostic directionally. And in a market like Silver where the shorts are better capitalized than the longs, then the stops closest are on the downside. The problem is as it always has been, poor market structure is exploited by those with the means to do so.

If you really want to root out manipulation, you must find intent. In the past INTENT was almost impossible to prove as it resided in the head of the trader spoofing the market. But now intent is very easy to prove.

Intent is encoded in the algorithms themselves. The algos embody the conditions, tactics, and goals of the trader who designed them. They are his intent downloaded into a program. Do you really want to stop manipulation by predatory Algos? Then subpoena the programmers. That is how they got Mike Coscia. Why would they not go after the bigger violators using this clear approach? You know why..

Subpoena the programmers and you lawyer types will get the 3rd leg of that "legal stool" you need to convict. But you have to want to first. Do you want to? I do not think so. And so the pricing mechanisms of our markets will shrink in importance. But that is just my opinion.

My first post on manipulation covering Warren Buffet"s 1997 Silver Squeeze was anonymous posted on zerohedge for fear of retribution by "them".  How messed  up is that? Maybe justice will be done someday

Here are some choice quotes from the interview:

• the silver and gold market have the majority of their stops lower, not higher – and that’s why the market goes lower.


•  it’s an algorithm, it’s not bullish or bearish  it’s just looking for the stops


• I’m going to come down firmly on the side that it is manipulation and it is unethical and it should stop   


• here’s the problem… the algorithms are now faster than the exchange’s ability to freshen up where its bids are


• it aint just Gold and Silver. The thinner the market, the bigger the spoof

When markets quickly move lower or experience a flash crash, the media is quick to point to a ‘fat finger.’ But, to veteran trader Vince Lanci, the problem is rooted in the technology running markets. ‘Manipulation does happen but what’s happening now is not a fat finger; that’s just a good headline,’ he told Kitco News. ‘It’s a combination of algorithm trading, institutional money and stop losses.’ To Lanci, algorithms are the real issue. ‘It’s an algorithm. It’s not bullish or bearish, it’s just looking for the stops,’ he said. ‘The silver and gold markets have the majority of their stops lower, not higher – and that’s why the market goes lower.’ Lanci, who tracks big market moves often as a contributor on Marketslant.com, said this type of price action can happen in any market. ‘I’m going to come down firmly on the side that it is manipulation, it is unethical and it should stop,’ he said. ‘But here’s the problem -- the algorithms are now faster than an exchange’s ability to freshen up where its bids are.’

 About Vince:

Vince Lanci has 27 years’ experience trading Commodity Derivatives. Retired from active trading in 2008, Vince now manages personal investments through his Echobay entity. He advises natural resource firms on market risk. Over the years, his expertise and testimony have been requested in energy, precious metals, and derivative fraud cases. Lanci is known for his passion in identifying unfairness in market structure and uneven playing fields. He is a frequent contributor to Zerohedge and Marketslant on such topics. Vince contributes to Bloomberg and Reuters finance articles as well. He continues to lead the Soren K. Group of writers on Marketslant.

vlanci@echobay.com

Mobile: (212) 223-1000

Read more by Soren K.Group

These Are The 10 Most Crowded Long And Short Trades According To UBS

In this market where fundamentals long ago ceased to matter, and where positioning remains one of the few remaining sources of alpha, investors have been focusing on lists showing the most over and under-owned stocks. However, contrary to the narrative that the most heavily owned stocks outperform the most shorted, or underowned ones, and vice versa, recently BofA calculated that for the third year in a row, "the Top 10 most overbought stocks have trailed the S&P for each of the past three years, while the Top 10 "most neglected" stocks outperformed the S&P on average by 11.6%."

This is what BofA"s quant team found:

As flows from active to passive funds have accelerated, one strategy that has worked unusually well for the last several years is a simple positioning trade of selling the 10 most overweight stocks and buying the 10 most underweight stocks by active managers. This single trade has yielded over 16ppt of alpha year-to-date. And implied derisking/ outflows on Brexit alone have been fierce, with the same strategy generating 5.2ppt of alpha just since last Thursday’s close. Even if Brexit’s impact on funds is limited from here, we believe that crowded stocks will likely continue to underperform neglected stocks: a whopping two-thirds of US large cap AUM still resides in active funds - there is likely a lot more to go in the rotation from active to passive.

Visually:

As such, a useful trading framework, would be to look at the Top 10 most crowded trades of active managers - on either side of the ledger - and to short the 10 most overweight, while going long the 10 most underweight stocks.

Conveniently UBS has updated its list of the Top 10 most crowded trades, revealing "where are the largest active positions." How does UBS  measure the most active positions?

Using the institutional ownership data provided by FactSet, we form an active trading portfolio by aggregating positions across global active managers. Essentially, we sum up all the holdings in dollar value across all the active managers and calculate the weights of stocks in this active trading portfolio. We then compare this weight with the relevant equity index benchmark to form the active weight.

So, without further ado, here according to UBS are the Top 10 most crowded long and short trades, and not surprisingly, it"s all tech among the top 5 longs, which include Google, Alibaba, Amazon (a jump from 8th spot as of the last ranking), Facebook and Visa (with AAPL sliding into 6th spot), while on the short side one name stands out: Tesla in the perennial top slot, which may explain why no matter how bad the news, even the smallest glimmer of hope, whether a tweet from Elon Musk or an upgrade, prompts a sharp squeeze, like today for example.

Based on UBS data, this is how these two baskets have performed on a YTD basis:

Finally for those wondering, here is a breakdown of how levered hedge funds are as mid-July courtesy of JPM Pribe Brokerage. It will probably not come as a surprise that every single category has increased its leverage on a 3M, 6M and 12M basis.

David Stockman Warns The Market's "Chuck Prince Moment" Has Arrived... "Only More Dangerous"

Authored by David Stockman via Daily Reckoning,

On July 10, 2007 former Citigroup CEO Chuck Prince famously said what might be termed the “speculator’s creed” for the current era of Bubble Finance. Prince was then canned within four months but as of that day his minions were still slamming the”buy” key good and hard:

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,” he said in an interview with the FT in Japan.

We are at that moment again. Only this time the danger of a thundering crash is far greater. That’s because the current blow-off top comes after nine years of even more central bank policy than Greenspan’s credit and housing bubble.

The Fed and its crew of traveling central banks around the world have gutted honest price discovery entirely. They have turned global financial markets into outright gambling dens of unchecked speculation.

Central bank policies of massive quantitative easing (QE) and zero interest rates (ZIRP) have been sugar-coated in rhetoric about “stimulus”, “accommodation” and guiding economies toward optimal levels of inflation and full-employment.

The truth of the matter is far different. The combined $15 trillion of central bank balance sheet expansion since 2007 amounts to monetary fraud of epic proportions.

The massive injection of fiat credit has drastically falsified prices in the debt and money markets. Through the channels of cap rates, carry trades and corporate financial engineering, the prices of equities and all other risk assets, have been falsified too.

Bond and stock prices are way too high, and that reality has infected the very foundations of the financial system. Like the hapless Chuck Prince last time, today’s traders and robo-machines have lost all contact with the fundamentals of corporate performance, macroeconomic outlooks and the political risks of a Washington.

Traders today are just dancing – blindly. That’s why the Russell 2000 hit 1442 the other day, capitalizing the earnings of small and mid-cap domestic companies at 87.5 times.

That’s crazy in its own right. As measured by valued added output of the U.S. business sector, the main street economy – where most of these companies live — has expanded at a tepid 2.1%  annual rate since 2002. By contrast, the RUT index has increased by 10% per annum since then.

At the same time, the level of speculation in the hyper-momentum tech stocks is even more stunning.

We are in the blow-off stage of the Fed’s third and greatest bubble of this century. Yet the stock market has narrowed drastically during the last thirty months, as is typical of a speculative mania. This narrowing means that the price-earnings ratio (PE) among the handful of big winners have soared.

FAANGs and Bubble Finance

In the case of  the so-called “FAANGs + M” (Facebook, Apple, Amazon, Netflix, Google and Microsoft), the group’s weighted average PE multiple has increased by 50%.

That’s caused the market cap of these six super-momentum stocks to soar from $1.7 trillion to $3.1 trillion during the period or by 82%.

The combined earnings of the group have grown by just 20%. 75% of this huge gain in market cap is attributable to multiple expansion, not operating performance.

The degree to which the casino’s speculative mania has been concentrated in the FAANGs + M  can also be seen by contrasting them with the other 494 stocks in the S&P 500. The market cap of the index as a whole rose from $17.7 trillion in January 2015 to $21.2 trillion at present, meaning that the FAANGs + M account for 40% of the entire gain!

If this concentrated gain in a handful of stocks sounds familiar that’s because this rodeo has been held before. The Four Horseman of Tech (Microsoft, Dell, Cisco and Intel) at the turn of the century saw their market cap soar from $850 billion to $1.65 trillion or by 94% during the manic months before the dotcom peak.

At the March 2000 peak, Microsoft’s PE multiple was 60 times, Intel’s was 50 times and Cisco’s hit 200 times. Those nosebleed valuations were really not much different than Facebook today at 40, Amazon at 190 and Netflix at 217 times PE.

The point is, even great companies do not escape drastic over-valuation during the blow-off stage of bubble peaks.

That spectacular collapse was not due to a meltdown of their sales and profits. Like the FAANGs +M today, the Four Horseman were quasi-mature, big cap companies that never really stopped growing.

For example, Cisco’s revenues have increased from $15 billion to $50 billion annually during the last 17 years and its net income has tripled to $10 billion. Yet Cisco’s market cap today is just $160 billion or only 30% of its 17-years ago bubble peak.

The reason is PE normalization. In this case, the company’s hideously inflated 200 times PE multiple imploded with the tech crash. It now stands at 15 times PE.

Amazon and the Chuck Prince Market Redux

Amazon is now set for that kind of PE implosion during this cycle. It’s stock price doubled from $285 per share in January 2015 to $575 by October of that year; and then it doubled again to $1026 in the 20 months since.

Along the way it picked up a hefty $350 billion in added market cap. That’s nearly $12 billion of value gain per month!

Amazon is now 24 years-old, not a start-up; and it hasn’t invented anything explosively new like the iPhone or personal computer. Yes, it is taking retail market share by leaps and bounds, but that’s inherently a one-time gain that can’t be capitalized to infinity.

Indeed, 91% of its sales involves sourcing, moving, storing and delivering goods — a sector of the economy that has grown by just 2.2% annually in nominal dollars for the last decade.

Amazon embodies the speculative mania of the current market. It is simply ludicrous to put a multiple of 190 times PE on a company that runs a profitless $130 billion e-Commerce sales juggernaut.

Even as its stock price has tripled during the last 30 months, AMZN has experienced two sharp drawdowns of 28% and 12%, respectively. As shown in the first chart below, both times it plunged to its 200-day moving average in a matter of a few weeks.

A similar drawdown to its 200-day moving average today would result in an immediate 16% sell-off. But when, not if, the broad market plunges into a long overdue correction the ultimate drop will exceed that by a greater magnitude.

In the meanwhile, the market mindlessly melts-up because the Fed has destroyed all of Wall Street’s natural forces of financial discipline. Eight years of central bank money printing and intrusion have destroyed short-sellers and caused day-traders and robo-machines to be wired to buy every dip.

Never mind about the gong show in Washington. Or even the fact that the Keynesian economists in the Fed’s Eccles Building does actually intend to normalize rates and shrink the Fed’s balance sheet.

The talking heads wandering around Wall Street have come to the delusional belief that the bubble can live forever without help from Washington or the Fed.

With only a small share of companies having reported, LTM earnings for the S&P 500 have already dropped below $105 per share on a GAAP basis. That’s still below the $106 per share posted way back in September 2014 and barely above the $100 per share reported in 2013.

Make no mistake, this is the Chuck Prince Market Redux. Only the daredevils and Wall Street dancing machines would dare buy the S&P 500 at 25 times PE, the Russell 2000 at 88 times PE, Amazon at 190 times PE.

For everyone else, the present blow-off top is surely a godsend.

Never has there been a better opportunity to get out of harm’s way, nor a clearer warning that a thundering crash is waiting just around the bend.

Spoofing Lessons From Andy Hall - The Oil AND Silver King

A Silver Legend Throws in the Towel on Oil

By Vince Lanci for Soren K. Group

BACKGROUND

In 2010 I wrote an anonymous article for Zerohedge on Silver manipulation. Anonymous because the article was in part an indictment of the market structure on COMEX at the time. I was afraid of backlash against me and my nascent family, having already having seen the underside  of a bus in 2003 via my own actions and the need for a conflicted, and unqualified compliance officer / bureaucrat Tom LaSala in danger of losing his job after a horrendous failure to protect the NYMEX electricity contract. This, according to NYMEX / CFTC sources then. But I digress. 

About the  author: Vince Lanci has 27 years’ experience trading Commodity Derivatives. Retired from active trading in 2008, Vince now manages personal investments through his Echobay entity. He advises natural resource firms on market risk. Over the years, his expertise and testimony have been requested in energy, precious metals, and derivative fraud cases. Lanci is known for his passion in identifying unfairness in market structure and uneven playing fields. He is a frequent contributor to Zerohedge and Marketslant on such topics. Vince contributes to Bloomberg and Reuters finance articles as well. He continues to lead the Soren K. Group of writers on Marketslant.

 

Hall WasThe Uncrowned King of Silver

For me, PhiBro was a mentor in how to not be a victim and to try to divine my opponents" intentions just by watching their trades. An exercise in applied empathy if you will. To study PhiBro is to study Andy Hall.

Andrew Hall is a legend in the trading community. He was instrumental in execution of the 1994 Silver squeeze and the 1997 Buffet Silver buy.  He was a manipulator of Silver to the upside. But metals were just his HOBBY. And when Hall had orderflow, he maximized returns for clients and the prop desk at PhiBro. The man knew how to front run! But without order flow..

 

Astenbeck"s  Returns.

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Maybe the seat makes the money, not the man in it? But we aren"t here to kick him. Rather to describe what the man is good at. and to describe what we observed from  him.

Andy Hall, Oil  Perma-Bull

His baby was oil. We remember being on the wrong end of many mini oil plays by his desk at PhiBro right before a refinery fire became public. Here is one play his desk loved to do at least once a month :

• Hall Gets Long Oil > Broker buys Calls for PhiBro hard and sloppily  > Oil rallies > Refinery fire news hits > Oil rallies more > Hall gets out of longs > Cue the crying options traders.

This was brilliant because he played the most liquid market against news in a much less liquid one. And a refinery fire is not necessarily bullish oil. It destroys oil demand as the refinery shuts down.

But when the option broker telegraphs who is buying, and the PhiBro reputation precedes him, and the option marketmakers  rush like lemmings to buy futures to hedge their short deltas.... you get long!.

 

Hall Was Immune to Buffet"s House Cleaning

We also knew traders on his desk that got fired by Solly, PhiBro"s parent,  after Buffet came in 1994 to rescue them. Hall did not. Because Hall was in energy, and while he had his own position in Silver on both occasions, he was not the poor sole who took the fall in 1994. 

 

Why Hall Was Great

The reality is, it is not so  easy to be right without client flow behind you. Hall"s early success in oil on his own may have been in part a function of a secular bull market in commodities to begin with. Personally, our experience  has been that Hall was not a directional expert, but he knew when a market was lopsided and knew how to catalyze the exit problem for everyone else. He also was expert at creating exit strategies for his own massive positions. 

Once  I saw a broker in Silver futures laughing (in relief) and shaking his head after executing and seemingly butchering a 5,000 sell order. I knew this broker well and asked him: "Was the client upset?" His answer was " NO, He was laughing!" To which i prodded him: "Was this the big player you have?". His  response was: NO, THIS WAS THE CLIENTS ENERGY DESK TRADER. And HE WAS LAUGHING AS I FILLED HIM 20 cents LOWER THAN I SHOULD HAVE.

Apparently this was Hall. And he had been long from $3.00 lower in Silver. To top that, a silver options broker had bought 1,000 calls loudly 30 minutes prior, driving uo the futures price about 20 cents. This was the same energy tactic Hall used so often. And a lesson was learned.

Taking on the Banks

Possibly least understood was his acumen in playing the oil futures term structure. We saw and were informed of his massive plays where calendar relationships were out of whack and he stepped in to fix them. He would be the buyer of 2 year December futures after  a bank was done laying off producer hedges  for his "back-to-back" vig. Then he"d sell another month in which he thought the price was out of whack on the high side. He exploited distortions created by organic order flow. Then he waited to be right. And sometimes, he nudged himself in being right as these were illiquid contracts. He would test the resilience of the sell side (maybe the bank actually held onto some of the hedge given them by the client?) by buying in thin hours to see if they pushed back. This is spoofing by the way. But he wasn"t necessarily fishing for stops like a slow motion algo. He was looking for sellers as he bought. And if they didn"t buy, he"d keep pushing. 

I labelled this to all who would listen as an inverted  pyramid style. It was the antithesis of investing.  It went something like this:

1. Already be long  (when wasn"t he?)


2. Buy 1 contract


3. Buy 2 contracts if the fill on the first one was poor


4. Buy 10 contracts even worse


5. Buy 100 contracts even worse, then bid for 1000 at that price


6. Buy some calls which will create option related futures buying


7. Sit back and see what happens.


8. If the market takes off, sell as many futures as you were long 


9. Use the calls as either a tail or convert them to synthetic puts

 

Bidding to Sell

I knew a  precious metals floor broker who actually lost his business because of executing for PhiBro in this fashion. The broker was bidding and showing  some ridiculous volume for one part of the PhiBro desk. And in between his announcing his bid he was selling to locals 10 cents under his bid.  He could not cross the trades as they were for the same firm, but from different desks / clients. The broker was accused of facilitating market manipulation.

Crime scene depicted, but pales by comparison to HFT/ Algo crimes which are floor tactics on streroids with no counterparty transparency.

What really happened was he was selling for a Phibro trader or client long, while simultaneously bidding for another Phibro person.  That broker was handing money to locals who ran from him, scared it was a trick. I saw this happen. And it was hilariously scary.  I"m sure some of the details are not right here, and I have an alternate explanation of what may have been going on at the PhiBro  desk, but it changes nothing. Phibro was bidding above where they were selling and neither side could get filled.

 

A Product of PhiBro Culture

To begin to try to understand Hall a bit one must understand the culture of PhiBro. That firm started in the least liquid products  imaginable: iridium and such. To be a marketmaker in assets like these, one must have a brilliant tactical mind for creating your exit liquidity. Hall has that skill. One must also recognize the right time to corner a market. Hall did this. And one must know how to disguise one"s intentions in a small market where participants are easily identified. The PhiBro trained Hall did this.

These survival skills lent themselves greatly to manipulations of Silver on more than one occasion (crushing overhedged producers), front running refinery fires on many occasions, and in recognizing distorted futures curves from undigested order flow (and subsequently taking the banks who were order-flow monkeys on)

Read on and keep the above in  mind when reading Hall"s letter. 

- VLanci@echobay.com

 

Andy Hall"s Letter to Investors 

as published in ZH

[emphasis by Tyler Durden]

July 3, 2017

Dear Investor,

The oil rout continued in June with prices entering bear market territory. Not only did sentiment plumb new depths but fundamentals appear to have materially worsened. Demand growth seems to be somewhat less than anticipated while supply keeps surprising to the upside. The expected acceleration in inventory drawdowns has not materialized – at least as evidenced by available high frequency data. Several weeks of lackluster inventory data from the EIA, along with reports of increasing amounts of oil in transit and in floating storage, disappointed expectations for accelerating stock draws following the arrival of peak seasonal demand.

Meanwhile, U.S. shale operators have continued to add rigs at a surprisingly fast rate thus raising the odds for significant oversupply in 2018, even if OPEC maintains its production cuts beyond Q1. Over the past month, the market has in effect priced in two negatives, one long-term, the other short-term.

The longer-term negative is that it is becoming increasingly evident that, under most reasonable scenarios, U.S. shale oil will be the marginal source of supply, at least until 2020. There are enough non+OPEC, non-shale production projects already in the pipeline (and which were sanctioned when prices were much higher than today) that incremental U.S. shale oil production alone can balance the market for the next two or three years. Moreover, and more importantly, it is now becoming apparent that the cost of this oil is significantly lower than was believed to be the case even a few months ago. That means the long-term price anchor for oil has moved lower. At the start of the year, the anchor was thought to be about $60 (Brent) and rising over time. Today, it appears to be closer to $50 (and possibly still falling). Prices for long-dated futures have therefore moved down to reflect this new perception.

The short-term negative is an apparent deterioration in the supply and demand balances for 2017. Until recently it looked like demand would exceed supply by as much as 1.5 million bpd if OPEC maintained its production cuts through 2017. This would have eliminated the global inventory surplus sometime in Q3 and resulted in a backwardated market. It now seems, however, that the supply deficit will be considerably smaller than originally expected – probably only around 0.5 million bpd. There will therefore still be sizeable excess stocks at the end of the year. This realization has resulted in the market moving into a steeper and uninterrupted contango with spot prices falling relative to deferred prices which, as just noted, have themselves ratcheted lower.

We discuss both these developments in more detail below. However, absent some geopolitically induced supply curtailment or a further cut by OPEC, oil prices are likely to be range bound around a level that limits the growth in shale oil production. That would mean the forward WTI strip ought to be somewhere below $50.

Shale is now the marginal barrel

Technological advances have continued to drive down well breakevens as well as expand the shale oil resource base in the U.S. In a recent report, PIRA estimated that there are now 80 billion barrels, or half of the recoverable U.S. shale oil resource base, that is economic at $50 Brent (say $48 WTI) or less. This represents some 215,000 well locations. Each of these on average can produce around 300 bpd in its first year on stream. The current horizontal oil rig count is 650 and has been growing at a rate that would bring the count to close to 800 by the end of the year. 800 rigs can drill about 15,000 wells per annum which means potentially 4.5 million bpd of gross new production. After deducting legacy decline this would translate into net production growth of more than a million bpd per annum, which exceeds the expected “call on shale” (demand growth less non-shale crude supply growth from non-OPEC, OPEC crude and other non-crude liquids). Today’s rig count or lower would be necessary to constrain shale oil growth to the 0.7- 0.8 million bpd of year/year growth in shale oil production that is probably required to balance supply and demand.

The market is therefore trying to find a price level that curtails rig additions (and/or well completion activity) to a level commensurate with the call on shale. Exactly what that price is can be debated and the truth is no one really knows. It depends on current and future rig productivity, how drilling and completion costs respond to rising oil field activity levels, the willingness of shale operators to outspend their cash flows and the availability and cost of capital to the industry.

Notwithstanding uncertainties surrounding all these variables, it does seem that the price needed for a given rate of growth in shale oil production has been falling over time. Well breakevens have dropped because of steep rig productivity gains and cyclical cost declines. They could fall further if continued secular gains in rig productivity outstrip the cyclical cost increases now resulting from higher oil field activity.

Over the past two years, average rig productivity in the U.S. Lower 48 states has grown by more than 20 percent per annum. In the Permian basin productivity grew by around 30 percent last year. These gains have been achieved through reduced drilling times from the use of pad drilling and increased well productivity from longer laterals, more intense fracking and higher proppant loadings.

Whilst the rate of rig productivity growth appears to now be moderating, it is unlikely to stop altogether. A recent Goldman Sachs analysis posits continued productivity growth for years ahead. This will be driven by higher rates of recovery of initial oil in place through the application of artificial intelligence and big data analytics. Goldman argues that this could eventually reduce breakevens to $45 and below. The best operators in the Permian like EOG already have well breakevens at, or even below, $40 WTI. As the rest of the pack catches up with the leaders, average breakevens are likely to fall further if Goldman is correct.

If the marginal cost of oil for the next 3 or 4 years really is headed to the mid-$40 range then OPEC’s attempts to push prices to $60 seem futile. It is unlikely that OPEC will find the cohesion necessary to keep prices at an artificially elevated level if all it does is accommodate rampant growth in shale oil production.

That line of thinking raises the possibility of yet another reversal in OPEC policy – abandoning supply management and letting market forces balance supply and demand. This would obviously result in significantly lower prices, at least in the short term. On the other hand, with many OPEC countries needing much higher prices for fiscal sustainability (for Saudi Arabia the level is over $80), there is an inherent instability which adds to the geopolitical risks to supply. But for now, it seems likely that OPEC, led by Saudi Arabia, will stay the course with its current policy of production restraint. Oil at $45-50 is preferable to it being at $40 or below, even if the loftier target of $60 has proven elusive.

With hindsight, OPEC’s attempts to manage supply were poorly conceived. Given the short response time of shale oil to changing prices, OPEC should have acted more quickly and more decisively. The production cuts should have been deeper and implemented immediately. As it was, OPEC talked up the market ahead of the actual production cuts thus helping to unleash a fresh wave of future shale oil production as emboldened operators upped their capex budgets and raised capital on the back of the higher prices. Additionally, OPEC ramped up production in Q4 2016 ahead of its mandated cuts, thus adding to the very stock excess they were hoping to eliminate. OPEC members also then inexplicably offset the impact of their cuts by drawing down their own inventories to maintain exports during Q1 2017. This made no sense given OPEC’s stated goal of reducing OECD inventories to their five-year average.

Fundamentals have deteriorated significantly

In implementing its production cuts at the start of the year, OPEC and its allies were aiming to eliminate the inventory excess. This would have allowed spot prices to rise relative to deferred ones, pushing the market into backwardation. A backwardated market would eliminate the “subsidy” shale operators have been realizing by selling forward to hedge production. This would therefore help curtail shale oil supply growth by removing this windfall hedging profit. But it clearly hasn’t happened. The spread between Dec 2017 and Dec 2018 futures contracts moved $3, from a $1 backwardation to a $2 contango, over the past month as it became increasingly likely that there would still be substantial excess inventories at the end of the year.

There are several explanations for why the expected supply deficit has not materialized.

• Firstly, demand growth has been somewhat disappointing. Based on indicators of economic activity, demand in 2017 should be growing by around 1.7 million bpd, if not more. Actual growth, however, seems to be closer to 1.4 to 1.5 million bpd for reasons that are not yet clear.


• Secondly, non-OPEC supply growth has been exceeding initial expectations – largely because of faster shale growth in the U.S. Forecast growth in non-OPEC supply for 2017 has been revised progressively higher by 0.3 million bpd. OPEC production is also now expected to be greater than seemed the case just a month ago because of the earlier than anticipated return of shut-in production in Libya and Nigeria. This will add around 0.2 million bpd of additional supply on average in 2017.


• Finally, revisions to data for 2016 now show a small flow surplus of 0.1 million bpd whereas previously there had been a small flow deficit.

Together these changes amount to a 0.9 million bpd deterioration in the supply and demand balance for 2017 and an initially expected supply shortfall for the year of 1.4 million bpd now looks like it will be closer to 0.5 million bpd. Because of lower SPR purchases in India and China, as well as stock reductions in the OPEC countries, the drop in observed commercial inventories will be even lower – perhaps as little as 0.3 million bpd. This is much less than the rate needed to mop up the stock surplus – some 450 million bbls at the start of 2017 - and the market will almost certainly enter 2018 with a still substantial inventory overhang.

Moreover, at the rate at which oil drilling rigs have been added in the U.S., non-OPEC production has been on a path to grow by as much as 2 million bpd in 2018. With demand growth of, say, 1.5 million bpd and a 2017 flow deficit of only 0.5 million bpd, and with higher year/year production from Libya and Nigeria, that would imply an annual average stock build next year, even if the current OPEC production cuts remained unchanged for the whole of 2018, something which is by no means a given. It is this specter of renewed stock builds in 2018 adding to still inflated inventories that has panicked the market and caused the forward curve to move into contango. This reversal of the time spreads, combined with the drop in deferred prices to match a lower perceived marginal cost, has resulted in nearby prices collapsing, even though seasonal factors are becoming their most favorable.

In short, OPEC, the market and oil bulls have run out of runway. There are just 10 weeks before fall turnarounds kick in and crude stocks in the U.S. start to build again. Excess crude inventories in the U.S. are around 80 million barrels, up sharply since the beginning of June, reversing the trajectory seen in April and May when sequential crude oil draws were rapidly eliminating excess crude oil inventories.

In the past month, however, excess crude stocks in the U.S. are back to the levels seen this time last year and there now appears to be little chance that they can be eliminated before the fall – especially if the rate of inventory change seen in the data for the past three weeks is maintained. Moreover, Q4 2017 will see an acceleration in U.S. oil production as the impact of higher rig counts is increasingly reflected in higher production.

The main culprit for the disappointing stock draws in the U.S. is a stubbornly elevated level of net imports. While imports from Saudi Arabia have finally turned lower, those from other OPEC producers (notably Iraq) have risen. Crude exports have also fallen in recent weeks, at least if the preliminary data are to be believed.

Backwardation was meant to take care of excessive shale production in 2018 and beyond by driving deferred prices to levels that would constrain its growth. But stocks have not fallen fast enough to sustain backwardation so the whole futures curve has downshifted instead.

When the facts change…

For all the above reasons, it looks increasingly like oil prices will be rangebound for some time to come. Hitherto, it had been our view that oil would trend higher as prices would need to rise to a level that would justify investment in more costly sources of supply than just the core areas of U.S. shale. However, not only has the core shale oil resource grown significantly – above all in the prolific Permian basin – but breakevens have dropped because of secular productivity gains outpacing cyclical cost increases, at least for now. Furthermore, there has been no shortage of capital to fuel the growth in shale oil production and this has allowed operators to significantly outspend their cash flows. The marginal economics of the typical shale oil producer have proven to be no impediment to the industry’s resilience. The breakevens referred to earlier are based on half-cycle economics. Full-cycle costs that cover land acquisition, infrastructure and overhead are probably almost $10 higher. But companies base their drilling decisions on half-cycle costs even if this leads them on the path to eventual bankruptcy (to which the shale oil industry is no stranger) so long as they have access to capital. It’s quite possible that shale oil production growth can only be reined in by the capital markets rationing the supply of funds as industry management seems to be more focused on growth than generating free cash flow or even paper profits [ZH: this is something we have been pounding the table on since 2014, most recently in mid-June].

It also appears that the cost of developing other supply sources, such as deep water offshore, has been falling dramatically making them competitive with shale in many cases. Because of these developments, the cost curve for oil has become much flatter. There is now an abundance of potential supply at around $50 Brent. Prices will tend to oscillate around this long-term price anchor in response to changing inventory levels as the market tries to determine the right price to satisfy the call on shale. With the current inventory surplus and what looks to be its slow dissipation, markets are also likely to stay in contango, barring some sort of supply shock.

These developments call for a more opportunistic approach to the oil market than hitherto. Whereas it once seemed positions could be held with an eye to a longer-term secular appreciation, that is no longer the case. Indeed, the evidence is now in plain sight. Over the past year, the front month WTI futures contract has moved by double digits in percentage terms 10 times within a $40 - $55 band. This volatility has been accentuated by large financial flows into and out of the market by non-traditional investors and algorithmic trading systems. Attempting to capture just a percentage of those moves makes more sense than trying to ride what has turned out to be a non-existent trend, especially when contango inflicts a negative roll return on investors. The extreme volatility within a rangebound environment also argues for a more tactical and conservative approach to portfolio management.

For now, the market is heavily oversold with a record speculative short position. Q3 should still see decent stock draws even if they are insufficient to eliminate excess stocks. Also, increases in the rig count appear to be ending and could decline in the coming weeks and months. It also remains to be seen how quickly the increased drilling activity will translate into a commensurate increase in the number of completed wells and whether cyclical cost pressures will accelerate or bottlenecks develop. Already, the number of drilled uncompleted wells (DUCs) has been rising quite rapidly. There is also a non-zero chance that OPEC might surprise the market with a further “shock and awe” production cut. Taken together these considerations mean there is a good chance for a price recovery from current levels. However, this recovery will be limited for the reasons set out earlier and because of the overhang of potential selling from oil producers who are significantly underhedged for 2018.

Best regards

Andrew J. Hall

Chairman and CEO

Read more by Soren K.Group