![]() ![]() take a speculative position that volatility in the market is going to rise. One way to buy insurance on equities is to buy put options on equities. Instead of rebalancing their portfolios or taking chips off the table, however, they are looking for ways to have their cake and eat it too by buying insurance. We talk to a lot of investors who go along for the ride as the market is rising, but are rather concerned the party could come to an end. In the meantime, while the European Central Bank (ECB) and Bank of Japan (BoJ) are still ‘printing money’, the Fed is trying to raise rates. ![]() It should come as no surprise that taking the lid off might cause a spike a volatility, e.g., a taper tantrum. In the past, I have compared central bank efforts to suppress risk akin to putting a lid on a pressure cooker. As a result, in our opinion, the current design of the system makes the periodic flash crash a near certainty. Flash crashes can then occur when investors place market orders in the wrong belief that the system will take care of them. In addition, Dodd Frank discourages traditional market makers to provide liquidity. Suddenly, just about everyone withdraws liquidity because something appears wrong. Except when the lead market maker has a glitch. Everyone is happy, including the investor. ![]() Through that, all the other market makers know they can always offload their risk to the lead market maker. Each ETF has a so-called lead market maker that, by arrangement, gets a better deal than the other market makers. Exchanges are providing incentives to these market makers ever look at those exchange fees on your trade ticket? The exchange pays market makers from these fees for each share they buy or sell (ranging from fractions of a cent to multiple cents) such a “rebate” gives market makers a better price than you can possibly get, so they can cost effectively hedge their own risk, thus incentivizing them to provide liquidity. In today’s ETF driven world, to make ETFs track underlying indices, there are so-called market makers providing liquidity. Pardon the pun, I believe investors completely underappreciate hidden risks in the markets, notably the risk of liquidity evaporating. When I look at market risks, I feel like investors are in ‘la la land,’ ignoring the moonlight. ![]()
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