I had Big Ideas to write something about the infamous ‘To Stoploss or Not To Stoploss’ debate - but the following subject area came into my head and it seemed sort of appropriate with Markets going through a pretty painful Correction at the moment. Additionally, Paul Scott on his Small Cap Value Report on Stockopedia wrote some very good text on this in the ‘Comments’ bit at the bottom either in his Friday 10th Oct or Monday 13th Oct update - he was ably assisted by inputs from several commenters. I will give my two-penneth worth in a future Blog Post. (Edit note 17th Dec 2015 - I did - link at bottom of this blog).
The first Concept to appreciate is that AT A GIVEN SHARE PRICE, there are an EQUAL NUMBER of buyers and sellers. This is always true, and it is the Share Price that moves to ensure that there are always Buyers to match Sellers and Sellers to match Buyers. Right, some readers may object already - when they look at ‘Trade’ data on ADVFN or MoneyAM or whatever, there are loads more buys than sells. The situation here is that firstly a computer guesses whether a Trade is a buy or a sell dependent on the price transacted and secondly that many trades take place ‘in the background’ - usually where a large Sell or large Buy is dripped into the market by a Market Maker so that the huge volume does not upset the price (this could be over many days or even a couple of weeks). These large Deals are then presented on the Trades Data as one big Trade - but that is not how they were executed.
In addition, on larger Stocks, many Shares are now traded ‘behind the scenes’ in ‘Dark Pools’ - these are informal ways in which Shares can change ownership without visibility to the Public Markets. The obvious consequence of this is that the ‘Trades’ information on most websites is pretty useless - I never look at it.
Dark Pools are run by Large Banks for their own Clients to buy and sell stock at so say advantageous prices - in reality they are a way for High Frequency Traders (HFT) to rip the Clients off !! (get a copy of ‘Flash Boys’ from Wheelie’s Bookshop if you want to understand how this HFT stuff operates - it’s extremely eye opening).
Let’s look at this closer. Imagine you have a Share Price that is trading at 100p (for simplicity, let’s ignore the Bid / Offer spread and just stick to the ‘mid’ price). Now imagine what happens if the price was to go up to, say, 110p - it is obvious that if this occurs, then many holders of the share might be tempted to Sell - because the price has gone up and given them a nice profit. However, they can only sell at 110p if the Buyers are prepared to pay 110p to buy the shares - this is the key point, THE PRICE HAS RISEN BECAUSE BUYERS ARE PREPARED TO PAY MORE TO OWN THE SHARE. This may occur because there has been a Tip in a Newspaper, or a Good Trading Statement or a myriad of other reasons. Effectively, in this example, Sellers have the upper hand because they can hold out for more.
Now think about this again. The price was 100p and Market Participants know this (everybody looks at charts) so there is only a limited number of buyers who are prepared to pay 110p and after a period the DEMAND for shares at 110p starts to weaken. As this demand falls away, the Price needs to fall to make sure there are Buyers for the Sellers to pass Shares on to. As the price falls back towards 100p, Buyers start to get tempted in again - at 105p there might be a good level of Demand from Buyers. Therefore, what has happened as the price drops from 110p is that SELLERS ARE PREPARED TO ACCEPT LESS FOR THEIR SHARES IN ORDER TO SELL THEM. It is worth appreciating also that Buyers and Sellers motives are many and varied - for instance, a seller might be having a divorce so needs to dump shares or might have a huge profit and is getting worried about overall market conditions so wants to lock in some gains.
Imagine now that the excitement of the Tip or whatever it was that enabled the price to rise now abates after a few days and the share price starts to fall back - what is happening now is that Sellers are unable to attract buyers at 105p or maybe even at 100p - so let’s say that the price has to fall to 90p before the Demand from Buyers becomes high enough that Sellers can offload to Buyers. However, there will only be a limited number of Sellers at 90p so if Buyers wish to acquire stock at this ‘Bargain’ level they will need to be quick and it is likely that the market will be unable to match Buyers with Sellers at 90p - this means that the price will need to move up to say, 95p, to encourage sellers to provide a Supply of stock. In this latter case, BUYERS MUST BE PREPARED TO PAY MORE THAN 90P FOR THE STOCK and SELLERS ARE HOLDING OUT FOR A HIGHER PRICE.
So, it should now make sense (ok, probably you will need to read those examples a few times !!) that it is not really about numbers of Buyers and Sellers - it is in fact more about how Price moves attract Buyers or Sellers and encourage them to act.
Phew, I am sorry if all that is rather complex. I am sure if you think hard it will make sense. In simpler terms, it is all about Supply and Demand - a classic market. I won’t go into it in detail, but you can relate it to any market for anything in the Economy - for instance, when Tablet Computers were first launched, there was a lot of Demand and limited supply (only Apple made one) so the prices were high. Then, over time, Supply increased as other manufacturers brought out competing Tablets - this increased supply drove the price down.
The Stockmarket is effectively an extremely efficient market where Supply and Demand can change almost instantly and prices react very fast - obviously in other Industrial Markets there can be considerable lags in increased Supply and changes in Demand - for example, building a new factory can take months and months.
Right, how does this relate to what we are seeing in the markets at present? Well, it is really pertinent to the moves in Share Prices of Small Market Capitalisation stocks where there is very limited availability of shares - i.e. they are very illiquid.
Imagine a tiny company that has just 100 shares in existence. Now imagine that the Directors hold 30 of those shares and a Pension Fund owns 20 of those shares and Unit Trust funds hold 20 of those shares - all these Investor types are most likely long term holders and not likely to sell much, if any, stock. OK, this means that 30 shares are held by Retail Investors - that’s us people.
This means that even though there are 100 shares, only 30 are ever likely to really be available on a day to day basis to satisfy the whims of Buyers and Sellers - and probably 20 of these shares will be in the hands of ‘Long Term Holders’ who will not sell either. So there are actually only 10 shares available in the ‘Pool of Liquidity’ in the market - the shares are Highly illiquid.
Now imagine the shares are 50p each and there is a General Market Panic like we often see in Correction Phases of the Market. There will be very little Demand from buyers so the price will need to fall a lot to get them interested (the Price needs to be low enough to overcome their Fear and to make them think they are getting a real ‘Bargain‘) and sellers will have to accept much lower prices to get rid of their stock - but many sellers might not be prepared to let their stock go for less than 50p so the Pool of Liquidity dries up even more. If the price fell to 40p and Buyers snapped up the few available shares, the price would need to rise again to tempt Sellers to Supply stock to the market - and some Sellers might hold out for 50p or more - this is why you get wild swings in illiquid Small Cap stocks.
If you consider a huge stock like Vodafone with a Market Capitalisation of about £59billion and where 100 million shares or more are regularly traded on a Daily basis, there is always huge Liquidity sloshing around for Buyers and Sellers so the prices do not jump up and down in the same way. A 4% move would be a lot in one day for Vodafone, whereas on many Small Cap and Aim stocks they can move 10% easily. In really bad times for the Markets, you can see Small Cap Stocks fall by ridiculous amounts in just a few hours and they swing around like crazy.
The Ephemeral Nature of Liquidity
I just gave an example of Liquidity with regard to an individual Stock, but now I want you to think more about the nature of Liquidity in the Stockmarket in general. Much of what I will write now applies at Stock level but I am really trying to apply it to the Market.
The point to take on board here is that Liquidity is by no means a fixed thing - Levels of Liquidity can vary immensely and Liquidity can be created quickly and can dry up even faster. This is why Market can fall extremely fast when Fear really grips hold - the underlying root of these big drops is that Liquidity is drying up and the Pool of Stock available is shrinking fast.
That last sentence is not really correct - it is simplistic. The reality is that when Fear really sets in to an extreme extent, the Pool of potential Buyers totally dries up - there is just no one wanting to Buy, but loads of Sellers desperate to get out and dump their Stock. In this situation, Sellers need to lower their Price Expectations to encourage Buyers to take the Stock off their Hands - and Sellers are competing to undercut one another. So rather than Liquidity drying up as such, it is really about an imbalance between Buyers and Sellers that does not occur at more calm and normal times.
The other concept to understand about Liquidity is how Money is effectively ‘magiced out of thin air’ - but it is also vital to realise that this Magic Money can evaporate in an instant - so Pools of Money expand and contract very quickly - especially at Market Extremes - either Bull Market highs, or Bear Market Lows.
I do this Money creation thing all the time - it is wonderful. Whenever I place a Spreadbet, I am effectively creating Magic Money. For instance, if I buy a Vodafone Spreadbet equivalent to Shares £5000 of Exposure, I only need to put down a Deposit (Margin) of £250 - so the other £4750 is Magic Money that I have instantly created out of Thin Air. How cool is that?
Of course, the catch is that this Magic Money can evaporate in an instant as well. Say I close my Spreadbet straightaway, then £4750 of Money is removed from the Markets - so you can see at a Macro Level how this kind of Magic Money creation using Margin Trades on things like CFDs (Contracts for Difference), Options and Spreadbets etc. can hugely affect the overall level of Liquidity in the Markets.
On the way up, Bull Markets ‘climb a wall or worry’ and Magic Money is steadily created. Unfortunately, Fear is more powerful than Greed, so when a Major Correction comes or we enter a Bear Market, then Magic Money just disappears in a flash………
I’m not going to go too heavily into this bit - I have added a Podcast link at the bottom of this blog which is well worth listening to. What I want to add here is that when I said earlier THERE IS ALWAYS A BUYER FOR A SELLER (and Vicey Versy), this is really more nuanced - the Buyer or Seller could be a Market Maker.
This is really the role of a Market Maker - they sit in the middle between ‘real’ Buyers and Sellers to provide Liquidity when trading volumes are light and/or when Buyers and Sellers cannot be matched up in terms of the Prices they are willing to trade at. For example, you may wish to Sell some Stock at 85p but there might be no buyers, however, a Market Maker knows she/he will be able to shift the shares later in the day, so she/he will take them off you and sell them on later for 86p or whatever when the Buyers appear who are willing to buy at the higher price.
Market Makers will only Buy or Sell Stock at a given price if they know (i.e. they are very confident) that they will be able to trade the Position later in the day - they usually go flat by the end of the Day (hold no Positions overnight).
This article has gone on far too long (humble apologies) and I have deliberately left out the complications of Market Makers and Automated Trade Matching systems.
I have also missed out ‘Tree Shakes’ - Robbie Burns talks about these a bit in his book ‘The Naked Trader‘.
OK, let’s cut to the chase. The nub of this, and what is worth ‘taking on board’ is that Share Prices tend to move in ‘Waves’, driven by Buyer Demand and / or Lack of Demand, and Seller Supply and / or Lack of Supply. Practically, this means, when a share price has shot up over a few days, don’t get all excited and Buy it because “it is going up !”, but stay calm and wait for the Wave of Buyers to subside and the price to ease back - then you can buy at a much better price.
Same with Selling - sell into these moves upwards of buyers, not into moves down. When the price moves down, weak Sellers are panicking and accepting lower prices but this Wave will dry up and the price will recover - you can then sell at a higher price.
Put simply - “Don’t Panic” and never Rush anything in Stockmarket Investing…………if you find yourself rushing to do something (you know, you feel stressed and your heart is pumping), then you are probably making a mistake. STOP. Calm down. Walk away and think hard about what you are doing.
I hope that clears up a few mysteries - understanding some of the detail of how and why Prices move can really help with timing. Good luck for the rest of 2015 and make sure you have got all the Prezzies ready !!
BONUS SECTION - Market Maker Podcast
Justin on Sharepickers.com recorded an excellent Podcast with a former Market Maker the other day - you can find it here - you want Number 369. It starts off with an interview with the CEO of Audioboom BOOM and the Market Maker is at the end. Well worth a listen:
Link to Stoploss Blogs: