FMX | Connect (Reported 4/25/2011)

THE FULL STORY IS AVAILABLE IN PDF AT THE TOP OF THIS DOCUMENT.

Overview

Price Manipulation and its cousin “mismarked books” are as much a product of systemic dysfunction as they are of unethical individual behavior. The 3 part series we have planned is educational in nature and aims to outline those system-wide imperfections at the highest level. For today we must focus on what is shaping up to be a rare opportunity to watch a pitched battle between major players in Gold. In short, we are interrupting your regularly scheduled program.

 

Current Events: The Potential Pin in Gold Options Tommorow

Right now there is a war in Gold options. It is between the May 1520 longs, who most likely are unhedged, and their short option counterparts, who most likely are hedged. One would think the longs intend to sell futures at some point, perhaps 1520, perhaps 1540 we do not know. It is also possible that they intend to take delivery, but that is unknowable for the moment. The shorts are probably delta hedgers and have no desire to see this market go above 1520, much less move at all.

 

The Players

 

• The Longs- have accumulated over 5,000 lots in a two week period and we would assume they are bullish. They are patient dip buyers and seem to have little fear of the Bullion Banks that are often accused of manipulating PM prices lower or keeping prices range bound at expiration.

 

• The Shorts- are Bullion Banks, market-making firms, locals and possibly some hedge funds. There is no collusion implied here. In fact, these firms are usually at odds with each other in terms of option open interest. The majority of the shorts trade options from a non-directional point of view. That is, they are professionals who, when short an option do not want the market to move either way. Conversely, when they are long an option, they want the market to move quickly through or away from the strike they own.

The Play
We feel the Longs were betting that once the gravitational pull of the $1500 strike was broken, that the market would move quite easily to the strike with the next largest open interest, the $1520 strike. They may be privy to large order flow in futures, they may have large futures order flow, or they may simply be speculating with nothing other than their wallets and the ability to read market behavior through price action. They can spot a market that is lopsided in one direction when they see it.

 

 

Snapshot: May Gold Open Interest

 

product	contract	type	strike	volume	open interest
OG	May-11	C	1480	598	2303
OG	May-11	P	1480	368	675
OG	May-11	P	1485	271	341
OG	May-11	C	1485	11	666
OG	May-11	C	1490	5	970
OG	May-11	P	1490	379	416
OG	May-11	P	1495	86	280
OG	May-11	C	1495	35	361
OG	May-11	C	1500	211	6762
OG	May-11	P	1500	445	522
OG	May-11	P	1505	17	333
OG	May-11	C	1505	76	306
OG	May-11	C	1510	507	1731
OG	May-11	P	1510	344	116
OG	May-11	C	1515	116	1374
OG	May-11	C	1520	580	5823
OG	May-11	C	1525	143	747
OG	May-11	C	1530	128	578
OG	May-11	C	1535	95	289
OG	May-11	C	1540	9	730
OG	May-11	C	1550	40	1570
OG	May-11	C	1600	26	1515

The Next 48 Hours
We have alerted the reader to this possibility for the past week. All that remains is this:

Today the LME is closed
This deprives the market of a deep source of liquidity. While the LME Players are surely watching and trading today, we suspect the “A’ teams may not be, however, as holiday continues for many and trading at 9PM London time is not very fun if you are an MD at a large Bank. Also remember there was no LME fix today, which has an effect on balance sheets for London firms. No London Fix, no Balance Sheet Axe, so to speak.

Tomorrow Comex Options Expire

If the Option Longs are right, then the market will be propelled through the 1520 strike. Futures should receive additional support at some point from the negative gamma hedging of those non-directional players who MUST adjust their delta hedges.  The longs are playing for a longer time line than the shorts in this instance.
If the Option Shorts win this battle then we will pin the strike. Remember, a violent sell-off is not good for the shorts either. A pin means the options go out worthless theoretically, and the future hedges that longs carried against those shorts can be liquidated for a profit.
Let’s assume next that the Options Shorts “win” this battle and through hope, prayer, or their own attempts to keep the market in a range, the $1520 strike is Pinned or near-Pinned on the closing bell at 1:30 PM ET tomorrow.

The Pin
If a Pin occurs, the longs have another two and a half hours to decide if they wish to abandon or exercise their calls. They own the optionality at the strike. The option shorts can still lose a lot of money, even if the option longs make none. A sell-off is very possible, wherein the option longs abandon their calls, but the option shorts still have hedges to unwind. The Shorts would be forced to use statistical methods to determine if they will get exercised or not. More than likely this is a digital event, and statistics do not matter when most of the contracts are in the hands of a single player or a group of like minded players, as may be the case here. We are likely looking at an all-or-none exercise if we pin the strike. The shorts would be in the dark.

Manipulation in the Commodities Market
A multitude of individuals and firms have been accused of market manipulation, over the years. Many individual traders have been brought to task for their actions. The Hunt Brothers attempt to corner Silver, Yasuo Hamanaka of Sumitomo for his copper manipulation in 1995, by, various “rogue’ traders and brokers and most recently, the CFTCs successfully prosecuted of a case involving Brian Hunter of Amaranth for his actions in the natural gas market. Nonetheless, very few firms have suffered commensurately.

Business as Usual
Firms that have been successfully prosecuted continue to operate in the markets they have manipulated, usually with monetary wrist slaps. To be fair, major firms settle disputes all the time, but the fines are not proportional to their balance sheets when compared to the individual fines; nor are the firms’ abilities to go back to business-as-usual in the market place affected.

It’s Baked in the System
We believe manipulation is a product of many things, and attempt here to boil them down to three broad categories. First, the U.S. Government’s accounting and regulatory policies unintentionally enable these events to occur. Second, the rights accorded corporations give them the ability to mandate profits above all else, all the while getting the same privileges an individual person does. Companies have no social contract and their goal is to continue to exist, a combination easily misused. Finally, market structure, especially in commodities lends itself to a tail wags the dog situation wherein the transparent pricing mechanism for settling contracts is not where most of those contracts actually trade. This results in a disconnect between liquidity and price that can lead towards “managed market” abuses.

We intend over the next week or so to outline at the highest levels how government policies, corporate mandates, and market structure contribute to the moral hazards in derivative markets.

For today and tomorrow, we will just be watching the Precious Metals markets like we suspect many of you will. Good Luck.

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