A buy-side head trader once told me that the best market he could hope for would be one that would be open for just an hour a day. Sixty minutes. It would be a market that would concentrate and focus on active buyers and sellers, forcing them either to agree on a price or go home with nothing done -- if you wanted to trade, you'd either put up or shut up. It would be a market where size would matter and where gaming would be challenging.
That discussion occurred eight or so years ago, but it has stuck with me through the market fragmenting, the development of dark pools, the algo craze, the HFT rebellion and the general market insanity of the past six months. In today's increasingly challenging market, there may be a number of traders willing to give up the continuous market for one where active buyers and sellers came prepared to trade.
The market today is an increasingly strange and foreboding place. It seems to limp along all day till the closing, at which time the traders finally wake up and trade like Rip Van Winkle coming to from a six-hour nap. Increasingly, more and more volume is transacted on the close. In fact, 10 to 12 percent of the S&P 500 and 18 to 20 percent of the Russell 2000 volume now trades in the last five minutes of the day.
Traditionally, volume has always been weighted evenly toward the beginning and end of the trading day. Morning flow was comprised of retail orders entered the night before, while closing flow was index-driven and tied to a benchmark. Volume charts looked like a smile with the ends curved higher than the mid-day flow. Today, that smile has turned into some sort of demented, Joker-esque smile, with the right side at eye level and the left side flat.
So why is as much as 20 percent of the volume transpiring in just 1.2 percent of the trading day? What is wrong with the continuous market that forces so much of the trading volume to transpire at the close?
First, retail investors are nowhere to be seen. Be it the lambasting of the banks, the recession, the sovereign debt crisis, rampant volatility, lack of investible funds, bad high-frequency press, the SEC cracking down on bad actors, or just a lack of market confidence, retail investing in U.S. equities simply is down -- investors have pulled almost $500 billion out of U.S. equity mutual funds since January 2007.
Second, market making is being dominated increasingly by lower-capitalized liquidity providers employing high-frequency trading strategies. These firms tend to go home with little or no position. So it becomes imperative for them to flatten out any position at the end of the day.
Third, traders want to trade when other traders are trading. As liquidity begets liquidity, it sucks more flow into the close where it can more easily interact with other orders. As the day progresses, buy-side traders also need to execute. While trades frequently take longer than a day to execute, time means money, and the overnight brings increased risk that the market will move away from the target -- pressuring traders to get as much done as possible.
Gaming also has become more of an issue. Gaming can be accomplished more easily when there is less volume. Conversely, it is much more difficult when more folks are trading. During peak trading times, mispriced merchandise is more easily spotted and traded around.
And last but not least, much of the end-of-day flow is matched during the closing auction, where buyers and sellers submit orders to be matched off at a single, end-of-day price. This auction allows massive quantities of orders to be matched at a single price truly reflective of supply and demand -- especially when intraday liquidity is low and it becomes hard to execute, and sometimes even harder to determine a reflective price.
Increasingly, it looks like traders are voting with their flow. In aggregate, traders seem to be moving away from the continuous market to an auction-type environment -- driven by indices and closing prints. While generally traders like continuous markets, increasingly it seems like there may be a need for something new. Or maybe we just shrink the day to a single hour, concentrate attention and flow, and bring the market focus back to price instead of speed.
Larry Tabb is founder and CEO of Tabb Group, a capital markets strategic advisory firm.