How Knight Makes a Market: Evidence from RWE Group

Fond of trading on the OTC Bulletin Board, among other prominent markets, Knight Capital "trades or makes a market in over 19,000 U.S. Equities" according to their website.  The goal of this post, and I hope those going forward, is to examine the science behind Knight's activities.

The example today is RWE Group.  What they do and how they do it is wholly unimportant for this exercise.  The important and relevant data points to build on today are price and time.  Price for RWE quoted in Euros, RWEOY quoted in US dollars, the EUR/USD interbank rate, and the synchronized time stamps for all 3 variables.

Outrights: The two stocks together.  RWE (blue/red) is denominated in Euros and opens at 02:00AM while RWEOY (green/purple), denominated in US dollars, does not open until 08:30AM, despite a relatively tight bid/ask for the prior hour.  The chart below is April 8, 2011, from left to right, 2:00AM CST to 3:00PM CST.

Currency: The EUR/USD interbank currency rate available via IB's Idealpro.  The currency was recorded simultaneously with the two stocks to avoid using potentially stale quotes.

EUR/USD - 8 April, 2:00AM to 3:00PM CST

Implied Value.

Using the price of the shares denominated in Euros and the live EUR/USD exchange rate, a theoretical value for the USD-listed shares can be derived.  Gagnon and Karolyi (2004) provide an exhaustive study into this relationship.  The authors study 589 pairs of dual-listed stocks from 39 countries using daily closing prices from 1990 to 2002.  While most pairs are found to stay within a 15 to 20 basis point (.15% to .2%) range with one another, the authors note that "the premium on the cross-listed shares relative to home-market shares can be as large as 66 percent and the discounts as large as 87 percent," but deviations of such magnitude were found to last no longer than one day."

"Deviations from price parity,” they suggest, “their persistence over time and the excess comovements are related to country-level and firm-specific attributes that reflect, not only institutional impediments to arbitrage, but also informational barriers in the form of information asymmetries among different investors and the presence of noise traders."  They find that "excess comovements are significantly related to the fraction of global trading that takes place in the U.S. markets." Ejara and Ghosh (2004) support their findings and provided important research into the field.

Below is the implied value of RWE priced in USD combined with the live quoted price of RWEOY duly listed in USD. The market for RWEOY is most robust during the overlapping hours when market making firms are able to more easily transfer risk from one market to the other. The bid/ask spread of RWEOY after the European closing (on the right of the chart) is evidence of this mechanism.

April 8, 2011

July 15, 2011

Finding the difference between the synthetic value of RWE and the real value of the RWEOY is the arbitrage. In this case, as in others, dynamic inventory and risk management systems must be in place for the pricing participants.

Overlapping Market Spreads.

April 8, 2011 

July 15, 2011

Further Reading:

A Resolution of the Chinese Discount Puzzle

Arbitrage-Free Limit Order Markets and the Pricing of Order Flow Risk

Over The Counter Bulletin Board Exchange: The Impact of Liquidity and Size to Return, Volatility, and Bid/Ask Spread [pdf]

Boeing / Lockheed Pairs Trade, Cont'd

BA released earnings this morning not surprisingly showing strong growth over Q3 2006. EPS beat the Street's estimates of $1.24, coming in at $1.44, a $0.55 gain over Q3 06. Revenue for the quarter grew to $16.52B, a 12% increase over Q3 2006. Showed conservative 2007 guidance of $5.05 - 5.15 EPS, vs. the Street's estimates of $5.06. Lowered 2008 guidance slightly due to previously disclosed delays in delivery.

LMT also posted strong earnings, beating the Q3 07 estimates by $0.16, showing EPS of $1.80 vs. $1.46 for Q3 06. Sales up 16%; Profit up 22%; Boosts 2007 EPS estimates.

In premarket trading, BA is trading $2 up around high $96; LMT relatively unchanged.

As in my original posts on this particular pairs trade (here and here), on 2 Oct BA began what ultimately became roughly a 12% correction, from a high of $106 down to $93/sh. LMT, on the other hand, continued in its trend up until 12 Oct, when it was trading around $111, when it began a steady fall over the next week, falling as low as mid-$103.

My original prediction on the direction of the two appeared to be coming to fruition, as evidenced by the 50-day chart below:



Support began to develop 10 Oct. when the volume increased significantly. Again, the smart money noticed a slight correction in Boeing, a solid, global firm, and saw a value play, so they began buying up. Coupled with the mutual funds, the Arbs began going long BA and shorting LMT, causing a convergence play.

I expect BA to be back in the low $100s by early Nov., while LMT will more than likely stay in a range of $107-111 until BA gains some ground.

FD: I have a position in BA.

Boeing/Lockheed Pairs Trade Part Two

Boeing looks to be on the rebound today as it posted the largest gain since 25 September. As BA began moving into the $93 range this morning, it seemed to be finding a solid level of resistance. An hour after market open, the bulls moved in for the value. Throughout the day, news started coming over that there had been some major restructuring among BA's Overseas Operations and 787 Divisions.

Not surprisingly, as I watched the Market Depth ticker, offers continuously got lifted throughout the day - sometimes in small volume, others in large, as evidenced by two major moves during the afternoon seen below. Within 10 minutes, there was a move from $94.75 up to $95.70, almost a full point. That was surprising enough, considering the relatively flat trading of the prior 3 hours. Again, at 3:15PM, BA got another shock from some major buyers - again, offers were lifted and the market moved from a low of $94.97, to the day's high of $96.27.



Clearly there were some major funds moving in to take advantage of the statistical anomaly caused by the news of production delays. Specifically, as in my original post on this subject, the spread between Boeing and Lockheed is clearly out of proportion relative to the risks associated with problems in management and delays in production.

As evidenced by the resent strength of Boeing and the relative weakness of Lockheed, it seems that the quants and their OMSs have been shorting LMT and going long BA as the spread begins to converge. I expect to see similar activity all the way up to the low $100s, and vice versa for LMT.



Technical Indicators that supports: (i) The 10-day RSI dipped below 25 yesterday, indicating an over-sold status, and (ii) trading closed below the lower Bollinger Band during yesterday's trading, indicating a possible move back to the opposite side near $105 or $110.

FD: I am long the Nov 100 BA Call.

Boeing is simply a better value

The recent headlines regarding Boeing's (BA) problems meeting their delivery deadlines have caused the stock to slide, as of this writing, to the low 95s, losing roughly 12% of its value during the previous two weeks. BA is still a solid company with good management, strong earnings, and good outlook. So, what could come of a 12-15% correction? Put simply, a wealth of opportunity.

Compare Boeing to Lockheed Martin (LMT) and you find two relatively similar, upward slanting, charts.

Many hedge funds utilize Statistical Arbitrage in order to pinpoint statistical abnormalities such as this. The typical play here would be to go long BA while simultaneously going short LMT, expecting the two to converge once again, or at the very least, continue in their trend up, with the gains from going long BA outweighing the losses from going short LMT.

If this analysis is correct, which Friday's trading has led me to believe, BA should begin to level out this week, while LMT moves lower or sideways. Friday saw BA open at 96.11 and close at 96.69, the first substantial increase in 8 days. Today will see a close lower, but in a range smaller than Friday's.

Full disclosure: I am long the BA Nov Call.

Play on a pairs trade

I have been watching Boeing (BA) and Lockheed Martin (LMT) for the past several months waiting for a deviation that would be large enough to exploit properly. Thanks to the delays in delivery, I believe BA, and Friday's trading tends to agree, has finally presented an opportunity too good to pass up.