"Edge Funds" -Spoofing by any other name?

          The article in the Wall Street Journal, As ‘Spoof” Trading Persists, Regulators Clamp Down, is about edges.  The “Russian” is accused of having an algorithmic edge, the ability to manipulate commodity prices by flooding the market with orders. Big banks were fined for having a trading edge in the commodity arena. So, is having an edge illegal? After all, hedge funds and big traders have had edges for years! They have vast wealth, smart employees, technology (algorithms too, no doubt), and recently, an accommodative Fed policy. According to David Einhorn, “Both poker and investing are games of incomplete information…you are looking for situations where you have an edge,” And hedge funds, due to their edges, are very adept at finding such situations.

            For example, recently, I watched the stock price of a company fly to highs it hadn’t seen in seven years. There had been no real changes to the company’s fundamentals. The company had a high debt to equity ratio, a climbing level of short interest, and little analyst coverage except for a few Hold ratings. What was the catalyst for this meteoric rise? A hedge fund discovered, using its many edges, that it was situated for easy profit…for them.

             First, the hedge fund bought 15 million shares of that obscure company’s stock. Next, the purchase was made public in its 13-F. The purchase in the 13-F was announced on CNBC. Then, the analysts stampeded into the picture. Even though nothing had really changed about the company, the analysts raised their ratings from a Hold to a Buy. New analysts jumped in with Buy ratings. The stock climbed to two-year highs! Then, the company announced a BIG buyback of their stock at the new highs! Thanks to an accommodative Fed policy, the money was cheap to borrow for the buyback. On that news, the stock price rockets up to key technical levels. That triggers the algorithms of traders everywhere to buy, buy, buy! --- sending the stock climbing high, high, high! And that smart hedge fund? While all that crazed buying is going on, it is not only selling shares but betting the stock will fall by purchasing PUT options against it! The hedge fund made, at least, $70.5 million in profits as the stock price climbed and will make $70.5 million in profits, or more, when the stock price falls to its former levels or lower.

            Hedge funds and big money traders have their trading edges and the “Russian” has his. Should edges be regulated or punished?  Benjamin Franklin offers food for thought, “A great empire, like a great cake, is most easily diminished at the edges.”  Could the fall of the Empire of Those with Edges cause the stock market to crash to a level that actually reflects the true valuations of the companies it represents? And… are we ready for such a fall?

Mary M. Glaser

Weatogue, CT