Goldman Warns the Rise of the Machines Leaves Markets Exposed

High-frequency traders are a threat to markets as they “know the price of everything and the value of nothing,” according to Goldman Sachs, quoting Oscar Wilde.

Computers are prized for their ability to process massive amounts of data better than humans. But it’s their relative inability to process a complex world that might lead machines to worry that humans know something they don’t when markets go haywire -- and exit a situation in which they don’t have the upper hand, wrote strategists led by co-Chief Markets Economist Charles Himmelberg in a note.

There’s an old poker adage that if you can’t spot the sucker at the table in your first half hour, it’s probably you. The same thinking informs why HFTs tend to withdraw in chaotic markets, according to Himmelberg.

“When shocks of unknown origin cause sudden price declines, HFTs may have reason to assume that the shock is being driven by fundamental news (e.g., if the price decline follows a complex macro surprise or dramatic policy announcement),” the strategists wrote Tuesday. “Under these circumstances, HFTs are at higher risk of being adversely selected by more fundamentally informed traders, so their optimal response is to withdraw liquidity by widening their quotes or by withdrawing them altogether.”

This can cause a feedback loop if the selling continues, leading to a lack of liquidity and thus bigger price declines, which drives HFTs to supply even less liquidity and in some cases even aggressively demanding liquidity, according to Goldman.

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Thus, the increasing popularity of algorithmic trading may be making markets more fragile. Indeed, abrupt “flash crashes” have occurred across stocks, fixed income, foreign exchange and volatility markets since 2010 amid this rise of the machines.

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Computerized trading comes with other risks. There’s little capital backing the most of these operations and a quick withdrawal of liquidity by HFTs could reinforce the negative perception of a macroeconomic event, adding to a vicious feedback loop, according to Goldman.

“Vulnerabilities in the new market structures are under-appreciated simply because they have not yet been stress tested by this long expansion,” Himmelberg wrote. “To us, the rapid growth of financial innovation and market share of HFT liquidity supply during the post-crisis period feels uncomfortably familiar.”

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Why Eldorado Gold Corp Shares Jumped 16.8% Today

What happened�

Shares of gold miner Eldorado Gold Corp (USA) (NYSE:EGO) jumped as much as 17.9% in trading Tuesday after some positive comments from Greece's energy minister, ultimately finishing the session with a gain of 16.8%.�

So what

A long conflict with Greece's government over environmental regulations has held up the company's plans to build a metallurgical plant for gold and other metals in the region of Halkidiki. But Greek Energy Minister George Stathakis said he hoped to reach an agreement in the "coming weeks" that would allow Eldorado to move forward with its facility.�

Image source: Getty Images.

There's no guarantee the outcome would be tremendously positive for Eldorado Gold, but investors are speculating that it will be.�

Now what

There's really nothing but speculation driving Eldorado Gold's shares higher today, but if a deal with Greece is indeed in the works, it could be positive for the company. Given weak financial results the last few years and a falling share price that's been lingering in penny-stock territory, I would be skeptical jumping on this news today. But if an agreement is reached, it would be worth evaluating the details to see if a profit is finally in the future for Eldorado Gold.

Warren Buffett Underestimates Warren Buffett

"My theory, Warren, is if it can't stand a little mismanagement, it's no business."�-- Charlie Munger

Let's say some pretty obvious things about Warren Buffett, starting with this: he's pretty good at investing. Good enough that�Berkshire Hathaway�(NYSE:BRK-A)(NYSE:BRK-B) shareholders of long standing (of one I have been for several decades) have profited wildly from his talents. Some have seen their entire financial condition altered, for the better.

So it's fascinating that, at age 87 and with a track record of success that almost defies reason, Warren Buffett seems so dearly to underestimate Warren Buffett. When he says "the reputation belongs to Berkshire now. We are the first call and will continue to be the first call," I have to wonder if he is kidding himself about his importance to the business. Even though Berkshire Hathaway�is a $500 billion company, it is very much overshadowed by Buffett.

Image source: The Motley Fool.

Warren Buffett's 70-year track record is amazing simply because he has enjoyed enduring market-beating returns while most kinds of investing success are mean-reverting. In A Random Walk Down Wall Street, Princeton professor Burton Malkiel showed how most mutual fund managers who outperform the market one year do not do so over subsequent years. The reason for this is pretty simple -- you make a bunch of good calls in stocks, they go up, then you sell and have to repeat that process. The repetition is not so easy. Times change, valuations change, people notice you've done well and copy you.

As an object example, 42,000 like-minded contrarians just sat for more than 6 hours to listen to Warren Buffett talk about investing. In uncomfortable chairs. In Omaha.

I once wrote�that Buffett was so good at making money that if you asked him to break a twenty, he'd give you two $10s and somehow have $13 million left over. I also once wrote that if investing were a card game, Warren Buffett's hand would have 37 aces in it. I like these quotes because they're funny but also because they employ proper punctuation.

He's historically great because he applied a discipline and logic to investing employed by few others. But Buffett has also received plenty of additional self-reinforcing benefits. For example, simply a report that Warren Buffett has bought a stock makes that stock go up. The timeframe doesn't matter as much to him since he holds stocks for such a long time, but the impact is there.

There's also the transitive property of Buffett, in which he invests in regulated industries where regulators may be more lenient on behavior because Warren Buffett is doing it and Warren Buffett does good things. A mobile home lender or a wild,�finite risk retrocessional transaction might receive less scrutiny as a result.

But the third area of self-reinforcement -- which he seems to discount -- is by far the most important. When companies want money, they tend to offer Warren Buffett deals on very favorable terms. This is what Buffett means by Berkshire Hathaway�being the "first call." And I think he has lovingly rendered Berkshire in his own image, but there is a reason that the media focuses on Buffett whenever Berkshire does something -- his name matters more. During the financial crisis, Goldman Sachs offered Berkshire warrants to go along with a $5 billion purchase of Goldman's preferred stock with a 10% dividend, plus warrants for 43.5 million shares. Did media reports focus on Berkshire Hathaway�or Buffett?

(What do you think? To channel Bloomberg's Matt Levine, "Buffett" sounds much better than "Insurance-Railroad-Candy Company Converts Crisis-Era Warrants for 2.8% of Goldman Sachs.")

That's because the Buffett reputation gives his deal partners something besides money -- it gives them access to the Buffett halo. That was incredibly valuable to Goldman, and to Bank of America, in the aftermath of the collapse of Lehman Brothers.

Buffett also buys whole companies, where these same publicly facing signals do not matter. There are lots of benefits for sellers to join the Berkshire Hathaway family: the ease of the transaction, the decentralized model, the retention of independence. But let's also put another one on the table -- it has to be pretty cool to sell your company to Warren Buffett, to have him say the occasional nice thing about you, to have the ability to pick up the phone and give him a call whenever you'd like.

This matters because actuarial tables suggest that Buffett will not be running the show at Berkshire Hathaway forever. And when he turns it over to someone else, the company will still be massive. And what then? If we agree that investing is largely mean-reverting, and if we agree that managing huge amounts of money creates huge challenges (how many hidden multi-billion deals are there?) then we have to accept the possibility that the personage of Warren Buffett matters, and it will matter much more when he's gone than he seems to admit.

Yes, Berkshire Hathaway's culture is amazing, but its culture also places an enormous amount of judgment in the hands of a single decisionmaker. Think about it this way -- if you were to set up a company today, would you want to have the CEO decide to invest billions of dollars on a whim, with no due diligence, lawyers, etc.? You'd better hope you have the right man or woman in charge if you do. Warren Buffett is the right man. But what if the next person lacks his same charisma? Does the Berkshire culture survive?

Buffett is also a champion of good corporate governance, which has benefited other investors who have never held a share of Berkshire. He has used his bully pulpit for good, including when he simply, during the worst of the financial crisis, wrote "Buy stocks. I am." I think as a tribute we should just go ahead and rename "all-you-can-eat buffets" to "all-you-can-eat-Buffetts." He'd appreciate the thrift. And the wordplay.

But it's also possible that he's underplaying the influence he has on the actual company he manages. His vice chairman, Charlie Munger, is 94 and won't be taking over for Buffett. I have been hoping against hope for a few years that he would invite his eventual successor up on stage to publicly start the transition with Buffett while he is still alive and in charge. I suspect that there is no person who will need the Buffett halo more.

3 Option Trade Ideas In Micron Technology

When analyzed from a quantitative perspective, Micron (MU) looks like a compelling investing idea. The stock is clearly cheap, and the business is reporting solid financial performance. However, uncertainty about pricing in the DRAM and NAND markets is a major risk factor for investors in Micron.

In order to mitigate those risks while still capturing some upside potential in Micron, the following paragraphs will be introducing 3 different options trades ideas based on Micron.

Micron Stock: Opportunity And Risk

Looking at the numbers, Micron stock seems to be offering plenty of upside potential from current levels. The company reported impressive financial performance last quarter, with revenue growing 58% versus the same quarter in the prior year and reaching $7.3 billion. In addition, the company retained 48.5% of revenue as operating profit during the period.

In spite of this, valuation remains remarkably low. Wall Street analysts are on average expecting the company to make $9.85 in earnings per share next year. Under this assumption, Micron stock is trading at bargain-low forward price to earnings ratio of 5.4 times earnings expectations.

This valuation is arguably due to pricing uncertainty in the company's main markets. According to data from Notable Calls, market dynamics for DRAM products are deteriorating rapidly. On the other hand, some Wall Street analysts remain aggressively bullish on the stock; on May 17 RBC Capital initiated coverage on Micron with a price target of $80. This implies a massive upside potential of almost 50% from current price levels.

Micron stock is basically an investment alternative with high risk and elevated potential returns. If pricing in the DRAM market remains relatively healthy, the stock could deliver huge returns for investors going forward. However, the industry is notoriously volatile and uncertain, and this uncertainty is weighting on the stock.

In terms of price action, Micron is up by almost 30% in the last 12 months, but the stock is moving mostly sideways in the past several months. Micron stock made new highs at around $62 per share in March, and it seems to have well-defined support levels at around $45 and $40 per share.

Options Trade Idea 1: Bull Call Spread

The bullish case for Micron is easy to see. If you believe that fears about falling DRAM prices are exaggerated, then it makes a lot of sense to make a strong bullish play on Micron. From that point of view, a bull call spread looks like an interesting idea.

For example, you can buy the call contract with a strike price of $53 expiring on June 29 and sell the call contract with the same expiry date and a strike price of $65. Based on prices at the midd-point of the bid and ask quotes, that spread would have a total cost of $345 per contract.

The maximum loss in this case is obviously the cost of the contract, and investors can gain as much as $855 per contract if Micron stock is above $65 on June 29. In percentage terms, this would mean a juicy gain of 247.83% in only 40 days.

The breakeven stock price for this strategy is $56.45 per share, so you need the stock to move upwards in order to make money from this trade.

Options Trade Idea 2: Covered Call

A covered call is a more conservative play, allowing investors to generate recurrent income from a position in Micron stock in exchange for a reduced upside potential in the position.

For example, buying 100 shares in Micron at a current price of $53.4 and selling the June 29 call with a strike price of $65 would generate $75 in premiums. This is a raw return of 1.4% in 40 days, which means an annualized yield of 12.8%.

As long as the stock remains above $52.53 per share this position remains above breakeven, so it's a smart way to reduce the effective entry cost when betting on Micron stock.

This is a good alternative for investors who want to own the stock and also want to be well rewarded for their patience by generating income from such position.

Options Trade Idea 3: Bull Put Spread

Another possibility would be a bull put spread. For example, selling the June 29 put contract with a strike price of $50 and buying the put contract with the same expiry date and a strike price of $46 would generate a cash entry of $112 per contract at current prices.

The maximum possible loss would be $288, which doesn't sound very exciting in comparison to a maximum possible gain of $112. However, based on historical volatility levels for the stock the chance of success in this strategy is above 65.2%. This strategy makes money as long as Micron stock remains above $48.88 by the options expiry date.

A bull put spread makes sense for those who believe that the main risks in Micron are already reflected on valuation and that the downside risk in the stock is limited.

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Disclosure: I am/we are long MU.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.