- Bitcoin is known for its wild price swings, but there’s one sector of the stock market that is even crazier, according to Don Ross, the chief executive officer of PDQ Enterprises.
- Ross told Business Insider trading in US small caps can be even more volatile than bitcoin. He thinks an auction model for trading in small caps would remedy that volatility.
Bitcoin, the red-hot cryptocurrency, is known for its spine-tingling volatility.
Its wild price swings have gripped the attention of Wall Street and make most moves in US equities look trivial.
But there’s one area of the stock market where trading is even crazier than bitcoin, where big trades can have a sizeable impact on the price of a stock, according to Don Ross, CEO of PDQ Enterprises, operator of CODA Markets, a Chicago-based dark pool.
That’s US small caps.
“As a major hedge fund chief investment officer put it recently,” Ross said in a blog post. “Trading small caps can be like ‘sticking your hand in a fan to see if it’s running.’ You may get your trade done, but you’re likely to be bloodied.”
That’s because there is often limited liquidity in the market for small caps. Thus, a big trade can impact the price so much that it ultimately will eat into the returns a trader is seeking to capture.
To illustrate his point, Ross points to Fonar, a small cap company trading on Nasdaq. When Fonar sees a lot of trading activity, its price is far more impacted than when bitcoin sees a lot of trading activity. Here’s Ross:
“$US5m in [daily] notional turnover is on the high end of normal for the stock. And at that level, as we see in the graphic [above], price variance, at bps, is not only way beyond what we see for SPDR S&P 500, at 0.25bps, but way beyond what we see for bitcoin! Bitcoin price variance is a mere bps at the $US5m turnover level.”
Ross said more than 4,800 stocks fall into the same camp as Fonar. He thinks a lack of liquidity among small cap companies can be remedied by changing the way they are traded.
“Most are relying on continuous markets, where a buyer missing a seller by seconds can result in opportunity costs that noticeably harm investment returns,” Ross said. “But there is no reason to rely on inapt and outdated market structure when computer technology is so vastly superior to what it was even a few years ago.”
Ross said small stocks would see better trading on a market with an auction model, not a continuous model. Trades in a continuous market model are executed on an ongoing basis whenever a buy order is matched up with a sell order, whereas orders in an auction model are all collected and then matched at a specific point in time.
To be sure, Ross’ CODA Markets is a dark pool that conducts trading via the auction model. Still, other market structure buffs agree that an auction model can help address the illiquidity many small caps face.
“I think it’s a good addition to the market, as buyside traders consistently tell us that finding small/midcap liquidity is one of their biggest challenges,” Richard Johnson of Greenwich Associates told Business Insider.
Johnson said there are a number of companies on the Street looking to launch an on-demand auction model.
“Stocks can be traded in automated on-demand auctions-auctions that summon latent liquidity to execute small cap trades with no information leakage and far less market impact,” Ross said. “Whereas continuous markets fragment liquidity through time, auction markets aggregate it-tamping volatility and making better prices for investors.”