Market Manipulation: A Recipe in Three Parts

Price Manipulation and its cousin “mismarked books” are as much a product of systemic
dysfunction as they are of unethical individual behavior. The 3 part series we have planned is
educational in nature and aims to outline those system-wide imperfections at the highest level.

For today we must focus on what is shaping up to be a rare opportunity to watch a pitched battle
between major players in Gold. In short, we are interrupting your regularly scheduled program.

Current Events: The Potential Pin in Gold Options Tomorrow

Right now there is a war in Gold options. It is between the May 1520 longs, who most
likely are unhedged, and their short option counterparts, who most likely are hedged.
One would think the longs intend to sell futures at some point, perhaps 1520, perhaps
1540 we do not know. It is also possible that they intend to take delivery, but that is
unknowable for the moment. The shorts are probably delta hedgers and have no desire
to see this market go above 1520, much less move at all.

The Players

The Longs- have accumulated over 5,000 lots in a two week period and we
would assume they are bullish. They are patient dip buyers and seem to have
little fear of the Bullion Banks that are often accused of manipulating PM prices
lower or keeping prices range bound at expiration.

The Shorts- are Bullion Banks, market-making firms, locals and possibly some
hedge funds. There is no collusion implied here. In fact, these firms are usually at
odds with each other in terms of option open interest. The majority of the shorts
trade options from a non-directional point of view. That is, they are professionals
who, when short an option do not want the market to move either way.
Conversely, when they are long an option, they want the market to move quickly
through or away from the strike they own.

The Play
We feel the Longs were betting that once the gravitational pull of the $1500 strike was
broken, that the market would move quite easily to the strike with the next largest open
interest, the $1520 strike. They may be privy to large order flow in futures, they may
have large futures order flow, or they may simply be speculating with nothing other than
their wallets and the ability to read market behavior through price action. They can spot
a market that is lopsided in one direction when they see it.
Snapshot: May Gold Open Interest

open
product contract type strike volume
interest
OG May-11 C 1480 598 2303
OG May-11 P 1480 368 675
OG May-11 P 1485 271 341
OG May-11 C 1485 11 666
OG May-11 C 1490 5 970
OG May-11 P 1490 379 416
OG May-11 P 1495 86 280
OG May-11 C 1495 35 361
OG May-11 C 1500 211 6762
OG May-11 P 1500 445 522
OG May-11 P 1505 17 333
OG May-11 C 1505 76 306
OG May-11 C 1510 507 1731
OG May-11 P 1510 344 116
OG May-11 C 1515 116 1374
OG May-11 C 1520 580 5823
OG May-11 C 1525 143 747
OG May-11 C 1530 128 578
OG May-11 C 1535 95 289
OG May-11 C 1540 9 730
OG May-11 C 1550 40 1570
OG May-11 C 1600 26 1515

The Next 48 Hours

We have alerted the reader to this possibility for the past week. All that remains is this:

Today the LME is closed

This deprives the market of a deep source of liquidity. While the LME Players are surely
watching and trading today, we suspect the “A’ teams may not be, however, as holiday
continues for many and trading at 9PM London time is not very fun if you are an MD at
a large Bank. Also remember there was no LME fix today, which has an effect on
balance sheets for London firms. No London Fix, no Balance Sheet Axe, so to speak.

Tomorrow Comex Options Expire

If the Option Longs are right, then the market will be propelled through the 1520 strike.
Futures should receive additional support at some point from the negative gamma
hedging of those non-directional players who MUST adjust their delta hedges. The
longs are playing for a longer time line than the shorts in this instance.
If the Option Shorts win this battle then we will pin the strike. Remember, a violent sell-
off is not good for the shorts either. A pin means the options go out worthless
theoretically, and the future hedges that longs carried against those shorts can be
liquidated for a profit.
Let’s assume next that the Options Shorts “win” this battle and through hope, prayer, or
their own attempts to keep the market in a range, the $1520 strike is Pinned or near-
Pinned on the closing bell at 1:30 PM ET tomorrow.

The Pin
If a Pin occurs, the longs have another two and a half hours to decide if they wish to
abandon or exercise their calls. They own the optionality at the strike. The option shorts
can still lose a lot of money, even if the option longs make none. A sell-off is very
possible, wherein the option longs abandon their calls, but the option shorts still have
hedges to unwind. The Shorts would be forced to use statistical methods to determine if
they will get exercised or not. More than likely this is a digital event, and statistics do not
matter when most of the contracts are in the hands of a single player or a group of like
minded players, as may be the case here. We are likely looking at an all-or-none
exercise if we pin the strike. The shorts would be in the dark.

Manipulation in the Metals Market

A multitude of individuals and firms have been accused of market manipulation, over the
years. Many individual traders have been brought to task for their actions. The Hunt
Brothers attempt to corner Silver, Yasuo Hamanaka of Sumitomo for his copper
manipulation in 1995, by, various “rogue’ traders and brokers and most recently, the
CFTCs successfully prosecuted of a case involving Brian Hunter of Amaranth for his
actions in the natural gas market. Nonetheless, very few firms have suffered
commensurately.

Business as Usual
Firms that have been successfully prosecuted continue to operate in the markets they
have manipulated, usually with monetary wrist slaps. To be fair, major firms settle
disputes all the time, but the fines are not proportional to their balance sheets when
compared to the individual fines; nor are the firms’ abilities to go back to business-as-
usual in the market place affected.

It’s Baked in the System

We believe manipulation is a product of many things, and attempt here to boil them
down to three broad categories. First, the U.S. Government’s accounting and regulatory
policies unintentionally enable these events to occur. Second, the rights accorded
corporations give them the ability to mandate profits above all else, all the while getting
the same privileges an individual person does. Companies have no social contract and
their goal is to continue to exist, a combination easily misused. Finally, market structure,
especially in commodities lends itself to a tail wags the dog situation wherein the
transparent pricing mechanism for settling contracts is not where most of those
contracts actually trade. This results in a disconnect between liquidity and price that can
lead towards “managed market” abuses.
We intend over the next week or so to outline at the highest levels how government
policies, corporate mandates, and market structure contribute to the moral hazards in
derivative markets.

For today and tomorrow, we will just be watching the Precious Metals markets
like we suspect many of you will. Good Luck.