It’s Black Friday in the US which is the start of the traditional Christmas shopping season.  To get us in the shopping spirit I figured we could all use a Dikensian visit from the Ghost of Black Fridays Past.  The ghost that happens to be pulling the late shift this year is from 1996 which turns out to be a pretty interesting year, Black Friday wise,  for two reasons: eBay and Tickle Me Elmo.

For those who don’t remember, Tickle Me Elmo was the hot toy of 1996.  It was a small red push doll of the Seasame Street charater Elmo that, thanks to some nifty electronics, laughed when you squeezed or tickled it.  I have no idea if it was actually a good toy – maybe two year olds just loved it.  Regardless, their parents went batshit insane over Elmo, first buying up all available inventory and then paying highly inflated prices on the secondary market.  Prices reputedly went as high as $1500.  The situation got so out of hand that mobs developed at stores rumored to have new Elmo shipments.  This eventually culminated in a riot at a Wall Mart midnight madness sale where an employee holding the last Elmo was beaten by customers and ended up with a broken jaw and ribs.  Just to add a surreal aspect to the whole thing the mob also aparently ripped off the employee’s pants.

While brick and mortar retail was beating back the Elmo-crazed hordes and finding their pants, eBay was introducing the world to the idea of internet retail.  Only at the time, it wasn’t called eBay but instead “AuctionWeb” – a name so lame I’ll refer to them as eBay even though they didn’t get around to changing it until 1997.  In 1996 they were the closest thing to a general purpose store on the internet – Amazon and the like wouldn’t branch out into general retail for another couple of years.

It’s here I want to pause this rather silly history lesson for a second and switch to the more serious topic of speculation.  One of the basic theses of this blog is that speculation is business.  I don’t mean that in the hokey infomercial sense that trading can be a work-at-home business for you.  Maybe it can, maybe it can’t.  There’s lots of factors that go into that.  What I mean is that speculation is just like any other middle man business – running a retail store or selling cars or whatever.  This isn’t just an analogy, it’s a subset relationship – speculation is a type of business.  If you set yourself up speculating in oil futures, you’re opening up a little shop of oil.  For some reason novice speculators seem to have a hard time accepting this idea.  Not so much intellectually accepting it, but actually behaving as if they were an “oil store” or a “Microsoft stock store” or whatever.  This can lead to some very odd and costly behavior – many novice speculators don’t take their markets nearly as seriously as their counter-parties do and never really figure out how to set themselves up as a useful middle man.

My goal today however is not to browbeat you to take your trading more seriously.  Rather it’s to help you tap into a stash of very useful speculation skills you didn’t know you had.  Specifically, knowledge about how to run a middleman business.  And for that, I want to return to eBay and run a thought experiment business selling there.  Now when I say you already know something about this, I’m not claiming that everyone reading this blog has experience running an eBay store.  Probably very few of you do.  But I do believe that most people are more easily able to access whatever business knowledge they do have thinking in a context like eBay where there are physical goods and known players rather than in the abstract and anonymous world of electronic trading.  What I hope to do with this post is show you that what you know about “conventional” business translates in a very concrete way to financial speculation.

So it’s 1996 and we’ve got a brand spanking new eBay business, which right now consists of $10,000 in capital and a computer with an internet connection.  After you get the paperwork out the way, the big decision for this business is exactly what you’re going to sell on eBay.  While picking specific goods might be complicated, this is a place where most people can come up with a pretty good answer as to what kinds of goods are of interest.  This is what I mean about people having existing knowledge about being a middle man.  If you asked Joe Sixpack you might get an answer like:

• something a lot of people want to buy
• something you can sell for a lot of money

These are actually remarkably good answers – put in business speak, the first is getting at total available market, sometimes abbreviated TAM.  The second is really gross margin – the difference between the cost of the goods and the price customers will pay for them.  These are the right two things to be concerned about – more transactions and a higher margin per transaction means more profits.  When rational businesses consider entering a market, those are about the first two things they consider.  So Joe Sixpack knows more about being a businessman than you might think.

Hopefully you’re seeing some parallels between our eBay store and financial speculation already.  One of the fundamental features of speculation is that you get to decide what markets to be active in, and when.  Unless you’re in the position of having a contractual obligation to make a market (something no one reading this blog needs to worry about) then you’re free to enter any market you can meet the capital requirements for at essentially any time, and likewise exit whenever you feel like.  That flexibility is an incredibly powerful tool and it’s surprising how few speculators take full advantage of it.

Back to our 1996 eBay store, we could spend a lot of time evaluating goods but I’ll just jump to the chase.  As you may have already guessed, the item you’d most like to have on the shelves of your virtual store is a Tickle Me Elmo.  The margins are huge – while you probably won’t sell it for $1,500 it should be very possible to get $250.  At wholesale an Elmo costs about $15 – a margin of 1666%.  That’ll work.  And if the mobs at Walmart are any indication there’s no shortage of buyers – whatever the TAM is, it’s far more than you can possibly satisfy.

There’s only one problem: you don’t actually have any Elmos.  You’ve got money.  And if you just go out and buy Elmos on the open market you’re going to be participating in the same braindead buying frenzy  your would-be customers come from.  That’s buying high – no way to make money.  What you need is a supply of Elmos at a reasonable price.  That price doesn’t have to be $15, but it has to enough less than $250 that you still have plenty of margin left.  If you could buy Elmos at $75, say, that would still be pretty good.  Hopefully again my reader’s innate business sense is kicking in and some ideas come to mind about how one might find cheap Elmos – maybe you put an ad in the paper (yes, in 1996 people still read the paper) reading “Will buy Tickle Me Elmos for $75 per” and see if anyone calls.  Maybe you go around to local toy stores and suggest that, were they to get some Elmos in, you’d buy them off the loading dock for $75 a piece and not rip anyone’s pants off.

And then, having put your sign out, you wait and see if you get any Elmos.  Maybe no one calls.  Maybe you get 5 or 6 from the newspaper ad.  Maybe the local Toys-R-Us decides they don’t need a riot and sells you a pallet of 100 off the loading dock.  Whatever you get, you throw on eBay and hopefully get a couple hundred dollars each for them.  If things go well you could very easily double your nascent firm’s capital in only a few weeks of work.  What’s remarkable about this particular approach to stocking your store is that there’s very little chance you will lose money or get stuck with unwanted inventory.  In order for that to happen, the Elmo shortage would have to end which seems unlikely.  The very thing that would end it (increased supply of Elmos) is the very thing a shortage implies doesn’t exist.

The basic logic of your Elmo deal is as follows:

1. Identify a good to speculate in based on sufficient TAM and a shortage of the good, which manifests as increasing price and gross margin.
2. Determine a “will-buy” price for that good which takes into account the shortage, leaves you sufficient margin, and leaves a reasonable chance someone will sell to you.  Make it be known you will buy the good at that price.
3. Wait for someone to take you up on your offer.  If someone does…
4. Sell the good at full post-shortage prices on the open market

Now I said before that speculation is just a specific form of business and that the logic is the same.  What I want to do now is show you how you would convert this exact same line of thinking into a financial speculation.

Step 1 is to find a market with a sufficient TAM and a shortage.  For simplicity’s sake let’s use the S&P 500 index futures market (GLOBEX ticker ES).  It’s huge and quite likely has more TAM than anyone on this blog can make use of.  Now we need to identify when there’s a shortage of ES.  We have two tools to do that – increasing price and increasing gross margin.  Price is easy to track – a candlestick or OHLC chart will serve nicely.  But tracking gross margin is somewhat more difficult for a couple of reasons.  First off, when we discussed gross margin for Elmo we were talking about the difference in price at two different markets.  One was the retail market where we intended to sell Elmos.  The other was the wholesale market where we wanted to buy them.  At first glance ES doesn’t have this property – there’s just one market, GLOBEX.  But as I previously alluded to, there’s actually two markets implied within that – a market of people bidding to buy, and a market of people offering to sell.  These are the two sides of the order book.  They serve the exact same roles as the wholesale and retail markets respectively did in the Elmo example.  So now we know how to compute gross margin – we watch transactions that execute at offer and average their prices over some period of time.  That’s the average selling price.  Simultaneously, we observe transactions that execute at bid, and average those prices.  That’s the buying price.  Subtract buying price from selling price, and that’s gross margin.

Now we come to a second difficulty – as central an idea as gross margin is to business (and I would argue speculation), very few other speculators seem to agree.  For example there’s no built in tool in NinjaTrader (my personal choice of charting packages) to compute it the way I described.  There’s not even any simple pieces to chain together to make such a tool.  Thankfully I’m comfortable with programming and NinjaTrader is easily extensible, so it wasn’t that hard to code something up.  Here’s a candlestick chart of the ES on 11/14 for about he first hour and a half after morning equities open with my new indicator:

The red and green lines on the candlestick part of the chart a buyer and seller price averages over the last 5000 trades on each side of the market.  The orange oscillator at the bottom is gross margin calculated from those lines, but averaged over a longer period of time (15,000 trades each).  Next post I’m going to use this chart to show how you trade the ES using the above logic, but for now just contemplate it and try to find the locations where there are ES shortages.

Continued in Part 2.