Discount Futures Brokerages Are Contributing to Volatility: Why It Matters

Since March 2020, the commodity markets, and financial markets for that matter, have been fraught with volatility. One could also argue the markets have been unusually unruly since the financial crisis.

We are constantly hearing stats such as "This is the worst month on record" for this asset, or the "best start of the year" for that asset. These types of events have become the norm rather than the exception.

We've spent a lot of time asking ourselves why. The truth is, there is a multitude of factors that are contributing to market volatility.

Most of them are widely accepted and discussed (central bank manipulation, black swan events, electronic access to markets breeding speculative frenzies, and algorithmic trading systems).

Still, there is one that is being largely overlooked. That is the impact of discount brokers, or more specifically, their risk management policies, on price action, particularly at peaks and troughs.

Market Prices Don't Have to Make Sense in the Short Run

We've been fielding a barrage of questions from brokerage clients, followers, and even friends and family regarding the collapse in natural gas prices. The basic inquiry is, "how can this happen?" or "why did this happen?"

My answer to their question is, "In the short run, prices don't have to make sense, but the math must work for commodity producers and end-users in the long run." It is one thing to see an asset with questionable intrinsic value, such as cryptocurrencies or meme stocks, go bust, but a commodity that plays a role in nearly everyone's daily life falling 80% in months, not years, is eye-opening.

A client recently called and asked, "Who wakes up in the morning and says, 'I want to sell natural gas at multi-year lows?'" The reality is, most of the selling is likely done by those who must sell, not those who want to sell because they are bearish. Further, a good chunk of the sell orders are likely not submitted by retail traders at all; their brokerages do so on their behalf in the name of risk management.

Blow-Off Tops and Bottoms Are Real

Although the market is always right, it is not always rational. This makes sense because real-time market prices result from human response to information and, more importantly, emotion. For this reason, since the beginning of centralized exchanges, we've seen chart patterns known as blow-off tops and bottoms.

A blow-off top is a scenario in which traders are highly motivated to buy at historically elevated prices due to FOMO (Fear of Missing Out) followed by the need to buy out of necessity (short traders running out of money, conviction, or both). Once the last of the buyers have plugged their noses and hit the execution button, the buying dries up, and prices reverse.

This reversal is often sharp and painful to those late to the party. Even worse, those bears who were either stopped out, panic liquidated, or force liquidated by their brokerage firm are stunned by the amount of money left on the table. As a broker, this is a problematic phenomenon to watch -- and is my least favorite part of the industry. Without fail, overextended trends end when retail traders throw in the towel by choice or by force.

In the past, the throw-in-the-towel price action in markets was seemingly less violent and less common. There are some obvious explanations for this, one being the electronification of markets.

Electronic execution enables market participants around the globe to react to events in real-time with a simple click; in turn, the trade is more susceptible to emotional execution. But it's been increasingly apparent that the price spikes that occur at blow-off tops and bottoms are exacerbated by brokerage firms force liquidating their clients as a means of risk management.

While this has always been a factor, the last few decades of futures trading have brought about a new breed of futures brokers, those of the discount variety. Customers do get what they pay for. I will elaborate later.

Futures Brokers Accept Risk for Commission

Futures brokerages are in the business of accepting the risk of their client's leveraged trading activity in exchange for a commission.

Unlike stocks, which expose investors and traders to limited risk, futures contracts come with unlimited risk. Occasionally, this could result in traders losing more money than they had to lose (on deposit in their trading account). Should a client account go debit (have a negative balance), the broker must immediately shore up the deficit with the exchange to ensure the functionality of the exchange is not impacted.

Brokerages are not charities, so paying for client losses or granting them interest-free loans to shore up obligations with the exchange is not desirable. Further, many are surprised to learn that if an individual broker is assigned to a client's trading account, it is the responsibility of that broker, not the entity he or she works for, to cover the shortfall.

Throughout my career, I have personally been held accountable for life-changing sums of money to cover losses sustained by clients who were unable to meet their obligations. Because of such experiences, I don't judge or criticize discount brokers for their margin and liquidation policies, but I think it is important to recognize the unintended consequences.

Brokerages set commission rates based on the perceived risk each client poses. Doing so is necessary for longevity; those that don't assess the risk and reward of being the middleman to a leveraged futures contract won't be in business for long.

While there are some gray areas, most brokerages opt to operate on either a discount commission or a full-service model. A few, such as my brokerage (DeCarley Trading), offer an in-between service. The business model chosen, and more importantly, the commission structure offered to clients, determines how much client risk can reasonably be accepted by the broker for long-term sustainability.

Discount Brokerage Clients get what they Pay for

The lack of commission revenue requires the brokerage to cut corners in either customer service, risk tolerance, or both. Thus, discount brokerages quickly liquidate client positions as a protection mechanism.

Even worse, discount brokers, as opposed to traditional full-service brokerages, have mostly opted to do away with margin calls. This means if a client account becomes overleveraged to the point at which the net liquidation value of the account is less than the the brokerage's required margin, which can be higher than the exchange's required margin, they simply liquidate positions without alerting the customer to their action.

This differs dramatically from the previous business practice of brokerages notifying clients of margin deficiencies and giving them a window of time to react by either trimming holdings, wiring funds, or entering hedging (margin-reducing) positions. To clarify, most traditional commodity brokerages, like mine (DeCarley Trading) still practice a margin call model, but as commissions plunge this type of protocol is becoming less common.

Mass Forced Liquidation Moves Markets

Although I cannot fully explain how or why, Murphy's Law, and years of observation, lead me to believe large number of retail traders run out of money at roughly the same time and price.

Perhaps traders look at charts and price history to assess what they believe would be the worst-case scenario relative to their account size and choose position sizing accordingly. It is not unlike the tendency for traders to put stop losses in the same general area. Thus, it is not hard to imagine a scenario in which the computerized risk systems utilized at discount brokerages to force liquidate overleveraged clients doing so in mass without concern over price.

The automatic process creates a price vacuum because the market is hit with an overwhelming number of sell orders relative to the available buy orders. The result is a stunning spike lower in prices.

Although the liquidation volatility isn't fundamentally sustainable in the long run, it is capable of ruining the day, year, or lives of retail traders caught on the wrong side.

Overnight Sessions Are Fraught with Blow-Off Top/Bottom Risk Due to Low Liquidity

It is also worth noting that brokerage-induced liquidation often occurs in the overnight session. This is when trading volume is the thinnest, but the risk to brokerage firms is the largest. Consequently, those discount brokers who are not interested in the margin call process are generally active in the overnight session liquidating client accounts. The result is often large and unusual price moves exacerbated by forced liquidation while most people should be sleeping.

Ironically, trend reversals tend to occur in overnight sessions; imagine being blown out of short crude oil trades near $130.00 in the middle of the night only to wake up the next day with prices $10.00 lower and $20.00 lower a few days later. This was likely a reality for many retail traders in mid-2022. That is one of the dozens of examples I've witnessed; traders squeezed out of positions at the worst possible time only to watch the market move in the desired direction without them.

Why Does It Matter?

Those who aren't actively speculating in the markets are probably thinking, "who cares"?

Long-term investors are less concerned about intraday or intraweek or intramonth volatility. Yet, if the price action becomes extreme enough, it might influence buy-and-hold investors to stray from their plan and liquidate holdings in panic. Further, price action in the futures markets affects buy and sell orders that occur in cash markets (both stocks and bonds); in many cases, the repercussions of those reactions persist for months.

An example of this was last year's runaway wheat and crude oil rallies at the onset of the Russian invasion of Ukraine. The seemingly endless runs in commodity prices triggered inflation concerns, which led to unprecedented selling in Treasuries.

In short, these types of futures market liquidation events bleed into investment markets and can cause real pain at the consumer level.