Here's a brainteaser: Did DH Corp. plummet 17 per cent Monday because the skeptical short seller behind a scathing report lined up hedge funds to suddenly back its trade, or did the stock tank because rational investors saw the short's report and quickly agreed?
Or, was it that a few investors saw the report and started selling, prompting algorithmic trading programs that prey on momentum to take over?
The frustrating answer: It's almost impossible to tell.
What transpired with DH's shares is something akin to a trading black box, and it's a scenario that is becoming much more common.
The recent criticism of Valeant Pharmaceuticals, voiced by a short seller, is the most obvious parallel – but it is just one of many. There are now full-day conferences in cities such as Toronto and New York designed to give money managers – some of whom call themselves "research analysts" – a stage to market their ideas. Sometimes their pitches fall on deaf ears, but when they do catch on it's practically impossible to figure out why.
The black box is partly created by the rise of electronic trading. Historically, investors had to execute their big orders through trading desks, and that made select people privy to what is happening in the market. Traders knew who was putting orders in and that information could be shared selectively, meaning at least a few people knew who was behind the trades.
Today, investment funds can trade using direct market access, or DMA. Using this method, they electronically connect their accounts to trading platforms provided by financial institutions that then process the orders. No need to talk to someone to execute large trades.
Complicating things even more, many trades are now done under the "anonymous" banner. Canada is a unique market, in that many clients are still willing to let traders show that their orders were executed through a given investment bank. If Toronto-Dominion Bank buys or sell shares for, say, Ontario Teachers' Pension Plan, more often than not you can track that TD executed the order. (Though you can't see who TD bought and sold for – only the stock being traded.)
When people trade under the anonymous banner, no one can tell who's doing the buying and selling, because the investor effectively has an invisibility cloak. All he or she needs to report to authorities is that shares were bought and sold – not by whom, nor where. The buyer or seller could just as well be an algorithmic trader, a high-frequency trader, a sell-side Bay Street trader, or me, trading through my personal account. Twenty-five per cent of DH's shares were traded under the anonymous banner on Monday, constituting the highest percentage of orders.
This doesn't mean there's never any accountability. Laws dictate that anyone amassing a stake in a company must eventually report their position under certain circumstances – once they own enough shares, for instance. But until then, they can largely do what they want, unnoticed.
It gets even more complicated when accounting for options activity. One example: short sellers have to mark themselves as such, and so-called "short interest" is published biweekly, so it can seem as though there is decent disclosure. But there are ways for investors to mask what they're really up to.
A reversal strategy, which involves shorting the stock but then also buying a call option as well as selling a put option, can do just that. It gets complicated, but the main gist is that an investor can make it seem as though there's increased short interest for a stock even though they have a separate position in a different market, which skews perceptions.
Confusing things even more is the fact that options trades and stock trades can be monitored by different regulators. If the regulators' systems don't speak to each other, it's way too tough to know what's happening.
None of this is to say that what the short sellers do is good or bad. All it means is that it's very, very hard for anyone to figure out what's going on. And in any market, uncertainty is what drives investors nuts, sometimes pushing them, or their computers, to be even more irrational.