Tradesports Contract Direction When No Trades Take Place

Level 2 as a Guide To Market Direction

Leading up to Skillings cross examination, the Tradesports contracts priced in a 70% chance of expiring at 100. Once Skilling took the stand, no trading took place until he had finished at the end of the week. With no price action can a trader determine if ther is a change in market sentiment? Or did his entire time on the stand have no effect on his odds of being convicted? Using the pending bid and offers when there is no price action can be a useful guide to where the market makers think the price action will go.

The Market Makers

Prior to taking the stand the Skilling contract bid-ask was approximately 5-7 points and, in theory, straddling the true price of the contract. Trading spreads are determined by inventory (in this case margin since there is no real "inventory"), order processing (not really a factor here), and adverse selection. Adverse selection means that the market maker is always in danger of being picked off by an insider or someone with more information. A less liquid contract requires a MM to increase the spread. The more likely a market maker is to get picked off on a contract, the wider the spread needs to be to compensate the MM for the risk.

Last week while Skilling was on the stand in Houston there was no trading but the bids and offers showed a lot of movement and widened. Spreads should widen around events that cause volatility, so this was no surprise, but the skew was heavily to the downside indicating that the MM's feared the contract not paying off. The contract that had been bought last in the 70's could still be bought at that level, but the sell side disappeared from 68 down to 50. The Bids dropped and the Offer didn't move, showing the expectations of the market maker even though no trades took place. Their expectations were to the downside since they were willing to sell at the same price but would only purchase contracts at a much lower level.

Followup

The market on Friday bumped up three points on the Skilling contract on no news. The MM's indication of a downward move didn't happen and the contracts for Lay and Skilling have settled down to the 70's where they have been for most of the trial. The spreads tightened to the upside and are now unnaturally tight for this contract. On current levels the initial trade rec holds: Long Skilling and Short Lay