Lesson 18 of 25 · 7 min

Why the bid thins before the price falls

Size behind the quote is the first casualty of rising volatility, and it can halve while the last traded price is unchanged.

The first symptom of a funding stress is not a lower price. It is a smaller quantity at the same price, which is a change that leaves no trace on a chart.

The constraint is on the intermediary's side. A firm that stands ready to buy works to a limit on how much price variation it is willing to carry in inventory overnight, and that variation is roughly the size of the position multiplied by the asset's daily volatility. Hold the limit fixed, raise volatility, and the position has to fall in exact proportion.

maximum inventory = risk limit / daily volatility

maximum inventory: The largest position the intermediary will carry in one name, in dollars of market value.
risk limit: The dollars of one-day price variation the firm is willing to hold. Set internally and rarely changed during a stress.
daily volatility: The typical one-day move in the asset, as a decimal. The term that moves.

With a $45,000 limit, a name at 1.3 percent daily volatility supports $3,461,538 of inventory. At 3.4 percent it supports $1,323,529 — 38.2 percent of the former, a 61.8 percent reduction. No price has moved and no opinion has changed. The willingness to absorb has fallen by nearly two thirds while the quote on the screen is identical.

Two things follow for pledged collateral. A position that could be cleared in a day at the old depth now needs 2.62 days at the new one, and a haircut priced against a one-day window under-covers a 2.6-day one. And lesson 11's estimator will not register the volatility rise for days yet, so there is a period in which the collateral's real liquidation cost has risen and every number in the lender's system still says otherwise.

A price change is an event and it is recorded. A depth change is a condition, it is recorded nowhere, and it comes first.

Key terms

Quoted size: The number of shares available at the displayed price. It varies enormously while the displayed price looks stable.
Inventory constraint: The internal limit on how much of one name an intermediary will hold. Expressed in risk, so it converts directly into a smaller position when volatility rises.
Absorption capacity: How much selling a market can take without a large price move. A function of intermediaries' willingness to hold, not of the asset itself.

Worked example

Two thirds of the bid, gone at an unchanged price

Illustrative figures. An intermediary with a $45,000 limit on one-day price variation in a single name, and a $3,461,538 position to be cleared.

Inventory supported at 1.3 percent daily volatility: $3,461,538
Inventory supported at 3.4 percent: $1,323,529
Reduction in absorption capacity: 61.8%
Days to clear the same position: 1.00, then 2.62
Change in the quoted price: None

Everything that determines what a liquidation will cost has moved, and none of it has appeared in a price anyone records.

Check yourself

An intermediary works to a $62,000 limit on one-day variation. Daily volatility on a name rises from 0.9 percent to 2.7 percent. What happens to the inventory it will carry, and to the time needed to clear a $4,100,000 position?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.