Stock Index Futures Expiration Tendencies

Commercial traders in the stock index futures behave quite differently than the Index traders or, small speculators who act as their counterparts. Collectively, this is perfectly logical. Index traders are positive feedback traders. Positive feedback traders add on to their bullish positions as the market climbs and scale out of their bullish positions as the market declines. This keeps their portfolio balanced to their available cash resources. This also places them on the side most likely to buy the highs and sell the lows. Typical trend following. Small speculators are a sentiment wild card. Their position is more price and sentiment based than anything else. The randomness of their sentiment makes their positions too yielding to lean on.

Commercial traders, on the other hand are negative feedback traders. Their strategy is a mean reversion, value based methodology. Collectively, their models tell them what price is, “fair.” The higher the market gets above their fair value, the more they sell. Conversely, the more the market falls below their fair value, the more they buy. Their direct actions typically trace out the meanderings of a wandering market placing their sell signals atop the market’s intermediate rallies and their buy signals below the intermediate lows.

There are two other aspects of commercial traders’ habits that must be examined before we approach the current outlook. Commercial traders use the stock index futures to hedge their equity portfolios. Their ability to sell short the stock index futures provides them with easily implemented downward protection against a decline in their equity portfolio. Furthermore, direct short sales in the stock index futures avoids the uptick short sale rules in equities along with the avoidance of accounting for capital, gains or losses as well as any changes in basis. This aspect of their behavior is observed by the varied but consistent, slightly negative correlation between the commercial net position and the underlying market.

The second aspect of commercial usage of the stock index futures is their implementation of options and the corresponding trades this forces them to execute in the stock index futures. Just as commercial traders maintain a slight short bias in the futures to protect against equity declines, commercial traders also sell upside calls in the options market in order to collect the premium and lock in some short-term gains.  Selling call options creates an instant credit in the trader’s account but similar to unearned income this cash is actually a liability whose profit is realized over the course of time. The short call option creates a net short position in the futures market. Commercial traders use the markets’ declines to jump in and buy enough futures to offset the upside liability created by the short call options thus, locking in the added alpha they collected upon the initiation of the short call option position.

Now that the basics are out of the way, let’s look at how this plays into the current market situation. Three out of the last four quarterly futures and option expirations have seen some very specific trading behavior by the commercial traders. Better yet, it’s been easily traceable as you can see on this S&P 500 futures chart  The market starts acting up around a month prior to expiration. That places us about a week out from the beginning of what I’m expecting from the June expiration and the June pattern has been the most consistent occurring in each of the last five years.

The pattern plays out with commercial traders pressing the market lower about 20-30 days prior to expiration. This decline accomplishes several tasks. First of all, it washes out the weak small speculative long position. Second, it’s far enough to force index sellers to lay off part of their portfolio. Finally, its far enough for the commercial traders to cover their direct short hedges as well as allowing them to get futures bought against their short call option positions at a discount. This buying has been enough to run the market straight back up to the highs and create a new churning pattern of consolidation at the highs leading into expiration.

This leaves the market sitting near the highs again and creates the same scenario of index buying and small spec buying that helps grind the market higher, yet again. It’s clear the way this has played out over the last few years that the commercial traders are in fact the only beneficiaries of these late quarterly cycle gyrations. However, it’s also clear that their footprints are easy to track including one of our recent pieces, “Commercial Traders Own the Stock Market Gyrations.” While we feel this is true most of the time, we feel far more certain given our current place in the stock index futures’ quarterly expiration cycle.

This material has been prepared by a sales or trading employee or agent of Commodity & Derivative Advisors and is, or is in the nature of, a solicitation. This material is not a research report prepared by Commodity & Derivative Advisors’ Research Department. By accepting this communication, you agree that you are an experienced user of the futures markets, capable of making independent trading decisions, and agree that you are not, and will not, rely solely on this communication in making trading decisions.

The risk of loss in trading futures and/or options is substantial and each investor and/or trader must consider whether this is a suitable investment. Past performance, whether actual or indicated by simulated historical tests of strategies, is not indicative of future results. Trading advice is based on information taken from trades and statistical services and other sources that Commodity & Derivative Advisors believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades.

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