We’ve discussed the peculiarities of the stock index futures’ expiration cycle in detail here before.
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.We posted a fairly long-term chart going back over the last four years and change. There have 16 quarterly expiration cycles in in the chart displayed. Ten of these expirations have experienced the same type of event and predicted forward action. While doom sayers may be gaining a louder voice, the smart money is still being placed on the long side.
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