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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.

Capitalizing on Fear in the S&P 500

The S&P 500 is within spitting distance of the 2007 highs. Remember 2007 when the economy was rolling along and everyone used the equity from their first house to buy a second or, third? Home ownership became everyone’s entitlement – the American way. Five years of deleveraging later and we’ve figured out that corporations know how to manage their businesses better than the bureaucrats know how to run our economy. Corporate balance sheets are healthy and Interest rates are at all time lows. Unfortunately, the government can’t figure out spending for a quarter, let alone an entire fiscal year.

We have written extensively on the topic of using stock index futures to hedge your retirement account. Typically, the response is, “How can I sell something I don’t own?” This week we are going to discuss Volatility Index futures. This is a product offered by the Chicago Board Options Exchange and it trades opposite the stock market. Therefore, buying VIX futures provides protection from a downdraft in the stock market while simultaneously limiting the risk of the hedge position.

First, it’s important to understand that volatility in the stock market is primarily associated with fear. Stock market declines put fear into the market’s participants. Fear generates wild swings in the market. Therefore, volatility increases with fear. The stock market collapse of 2008 was even wilder than the post tech bubble crash of 2000. The winter of 2008 saw the average monthly range in the S&P 500 increase to more than 145 points per month. This meant that the stock market had an average range between the month’s high and low of more than 20%. This continued for eight consecutive months.

VIX futures trade monthly and they are a direct measure of the volatility expected within the next 30 days. Therefore, if the price of the VIX futures is 17.00, the market expects that the S&P 500 futures may move as much as 17% over the next 30 days. The all time high for the VIX futures is 80.86, set in November of 2008.

This leads us to the second point. Fear is an emotion. Emotional actions exceed rational behavior in the markets. The all time high in the VIX futures suggested that the market could be priced more than 40% higher or lower from the prices we were trading at the time within 30 days. The S&P 500 closed at 812 in November of ’08. The VIX price suggested that by Christmas, we could’ve been trading as high as 1136 or as low as 487. The reality was that we traded from a low of 730 to a high of 836 in December of 2008. Clearly the imagination of the market’s participants got the best of them.

VIX futures are also an easy market to conceptualize in both pricing and movement. The current price is the market’s expected volatility between now and the expiration of the contract. The April VIX futures are trading at 16.50. That implies a volatility envelope of 8.25% higher or, lower. Volatility must be measured as a +/- envelope.  This suggests that the S&P 500 futures, which are currently trading near 1484, should be between roughly, 1606 on the high side and 1362 on the low side when the April VIX contract expires. The all time high for the S&P500 is 1695 in March of 2000 and the market hasn’t traded above 1600 since September of 2000.

The pricing of VIX futures is simply $1,000 multiplied by the index level. The April VIX futures trading at 16.50 has a full contract value of $16,500. This represents a multi year low. The all time low was 12.77 set on May 11th, 2007 while the previously mentioned all time high of 80.86 goosed the full contract value up to $80,860. May, 2007 was the same month that the S&P 500 traded back above 1500 for the first time since the 2000 tech bubble burst and should help to provide an apples to apples comparison of the relationship between the VIX futures and the broadest stock market benchmark, the S&P 500. The real key is that while the S&P 500 declined by 50% for a potential loss of $37,500 between May of ’07 and March of ’09, the VIX futures surged by more than 600% or, a potential profit of more than $68,000.

The trade that we are looking at hinges on two ideas; One, that political discord among the bureaucrats in charge of the U.S. budget will find a way to add some drama to the markets or, secondly that buying the VIX futures provides a supported position with limited risk as a hedge against another 50% decline in the stock market.

The 3.73 point difference between where the April VIX futures are currently trading and the all time low of 12.77 equals a potential loss of $3,730 dollars per contract, which is about equal to a minimal 5% decline in the mini S&P 500 futures at $3,710. However, any decline more serious than that could set the market’s emotions roiling and we’ve already illustrated the excess returns achieved through owning volatility futures, rather than outright shorting of the stock indices.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Cutting Through the Rhetoric

There are times when the markets tell us more about what’s going on than the people on TV. I think this is one of those times. The recent rhetoric has been a political budget argument over nickels and dimes when we they need to be talking about hundreds and thousands. The political blame and spin game is being played at its highest level. The reality is that we are quickly approaching the end of the second round of quantitative easing. The government’s balance sheet reached a record level of $2.63 trillion as of April 7th. This is evidence that the fed has been putting their purchasing power to work. The $600 billion that was enacted to keep interest rates low, provide loans to new businesses and help the economy regain its footing after the financial meltdown of ’08 may be coming to an early end. The markets suggest that the Fed’s next meeting on April 26th could put a kink in the free flow of dollars coming to the market.

There are arguments on both sides of this fence from the insignificant periphery right down to the board of governors itself. The quantifiable portion of this argument is that the commercial traders clearly expect a slowdown in inflation and the economy in the near term. The consensus and conviction of the commercial traders’ positions can be seen in multiple markets; corn, oil, heating oil, copper, bonds, 10 year notes, S&P 500 and Dow Jones futures, etc. Their shift in positions can best be described as, “defensive.”

Copper is typically referred to as the, “economist” of the metals markets. Its use in building construction has always been a fair barometer of the economy’s growth and contraction. Commercial traders in copper from the commitment of traders report have shed nearly 40% of their positions since late February. The combination of China’s successive rate hikes and tightening lending practices paint a clear picture that their fully stocked warehouses are in no danger of depletion.

The crude oil market has seen consistent selling by commercial traders above $100 per barrel. Fear, due to the unrest in Northern Africa has been the primary driver of crude oil prices. This market has remained oblivious to the fact that the storage wells in Cushing, Oklahoma are bumping along near record levels. The price of gasoline has disconnected from the price of crude due to refining issues, not supply issues.

Interest rate futures have seen a flush of commercial buying. The 10 year Treasury Notes have seen commercial positions increase by more than 20% while the 30 year bonds have seen commercial traders increase their net position from 70, 000 contracts at the end of February to more than 120,000 contracts currently. Their buying of U.S. interest rate futures is part technical, and part predictive of a flight to safety driving down Treasury yields.

The flight to safety is predicted from commercial traders selling stock index futures. Commercial traders were buyers on the mid March stock market correction. However, their buying was light and their selling since has pushed their net momentum to negative levels. They may view the extended period of low volatility in the VIX index combined with testing the markets’ February highs as reasonable long liquidation levels or, low risk short selling opportunities.

This combination of moves is certainly bearish. I believe it is predicated by the theory that QE2 may be brought to an early end. If this is the case, the short term reaction would be a stronger U.S. Dollar. This would obviously be a short term negative for commodity markets in general like copper, oil, grains, cotton, etc. However, this would do nothing to alter the global change in demographics. There will be no fewer people to feed and this will not impact the growing global purchasing power that has fueled much of the commodity rally. Therefore, the macro trends will remain intact. This will simply force out many of the weaker hands that have been riding the coat tails of the rallies on the way up.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Commercial Trader’s Role in the Stock Index Futures

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.

The stock market’s recent sell off between 7.5% and 14% depending on the index, was immediately followed by five straight day’s worth of rally. Apparently, the TV pundits are saying that the electronic meltdown was just what the market needed to attract fresh buying to the markets and push them back to 2007’s happy market levels. Unfortunately, based on commercial traders’ positions, they don’t seem to share the talking heads rosy outlook. In fact, their trading actions appear to favor, “The Coming Double Dip,” opinion.

Throughout the month of April, commercial traders have been steadily building short positions in the stock index futures. The behavior of the institutional trader is to vary their short position in the stock indexes to offset their perceived sense of risk in the stock positions they currently own in their portfolios. The execution of short hedges in the stock index futures allows them to hold on to their individual issues. The ability to protect their portfolio without having to sell individual issues also protects them from incurring capital gains penalties on their core positions. Thus by tracking commercial traders’ momentum we can get a feel for not only their positive or, negative outlook on the stock market but also their sense of urgency.

Individual investors need to know what options are out there to help them protect their hard earned equity portfolios. The stock index futures offer direct hedges to the Nasdaq, Dow, S&P 500 and Russell 2000 indexes. These markets cover everything from blue chips to heavy tech and small cap. They also trade in various size contracts to help tailor hedge positions to your underlying investments.At these levels, the small contracts have approximately the following cash values:

Market                 Cash Value        Margin RequirementS&P 500                      $56,500                  $5,625Dow Jones                  $52,500                  $6,500Nasdaq                        $18,750                   $3,500Russell 2000                $68,000                  $5,250

Using the above values, one can see the effectiveness of using futures to hedge an equity position, rather than a Contra, Profund or, other inverse equity mutual fund through the following example.

John Doe has $250,000 in equity positions through individual stocks, mutual funds and retirement plans. John is afraid that the market’s rally has run its course and given the overall economic outlook, would like to be able to protect his portfolio in the event of a downturn. Unfortunately, John has had some of the individual stocks for so long that his cost basis makes selling them and paying capital gains taxes an unappealing option. Several of his mutual funds are held in various retirement accounts run by managers who don’t solicit investment advice from their clients on a regular basis. Finally, John has another $75,000 in cash, short term rates and money markets. He considers this his operating cash for any opportunities or emergencies that might come up. So, what can John do protect his self in the event of a market downturn without tying up all of his free cash?

Assuming he would like to hedge half of his portfolio, he would determine the makeup of his holdings to see how he’d like to balance his hedge – small cap, blue chip, tech, etc. Now, he wants to give himself room for another 10% higher in the equities due to the “January Effect” or, market exuberance. Therefore, the free cash needed for this strategy would be approximately, $16,000 in margin to carry the equivalent of a $125,000 short equity mutual fund. Plus, he’s going to need an extra $12,500 to provide a cushion of another 10% rally in the equities. His total free cash outlay is $28,500. Thus, he effectively hedges half of his equity position while tying up only 25% of his operating cash.

The commitment of traders report for the stock indexes can be a good barometer for anticipated movement in the stock market. Furthermore, through the use of stock index futures and a competent broker, individuals can implement the same type of equity protection as the big boys.

Please call with any questions.Andy Waldock866-990-0777