Tag Archives: index traders

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.

Trading in Volatile Markets

Trading in Volatile Markets

Last week’s events bring to mind some important truths about
commodity trading. Many traders categorize themselves as fundamental traders or,
technical traders or, systematic traders. However, the best traders find it
hard, at best, to implement their particular trading plan when market
volatility explodes and the rules are changed in the middle of the game. Let’s
frame the market’s activity before we dissect its impact on trading styles.

First of all, the financial markets are in mass liquidation.
The stock market saw 150 year old stalwarts reduced to bankruptcy. The bond
market was experiencing priced in risk premiums higher than those witnessed
during 9/11. The commodity markets were under mass liquidation as Commodity
Index Traders, the managers of the long only commodity funds, were being forced
to liquidate on the way down to reduce leverage. Daily ranges were increasing
and cash balances were fluctuating wildly, regardless of trading style. The news
events that were surfacing daily were materially impacting not only the
markets, but the exchanges and trading strategies, directly.

For this discussion, it’s important to know a bit about each
trader’s style. Fundamental trader are long term, macro -economic investors who
place a high emphasis on, “being right in the long run.” They typically follow the Commitment of Traders reports or the USDA grain reports. Many fundamental
traders may claim to have, “been early,” when entering a market and are therefore
placed immediately into a losing trade. This is not a knock on their trading style
or, any of the others that I’m about to mention. Fundamental traders rarely
trade with stop losses because they don’t want to stopped out of a “noisy
market.” Generally speaking, they focus on a particular market or, sector and
tend to know it very, very well. Their idea of a “fair price,” or “fair value,”
leads them in and out of the market based on their models.

Technical traders rely on oscillators, indicators, trend
lines and so forth. Elliot wave analysts, Fibonacci traders and pattern
recognition also fall into this category. As long as the trend lines hold, the oscillator
bounces back or the wave count is right, it works. Pattern traders can trade
within the framework of their studies and historical models of what has worked
for them in the past and use them as best they can to forecast future price

Lastly, systematic traders focus their time on the
development of algorithms and buy/sell programs that, once implemented, provide
quantitative entry and exit commands. The implementation of the system comes
down to the trader’s ability and willingness to execute the program’s commands
exactly as the program specifies.

How has last week’s action affected trader’s ability to
trade? The fundamental traders have had to sit through some exceptionally wild
equity swings. Looking at last week’s moves, was the fundamental trader right
to say that gold was too cheap in the $700’s or is the fundamental trader right
to assume that gold is too expensive in the $900’s. There is no question that
crude was overpriced at $140+ per barrel but, I don’t know anyone who sold at
$120 on the way up and still had it for the ride back down.  If the fundamental trader can’t stay with the
position, does it really matter if he’s proven right, over time? This is where
the old saying, “The markets can remain irrational longer than a trader can
remain solvent,” comes from. Look at last week’s ranges and multiply them times
their point values. The mini S&P 500 was 11 points higher for the week
(+$550). However, the range was 155 points or, $7750 per contract. That’s a lot
of risk for someone buying the market’s $550 return.

Technical traders had many of their classic signals trigger
trading opportunities. Overbought and oversold readings were both pegged in
various markets. Index traders had VIX readings over 40 and TRIN indicators
over 900. Commitment of Traders Index followers received both buy and sell
signals and lastly, several trend lines were violated, only to have the markets
reverse course the following day.

System traders didn’t fare any better, I’m afraid. There
were some day trading opportunities but, anything given one day was taken back
over the next day or two. Therefore, losing trades abounded. Also making
matters worse, the exceptional volatility led to execution issues. Markets that
normally had a tight bid and offer with many contracts available on either side
suddenly found themselves at a loss for executing multiple contract orders at a
single price. Other orders, like stop or, market orders were executed far worse
than any slippage allowance that was modeled into the system’s creation.

The very short point of this very long article is that, sometimes,
it’s most important to focus on each trade as a single trade. Execute that
trade as if in a vacuum. When markets are swinging like they have been,
fundamentals can be thrown out the window, technicals taken with a grain of
salt and systems employed as best as execution will allow. Discretionary
traders have been provided with a tremendous opportunity. The ability to
synthesize macro- economic dynamics in a fluid environment filtered through the
lens of technical analysis and executed with the precision of a binary program
are the discretionary trader’s harvest season. This ability to take any trade
as simply, “a trade,” and maximize the profit and loss characteristics of each,
through careful monitoring, is the discretionary trader’s opportunity to ride
gold for $150 dollars in two days or squeeze 300 basis points out of the yield
curve. These are the, “Hero” moments that I will never be a part of as we continue
to try and carve something out of the middle.

Andy Waldock