There are a number of important changes taking place in the S&P 500 stock index futures. Normally, we focus on short-term swing trading opportunities. However, when something structural appears to be changing, it’s important to take note. The small speculators who bought the August decline expecting a strong closing quarter are very near to fighting a losing battle. Furthermore when the rapidly declining open interest and currently low volatility are factored in it doesn’t look like the small specs are going to get the strength they’d hoped for.
Traders and commentators often use the phrase, “Dog days of August” to describe market action. Unfortunately, the general public seems to view this as a statement of late summer weakness, rather than as the low volume, stagnant, range trading action that it actually means. The S&P 500 has been in a 5% sideways trading range between2020 and 2120 since February. We’ll look at option, technical and seasonal analysis that could push this market to new highs and break the summer doldrums.
Tough week in the markets as we generally got continuation where we were looking for rebounds. This led to a a pair of losers in gold and the Canadian Dollar against a winning trade in the stock indices due to their rebound.
The recent action in the equity markets has been volatile and confusing to say the least. Today, we’ll focus on the S&P 500 futures and the COT buy signal generated by the recent sell off. Later in the week, we’ll examine the decoupling between the Nasdaq 100 and the S&P 500 which could very well be the most obvious clue to the bigger picture.
The S&P 500 has rallied more than 12% in 24 trading sessions. This isn’t a terribly rare occurrence. Writing up a quick indicator shows me that there have been 18 observances of rallies traveling more than 10% in any rolling 24 day period. Restricting the filter to 12.5% still provides us with 9 observances while bumping it to 15% drops the return to 5 examples. The last 10% rally was in January of 2012 and the last 15% rally was in November of 2011. These last two observances were clearly during the churning process as the market had not made new all-time highs, yet.
The 18 total examples gained an average of .92% in the S&P500 futures one month later. The largest gain was 6% while the largest loss was 10%. Finally, the market ended up higher one month later exactly half of the time.
We began our week putting traders on notice that the silver futures market appears to be nearing an end or, at least commercial traders feel that buying silver in the futures markets is becoming more economical than mining for their necessary supplies.
You can see the surge in commercial buying along with the technical analysis that shows where the bottom is expected in the piece we wrote for TraderPlanet, “Silver Decline Nearing an End.”
Tuesday and Thursday we focused on a fairly rare occurrence in the S&P 500 futures’ expiration. There was a dramatic amount of commercial trader selling into the S&P 500 futures’ expiration. We plotted the Commitment of Traders which report showed that commercial traders sold more than 25,000 contracts in the two weeks leading to the September contract’s expiration. We used this as an arbitrary bar to back test and found this happens less than 15% of the time and has a consistent, repeatable effect on the S&P 500 futures.
We’ve been tracking the commercial traders’ actions via the CFTC Commitment of Traders report for years. Over the years, we’ve determined that their anxiousness to buy or sell matters every bit as much as their total buying or selling in raw numbers. The current situation in the S&P 500 futures is a great example of this.
John Mauldin recently wrapped up his annual Strategic Investment Conference and shared some insights from his illustrious speakers. In his world, the information he passed on in his summary was simply nuggets. In my world, I had to go digging for context to put it all together. As a trader, I live in a day-by-day world. As such, it’s easy to lose track of the big picture and at times, the proper context from which to view the macroeconomic landscape. Reading the notes from Mauldin’s speakers clearly illustrated two main points for my own trading.
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.