Tagged: futures

The Vital Day

Which is the most important trading day of the month?

“The one when my company reports results,” you say.

Good guess, and you’re usually right. Not this time. It’s the last day.  Yesterday was it, the vital day of April, the benchmark for monthly fund-performance.

All funds want to clock results, punch the timer when the sprinter hits the tape. But it’s most true for money tracking a measure like the S&P 500.

CBOE, the giant derivatives and equities market operator, began in 2014 offering an options contract to “allow asset managers to more precisely match SPX option expirations to end-of-month fund cycles and fund performance periods.” SPX is the S&P 500. CBOE offers many ways for investors to improve tracking or profit on variances.

CBOE describes SPX securities as “flexible tools that allow investors to synthetically adjust their positions to a 500-stock portfolio.”

All three big exchange groups (NYSE, Nasdaq, CBOE) operate equity and derivatives markets, and all promote pricing advantages for firms trading equities and derivatives simultaneously.

That means, public companies and investors, these exchanges are encouraging traders to speculate. How often are prices of stocks affected by the prices of derivatives ranging from options on individual stocks to futures on indexes and ETFs?  (Heck, there are options on futures.)

Answer: Behavioral analytics ModernIR developed show that about 19% of volume marketwide the last five days ties to derivatives. By sector, Communication Services was highest at 20.6%; Industrials the lowest, 17.7%.

Active Investment by comparison was 11.2% of volume in Communication Services stocks, and 12.6% in Industrials (sellers, however).

AAPL, trading today on results, had 23% of volume on Apr 29 – $1.03 billion! – driven by derivatives-related trades. About 150 S&P 500 components, and hundreds of others, release this week.

Derivatives are bigger than investment. Do stocks then reflect fundamentals?

BK plunged Apr 17 – index options expired that day – and the biggest behavioral change was in Risk Mgmt, reflecting derivatives. Shorting peaked Apr 17. Bets preceding results were quantitative, and big. Math.  Active money then bought the dip.

SIRI dropped on results like a diver off a cliff, and over 23% of its trading volume beforehand traced to counterparties for derivatives bets.

TWTR exploded from about $34 to over $40 intraday on long (not short) derivatives bets made with new options that traded Apr 22, driving more than 20% of TWTR volume. Active money played no price-setting role and was a profit-taker on the move.

INTC rag-dolled down Apr 26 with results, on volumes approaching 80 million shares, and the biggest behavior was Risk Mgmt – counterparties to derivatives bets.

CHRW was 70% short and 25% of its trading volume tied to derivatives – a resounding bear bet – before shares blinked out this week to December levels.

Imagine the value you’d add – what’s your name, IR professional? Portfolio manager? – if you knew the behaviors behind price and volume BEFORE stocks went wild.

A lesson: 

Fast Traders arbitrage the tick. That is, computerized trades profit by churning many securities long and short fleetingly, netting gains. The more money seeks a measure – indexes, ETFs, closet indexers, money trying to beat a benchmark – the more machines change prices. Fast Trading is 42% of volume the past five days.

Passive investment must track the benchmark. ETFs need variance versus the index to price shares. That combination is 27% of volume.

Active money chasing superior stories defined by fundamentals is 12% of market volume the five days ended Apr 29. So, during earnings season stocks had a 1-of-8 chance of being priced by story.

Derivatives (Risk Mgmt to us at ModernIR) used by indexes to true up tracking and traders to profit on volatility are 19% of volume.

Got bad news to dump, companies? Do it the last three trading days of the month. You’ll get hammered. But then it’s done. Money will return in the new month. Investors, in the new month the stuff hammered to finish the last month could win.

There’s a vital day: The last trading day each month. It trumps story. You should understand it. We can help you.

Selling the Future

Karen and I are in Playa del Carmen, having left the US after the Trump election.

Just kidding! We’re celebrating…Karen’s 50th birthday first here on the lovely beaches of Quintana Roo and next in New York where we go often but never for fun. This time, no work and all play.

Speaking of work, Brian Leite, head of client services, circulated a story to the team about Carl Icahn’s election-night buys. Futures were plunging as Mrs. Clinton’s path to victory narrowed. Mr. Icahn bought.

If you’ve got a billion dollars you can most times make money.  You’d buy the cheapest sector options and futures and aim your billion at a handful of, say, small-cap banks in a giant SEC tick-size study that are likely to move up rapidly. Chase them until your financial-sector futures are in the money.  Cash out.  See, easy.

(Editorial observation: It might be argued the tick study exacerbated volatility – it’s heavily concentrated in Nasdaq stocks and that market has been more volatile. It might also be argued that low spreads rob investors of returns and pay them to traders instead.)

If you’re big you can buy and sell the future anytime. The market last week roared on strength for financials, industrials, defense and other parts of the market thought to benefit from an unshackled Trump economy.

An aside: In Denver, don’t miss my good friend Rich Barry tomorrow at NIRI on the market post-election (Rich, we’ll have a margarita for you in Old Mexico).

We track the four main reasons investors and traders buy or sell, dividing market volume among these central tendencies. Folks buy or sell stocks for their unique features (stock picking), because they’re like other stocks (asset allocation), to profit on price-differences (fast trading) and to protect or leverage trades and portfolios (risk management).

Fast trading led and inversely correlated with risk-management. It was a leveraged, speculative rally. Traders profited by trafficking short-term in people’s long-term expectations (there was a Reagan boom but it followed a tough first eighteen Reagan months that were consequences of things done long before he arrived).

Traders buy the future in the form of rights and sell it long before the future arrives, so that by the time it does the future isn’t what it used to be.

They’re grabbing in days the implied profits from a rebounding future that must unfold over months or even years. Contrast with stock-pickers and public companies. Both pursue long arcs requiring time and patience.

Aside: ModernIR and NIRI will host an incredible but true expose with Joe Saluzzi of Themis Trading and Mett Kinak of T Rowe Price Dec 1 on how big investors buy and sell stocks today. 

Why does the market favor trading the future in the present? It’s “time-priority,” meaning the fastest – the least patient – must by rule set the price of stocks, the underlying assets. We could mount a Trump-size sign over the market: Arbitrage Here.

We’re told low spreads are good for investors. No, wide spreads assign value to time. Low spreads benefit anyone wanting to leave fast. Low spreads encourage profiting on price-differences – which is high-frequency trading.

Long has the Wall Street Journal’s Jason Zweig written that patience is an investing virtue.  Last weekend’s column asked if we have the stamina to be wealthy, the clear implication being that time is our friend.

Yet market structure is the enemy of patience. Options expire today through Friday. The present value of the future lapses. With the future spent, we may give back this surge long before the Trump presidency begins, even by Thanksgiving.

I like to compare markets and monetary policy. Consider interest rates. High rates require commitment. Low borrowing costs encourage leverage for short-term opportunities.  We’ve got things backward in money and the markets alike. Time is not our friend.

Upshot?  The country is in a mood to question assumptions. We could put aside differences and agree to quit selling the future to fast traders. Stop making low spreads and high speed key tenets of a market meant to promote time and patience – the future.

Rational Signals

The market message appears to be: If you want to know the rest, buy the rights.

While rival Nintendo is banking on Pokemon Go, Sony bought the rights to Michael Jackson’s music catalog for an eye-popping $750 million. This may explain the sudden evaporation of Jackson family discord. Cash cures ills.

In the equity market, everybody buys the rights to indexes and exchange-traded funds. TABB Group says indexes and ETFs drove 57% of June options volume, with ETFs over 45% of that and indexes the balance. TABB credits money “rushing into broad-market portfolio protection” around the Brexit.

Could be.  But that view supposes options are insurance only.  They’re also ways to extend reach to assets, tools for improving how portfolios track underlying measures and substitutes for stock positions. I’ve wondered about the Russell rebalances occurring June 24 as the Brexit swooned everything, and whether indexers were outsized options buyers in place of equity rebalancing – which then aided sharp recovery as calls were used.

We can see which behaviors set price every day.  On June 24, the day of the dive, Asset Allocation – indexes and ETFs primarily – dominated.  On June 27 Fast Traders led but right behind them was Risk Management, or counterparties for options and futures.

The tail can wag the dog. The Bank for International Settlements tracks exchange-traded options and futures notional values. Globally, it’s $73 trillion (equaling all equity markets) and what’s traded publicly is about half the total options and futures market.

Sifma, the lobbying arm of the US financial industry, pegs interest-rate derivatives, another form of rights, at more than $500 trillion. You’d think with interest rates groveling globally (and about 30% of all government bonds actually digging holes) that transferring risk would be a yawn.  Apparently not.  You can add another $100 trillion in foreign-exchange, equity and credit-default swaps tracked by Sifma and the BIS.

Today VIX derivatives expire. The CBOE gauge measures volatility in the S&P 500.  Yesterday VXX and UVXY, exchanged traded products (themselves derivatives), traded a combined 90 million shares, among the most actively traded stocks. Yet the VIX is unstirred, closing below 12. Why are people buying volatility when there’s none? For perspective, it peaked last August over 40 and traded between 25-30 in January and February this year and again with the Brexit in late June.

The answer is if the VIX is the hot potato of risk, the idea here isn’t to hedge it but to trade the hot potato. And for a fear gauge the VIX is a lousy leading indicator.  It seems only to point backward at risk, jumping when it’s too late to move. Maybe that’s why everybody buys rights?  One thing is sure: If you’re watching options for rational signals, you’ll be more than half wrong.  Might as well flip a coin.

We learned long ago that rational signs come only from rational behavior. In the past week right through options-expirations starting Thursday the 14th, Active Investment was in a dead heat with Risk Management, the counterparties for rights. That means hedge funds were everywhere trying to make up ground by pairing equities and options.

But options have expired.  Do hedge funds double down or is the trade over?  Short volume has ebbed to levels last seen in November, which one might think is bullish – yet it was the opposite then.

Lesson: The staggering size of rights to things tells us focus has shifted from investment to arbitrage. With indexes and ETFs dominating, the arbitrage opportunity is between the mean, the average, and the things that diverge from it – such as rights.

Don’t expect the VIX to tell you when risk looms. Far better to see when investors stop pairing shares and rights, signaling that the trade is over.

Side Deals

Yesterday on what we call Counterparty Tuesday, stocks plunged.

Every month options, futures and swaps expire and these instruments represent trillions of notional-value dollars. Using an analogy, suppose you had to renew your homeowners insurance each month because the value of your house fluctuated continually.  Say there’s a secondary market where you can trade policies till they expire. That’s like the stock market and its relationship to these hedging derivatives.

As with insurance, somebody has to supply the coverage and take the payout risk. These “insurers” are counterparties, jargon meaning “the folks on the other side of the deal.”  They’re banks like Deutsche Bank, HSBC, Morgan Stanley, Citi.

Each month the folks on the other side of the deal offer signals of demand for insurance, a leading indicator of investor-commitment. We can measure counterparty impact on market volume and prices because we have an algorithm for it.  Last week (Feb 17-19) options and futures for February expired and the folks on the other side of the deal dominated price-setting, telling us that trading in insurance, not the assets themselves, was what made the market percolate. That’s profoundly important to understand or you’ll misinterpret what the market is doing.

On Monday Feb 22, a new series of derivatives began trading. Markets jumped again. Yesterday on Counterparty Tuesday, the folks on the other side of the deal told us they overshot demand for options and futures or lost on last week’s trades.  And that’s why stocks declined.

The mechanics can be complicated but here’s a way to understand. Say in early February investors were selling stocks because the market was bearish. They also then cut insurance, for why pay to protect an asset you’re selling (yes, we see that too)?

Around Feb 11, hedge funds calculating declines in markets and the value of insurance and the distance to expirations scooped up call options and bought stocks, especially ones that had gone down, like energy and technology shares and futures.

Markets rose sharply on demand for both stocks and options. When these hedge funds had succeeded in chasing shares and futures up sharply in short order, they turned to the folks on the other side of the deal and said, “Hi. We’d like to cash these in, please.”

Unless banks are holding those stocks, they’re forced to buy in the market, which drives price even higher. Pundits say, “This rally has got legs!” But as soon as the new options and futures for March began trading Monday, hedge funds dumped shares and bought puts – and the next day the folks on the other side of the deal, who were holding the bag (so to speak), told us so. Energy stocks and futures cratered, the market swooned.

It’s a mathematical impossibility for a market to sustainably rise in which bets produce a loser for every winner. If hedge funds are wrong, they lose capacity to invest.  If it’s counterparties – the folks on the other side of the deal – the cost of insurance increases and coverage shrinks, which discourages investment.  In both cases, markets flag.

Derivatives are not side deals anymore but a dominant theme. Weekly options and futures now abound, more short-term betting. Exchange-Traded Funds (ETFs), derivatives of underlying assets, routinely populate lists of most active stocks. Both are proof that the tail is wagging the dog, and yet financial news continues casting about by the moment for rational explanations.

Every day we’re tracking price-setting data (if you don’t know what sets your price the problem is the tools you’re using, because it’s just math and rules).  Right now, it’s the counterparties. Short volume remains extreme versus long-term norms, telling us horizons are short. Active investment is down over $3 billion daily versus the long-term.

You can and should know these things. Stop doing what you’ve always done and start setting your board and your executives apart. Knowledge is power – and investor-relations has it, right at our fingertips.

Weighing Options

There’s no denying the connection between tulips and derivatives in 1636.

The Dutch Tulip Mania is often cited as the archetype for asset bubbles and the madness of crowds. It might better serve to inform our understanding of derivatives risk. In 1636, according to some accounts, tulip bulbs became the fourth largest Dutch export behind gin, herring and cheese. But there were not enough tulips to meet demand so rights were optioned and prices mushroomed through futures contracts. People made and lost fortunes without ever seeing a tulip.

While facts are fuzzy about this 17th century floral fervor, there’s a lesson for 2016 equities. Grasping the impact of derivatives in modern equities is essential but options are an unreliable surveillance device for your stock.

I’ll explain. ModernIR quantifies derivatives-impact by tracking counterparty trade-executions in the percentage of equity volume tracing to what we call Risk Management. We can then see why this implied derivatives-use is occurring.

For instance, when Risk Management and Active Investment are up simultaneously, hedge funds are likely behind buying or selling, coupling trades with calls or puts. If Risk Management is up with Fast Trading, that’s arbitrage between equities and derivatives like index options or futures, suggesting rapidly shifting supply and demand (and therefore impending change in your share-price). Options won’t give you this linkage.

Dollar-volumes in options top a whopping $110 billion daily. But 70% of it is in ETFs.  And almost 48% ties to options for a single ETF, the giant SPY from State Street tracking the S&P 500.

As Bloomberg reported January 8, SPY is a leviathan instrument. Its net asset value would rank it among the 25 largest US equities, ahead of Disney and Home Depot. It trades over 68 million shares daily, outpacing Apple. It’s about 14% of all market volume.  Yet trading in its options are 48% of all options volume – three times its equity market-share.

Why? Bloomberg’s Eric Balchunas thinks traders and investors are shifting from individual equity options where demand has been falling (further reason to question options for surveillance) into index options. SPY is large, liquid and tied to the primary market benchmark.

Bigger still is that size (pun intended) begets size, says Mr. Balchunas. Money has rushed – well, like a Tulip Mania – into ETFs. Everyone is doing the same thing. And just a handful of firms are managing it.  Bloomberg notes that Blackrock, Citigroup, Goldman Sachs and Citadel are the biggest holders of SPY options. Three of these are probably authorized participants for ETFs and the fourth is the world’s largest money manager and an ETF sponsor.

Mr. Balchunas concludes: “The question is how much more liquidity can ETFs drain from other markets—be they stocks, commodities, or bonds—before they become the only market?”

SPY options are an inexpensive way to achieve exposure to the broad market, which is generally starved for liquidity in the underlying assets. As we’ve written, ETFs are themselves a substitute for these assets.

The problem with looking at options to understand sentiment, volatility and risk is that it fails to account for why options are being used – which manifests in the equity data (which can only be seen in trade-executions, which is the data we’ve studied for over ten years).  If Asset-allocation is up, and Risk Management is up, ETFs and indexes are driving the use of derivatives. These two behaviors led equity-market price-setting in 2015. If you were reporting changes in options to management as indications of evolving rational sentiment, it was probably incorrect.

In the Tulip Mania, people used futures because there was insufficient tulip-bulb liquidity. The implied demand in derivatives drove extreme price-appreciation. But nobody had to sell a bulb to pop the bubble. It burst because implied future demand evaporated (costing a great lost fortune).

Options expire tomorrow and Friday, and next Wednesday are VIX expirations (two inverse VIX ETNs, XIV and TVIX, traded a combined 100 million shares Tuesday). Vast money in the market is moving uniformly, using ETFs and options to gain exposure to the same stocks. This is why broad measures don’t yet reflect the underlying deterioration in the breadth of the market (the Russell 2000 this week was briefly down 20% from June 2015 highs).

And now you know why. People tend to frolic in rather than tiptoe through the tulips. Be wary when everybody is buying rights.

Swapping the Future

Whole swaths of stocks moved 3% yesterday. You might thank Dodd-Frank for it, even if David Tepper gets credit (if you heard the Appaloosa Management founder’s interview you know what I mean).

To understand how, ever heard of a Rube Goldberg Machine? It’s an unnecessarily complex device for doing something simple. Cartoonist Reuben “Rube” Goldberg turned his own name into a rubric for obtuse machination with humorous creations like the self-operating napkin.

So your stock rose sharply for no apparent reason. Some will say it’s because David Tepper, who made $2 billion last year on a belief in strong equities, said on CNBC that “shorts should get out the shovels because they’ll be buried.”

But the answer to why your stock and maybe your sector yesterday moved, and how Dodd-Frank is a factor may be more like a Rube Goldberg Machine. MSCI global indexes rebalance today, and ahead of that we’ve seen surging high-frequency trading, telling us money is benchmarking ahead to equity indexes at newly higher rates. Options expire tomorrow and Friday, with VIX volatility instruments lapsing May 22, giving arbitragers better opportunity to pairs-trade.

And Dodd-Frank’s deadlines on swap-clearing rules take effect in June, so this is the last pre-central-swap-clearing options-expirations period, which set dates for swaps too.

Ever heard of single-stock futures? It’s a way to go long or short shares without buying or borrowing. There’s even an exchange called OneChicago owned by the Chicago Board Options Exchange, CME Group, and Interactive Brokers, for electronically trading these contracts where two parties agree to exchange a set number of shares of a given stock in the future at a price determined today. Also popular are Narrow-Based Indexes – futures contracts on a small set of securities, say, from an industry or subsector. (more…)

Guitar Hero of Trading Markets

Does it feel like the beatings will continue until morale improves?

What’s happened today is straightforward: Investors and counterparties – think of it like vacationers and providers of trip insurance – sorted out imbalances. The debits and credits were entered on ledgers last week with monthly options expirations. Yesterday, true-ups hit Asian and European markets. Today they rippled through ours.

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