Stock index options and futures business have grown immensely over the last couple of decades and now exert a considerable influence on all markets. An influence every trader should at the very least be aware of.
The hedge ratio is the calculation of this influence with white being neutral, then yellow for minimal following on through red into grey for ever increasing levels. At each level you will see futures buying or selling generated by dynamic delta hedging brought about by the market re-balancing its risk profile.
We have to stay with the S&P 500 as this index is “calling the shots” at the moment, and which is unsurprising as after all, it is by far the biggest of the lot. We pointed out the trouble it was likely to face at 1925 a couple of weeks ago ,and which it did manage to overcome during the following week after innumerable attempts and four days.
Then, the week after we pointed out the next big hurdle was at 1955, surprise, surprise, it was duly tested the following Monday hitting a new all time intraday high of 1955.55. So far, this remains intact.
Which brings us neatly to the current juncture with the index closing at 1930.11 on Thursday 12th June 2014 and so looking forward to the week ahead. Where, therein lies the rub, as it culminates in the expiry of the June triple witching contracts, and what we call the “Rollover” where it usually gets very, very busy and very excitable on the approach to this period as all the market participants jostle for position with each other.
This natural increase in activity is due to several factors; all combining and interacting and feeding off each other. Firstly, probability odds dramatically reduce as the deadline approaches (or put another way, time value decays away) and, which is another reason that participants are then forced to “roll” or close. In the futures market, at expiry, inactivity is simply not an option (sorry), something which can also easily increase the market’s volatility.
So, you have a maelstrom of lower probability odds and little time premium combining with the fact that one HAS to roll or close that serves to increase volatility. Quite often this explosion of activity can often be misdiagnosed and attributed to the wrong source, something that most media are guilty of as they need a “label” to assign a move to.
We produce specific charts for this rollover period for these reasons, in the hope of seeing what effect it might have on the market at the start of the next expiry, and which you will see next week…
In essence, on the approach to expiry, this is a time of great change in the hedge ratio, so do not expect the chart below to be unchanged by the end of the week!
As you can see we did indeed get that second move up that we were looking for in our last piece into the neutral zone to the 1895-1905 region. An upwardly moving neutral zone is a very bullish sign, as is the fact that the hedge ratio recedes in front of an advancing market, like here.
As it stands we have seen the pullback from 1955, to the bottom of the hedge ratio bandwidth it was in to 1925/1930, and so to us, it either remains in it or breaks to the downside and is pulled towards its new neutral zone at 1895-1905. Today is critical as it is right on the cusp.
If it reverts to 1895-1905 then this is also a “demarcation point”, as above the neutral zone the bulls are in charge whereas below it is the bears, so it is very significant regarding sentiment and ultimately direction.
As we illustrated with the FTSE 100 last week, which actually is the most remarkable of charts, having been “collared” going into the expiry by two walls of hedge ratio either side, we thought an update on the DAX 30 is also in order.
The last time we mentioned it there was a battle between the dark red hedge ratio and “big figure fever” with 10,000 being the prize. Said prize was grasped!
Of course having encountered the level of hedge ratio that was in place going into the bust through 10000, we can understand the trepidation of the index moving higher. But, the hedge ratio has now receded, just like the SPX which in itself is interesting and so provides easy room to rise further should it revisit here.
Now, just in time for the rollover week, there is a lot of yellow hedge ratio about, so we can expect the sort of hesitant type trading that we saw last expiry in my opinion.
Funnily enough the similarities with the SPX don’t end there though as with yesterday’s move up in the neutral zone to 9750-9850, we can expect some support here but if it breaks, then watch out below! We have today’s range as 9650 to 10050, and which is basically the entire yellow hedge ratio bandwidth including the new neutral zone.
Finally, in one of those strange twists in the markets, at the very start of this expiry from the top of the neutral zone to the dark red hedge ratio measured 400 points, which is exactly where it stands now. Watch these levels carefully for a breakout.
Boring next week will most likely not be!