Is the hedge ratio warning of an imminent top in the S&P? by Richard Jones

5 mins. to read

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 concern ourselves with markets from a purely derivative perspective, which we see as being one of the major influences on indices currently, but fully appreciate that there are still considerable fundamental as well as technical aspects that should be considered. 

However the start of this second triple witching expiry has created the most intriguing of situations across all the indices. We chart the expiry, therefore our charts cover (for June) the 19th May 2014 to 20th June 2014 period, and not a calendar month. Furthermore, unless all the markets we chart are closed on a specific day, we still include that day in our charts as it makes for easier comparison across all the indices. Therefore they are uniform and far easier to visualise how they interact with one another and their respective hedge ratios. 

This is especially important for the DAX 30 this expiry as the index was “flying solo” on Monday 26th May when the U.K. and U.S.A. were closed, and which should be readily identifiable on our charts. 

Of course, just tracking one expiry will not render you with an appreciation of how the markets have been evolving especially in respect of the hedge ratio, however hopefully over a course of a series of these articles we will go a degree towards remedying this. 

There is probably no better example of this than the DAX 30 which at last expiry had a very exciting time… going nowhere! 

It basically flat-lined around its neutral zone while at the same time managed to producing 100+ point move on a daily basis. But then again it did have a preponderance of minimal yellow hedge ratio surrounding it that allowed it such latitude. 

However at the end of this expiry it encountered just light red hedge ratio for the very first time (13th & 14th May) and had two of the quietest days of the entire expiry. So switch into June and as you can see from the chart below it has gone ballistic. 

Remember from our blog on Monday 26th May 2014 that it took 6 attempts throughout the day to get above 9750, only succeeding in the last hour. Then on that Monday it powered through 9850 “flying solo” and so finds itself up against dark red hedge ratio. 

This has now receded and now rests at 10,000 but again as we mentioned in our first blog, this is the same level of hedge ratio that stopped the plunge at 9850 when it was going the other way. 

So big figure fever vs. the hedge ratio it seems, but we are bearish. 

The FTSE 100 on the other hand is the polar opposite, and which ironically last expiry was exactly the other way round. However in the May expiry there was the AZN influence of course. 

The staggering aspect here is the fact that so far since the lasy expiry this index has traded in a very narrow hedge ratio bandwidth. 

In fact in the first week (Friday to Friday close) it actually fell 40 points, 0.58%, whereas every other index we chart rose, the DAX 30 for example by 139 points, 1.44%. 

By Wednesday, as you can see from the chart, the hedge ratio had changed but it still only just managed to eke out a close above this trading range at 6851. 

Of course by this stage the DAX 30 was hitting their dark red hedge ratio so was actually now a hindrance rather than assisting. 

This also neatly demonstrates why we include holidays in our charts as you can easily identify the corresponding trading days on each chart. 

Where we go from here is the big question, and as you can see the hedge ratio changes, but it has top and tailed this index for about a week and a half, so for us it is akin to trench warfare. 

Every gain is hard fought and hard won, and that is with the other indices hitting new highs, so if their support falters the FTSE 100 will be caught in no man’s land. 

So finally to have a look at the S&P 500, which is in similar circumstance to the FTSE 100. By this we mean that it has been caught out and is itself in a quandary. 

We pointed out in our blog on Monday that this index was 1.32% away from the change in hedge ratio at 1925 and the Nasdaq 100 was also 1.31% away from a level of serious hedge ratio at 3725. 

What we were unable to show was the Dow Jones Industrial Average on the Tuesday 27th May, their first day back after Memorial Day, which showed a serious hedge ratio level at 16700. 

So it seems like the DJIA hit this then pulled back finishing up 0.42%, with the S&P 500 having breached 1905 in the first minute of trading taking heed, but still ending up 0.60%. Whereas the Nasdaq 100 just carried on regardless, and as expected, to 3725, and the change in their hedge ratio, a rise of 1.24%. 

In an ideal world (when is it ever) we would hope that the big bad boy on the block, the SPX, would encounter a significant change in their hedge ratio which would then be supported by one or both of the other two hitting a significant hedge ratio level change. However this time it is the “other” two that have made the running which has left the pack dynamics a little confused in America. 

Nevertheless two out of the three of the the indices have now showed their hands, all that remains is for the SPX to reveal its and from what we can see 1925/30 remains a very serious hedge ratio hurdle to overcome.

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