Will 1955 cap the S&P’s advance today? Hedgeratio analysis

4 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. 

So this week we are going to start with the S&P 500 (SPX) as it is the one calling the shots again, and is now entering a very exciting period. 

Where we left you last week was explaining how the Dow Jones Industrial Average hit some serious hedge ratio resistance at 16700 that thwarted the SPX’s ability to match the gains experienced by the Nasdaq 100 and reach its target of 1925. 

This last week has changed the picture entirely now, as you can see from the chart below. 

However, before getting on to the chart to explain a bit more about the hedge ratio and what it is and does, you have to first appreciate the levels of business done. 

Stock index options and futures had a notional value of over USD$160 trn traded in 2013 whereas the worldwide value of all equities traded in the same year was an amazing USD$54.7 trn. 

We will go into a greater explanation of what it is and how the Hedge Ratio works in this month’s edition of Spreadbet Magazine, but for now, suffice to say that when an index encounters a new hedge ratio it will stimulate what is called “dynamic delta hedging”. 

In the case of the SPX this was when it hit 1925 and the hedge ratio changed to a darker red.

As the market was going up and was above its neutral zone this dynamic delta hedging would have taken the form of futures selling as the market had to re-establish its risk neutrality. Anyone who had seen our chart from the previous week would of been expecting this. For the actual market practitioners all they see is a mass of futures selling as soon as the market hits 1925. 

So as you can see from our chart above, this assault on 1925 took three days and many attempts, and in fact on the day, this index traded to both the top and bottom of the hedge ratio bandwidth (02/06/14) and attempted the break on no less than four occasions. The first getting above by 0.09, the second by 0.27, the third by 0.38 and finally 0.88 before settling at 1924.97. 

Of course the hedge ratio changed on Wednesday which allowed it to finally close above this hurdle, which it certainly seemed to be making a meal out of. 

We would like to point out that we do actually produce the hedge ratios for a trading day before that particular market opens, and thereafter it remains unchanged. The reason why the chart above does not have the hedge ratio for Friday 6th June 2014 on it is because this went to print long before the US markets were due to open. 

However there is a lot more in this chart than just the markets interaction with 1925, although how it does react to this particular level of dynamic delta hedging gives one an invaluable insight into how much business is going on and how committed the market is. 

One of the other aspects to note is on the very first day this index approached the 1925 level (30/05/14) the dark red hedge ratio receded to 1935 from 1930. 

It has since continued to retract, which very clearly and succinctly shows the hedge ratio in retreat above the market, so a reduction of potential resistance, which is always a good sign for bulls.

What would reinforce this would be a build up of hedge ratio below the market, which would signify growing support, which would also be a good thing for further gains. 

In this scenario, it is entirely possible to see a clearly defined channel, however in this instance although the hedge ratio has increased below the market it is too far away and not of significant enough proportions. What is also a good sign is that the neutral zone has also moved up to 1870-1880, as evidenced by the movement of the white bandwidth. 

For the really eagle-eyed amongst you, you may also notice the yellow hedge ratio falling around 1900, which as a further bullish sign and signalling another potential move up in the neutral zone to 1895-1905. 

More importantly, looking at Friday 6th June 2014 and these eagerly anticipated nonfarm numbers, assuming the dark red hedge ratio doesn’t change and that is now waiting for this index at 1955, this could cap gains. 

We have space for one more chart so we thought you might like to see the remarkable FTSE 100 (below) which apart from a couple of days has not strayed outside the light red hedge ratio bandwidth.

What makes this 50 pt trading range so interesting is that it has so collared this index whilst all the other indices are hitting records. 

The hedge ratio has changed above 6850 so in our daily European note we have the trading range now 6800 to 6900 incidentally.

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