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Will The Lowest Hedging On Record Play Tricks On OpEx Day When Open Interest Is Rumored To Be At All Time Highs?

Tyler Durden's picture




 

As there is very little trading volume in general these days, and far less non-robotic trading volume, today's trading will likely be defined almost exclusively by Wall Street's option trading brigade. As it is option expiration day, we expect a very rigorous attempt to take out all the pins where the open interest is highest. And courtesy of Sentiment Trader, we could be in for a doozy. Based on his Equity Hedging index, we are at an all time low in terms of his just created proprietary Hedging Activity index. Which means that a record number of people are currently unhedged. Couple this with rumors of one of the highest open interests in existence, and it may get ugly soon. As for forecastability of what this means in terms of returns, it's not pretty: "When the EHI dropped below 20, during the next three months the maximum gain in the S&P 500 averaged +2.5% while the maximum decline averaged -5.9%.  Each time, any short-term upside progress was erased during a swift corrective period at best." Then again, in a bizarro market entirely dominated by the Fed's telegraphing of its equity purchase decisions, we are fairly confident that the predictive prowess of any existing indicator is largely in doubt at a time when none of the traditional market dynamics are even close to being relevant. 

From Sentiment Trader

It's worth noting that the most recent reading of the Equity Hedging Index is at a new record low (data dates back to 2001).  You can find more background on the indicator here.  When we look at the various ways most speculators hedge against a decline, there is almost unanimous agreement among them.  Each hedging component is scored from 0 (no hedging) to 100 (extreme hedging).  Right now, three of them are at 0, three more are under 10 and one is at 36, giving us an overall average reading of 8.  The previous record low was a reading of 9 on 12/23/04.

What does this mean:

This Index takes into account the following ways that most speculators would hedge against a market decline:
 
1.  Raise cash
2.  Buy put options
3.  Trade an inverse ETF or mutual fund
4.  Sell short futures contracts
5.  Buy credit default swaps
 
The Index looks at each of the measures above and compares current levels to historical averages.  The more they show hedging behavior, the higher the EHI would go, and vice-versa.

When the EHI dropped below 20, during the next three months the maximum gain in the S&P 500 averaged +2.5% while the maximum decline averaged -5.9%.  Each time, any short-term upside progress was erased during a swift corrective period at best.
 
One would think that last week would have kicked at least a few folks in the hinder and reminded them that hedging can be a good idea sometimes.  But the cost is a drag when markets march higher, and apparently that cost is outweighing the benefits.

In other words, expect a doozy of an OpEx... or a whimper.

 

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Fri, 12/17/2010 - 12:57 | 813088 ghostfaceinvestah
ghostfaceinvestah's picture

Seeing a lot of low-volume, "max pain" type moves.

Fri, 12/17/2010 - 13:25 | 813195 benbushiii
benbushiii's picture

Do we really think if the Fed has been propping the market up since the end of August, that they are going to let it go down the weekend before Christmas?  A bad day today would not be good for retailers.  Then again smart money may like hitting the Fed's bids / propping to lock in gains.

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