Ignoring the Noise

SPX Daily 210513Good evening, Friends. Not long before the markets closed this afternoon, I got a note from a friend. It was a quote from some unattributed source,  stating that hedge funds were huge buyers of out of the money SPX calls. His interpretation was that this marked capitulation by underinvested money managers, and that the end of the march higher by stocks must be nigh. Once these folks have finished their buying, in his view, the party will be over.

Now, that may or may not be the case. When I hear from people claiming to know what “hedge funds” are doing, I’m immediately skeptical. These outfits don’t normally advertise what they’re doing, and in any case, there are some thousands of them, ranging from giants with the ability to use hundreds of billions of dollars in leveraged money, to what are basically small family offices. The range of expertise is likewise pretty wide, although not necessarily correlated with assets under management. Still, this friend isn’t stupid, so I decided to check around. One of the benefits of being involved on the institutional side of capital markets for many years is that the Rolodex fattens up.

VIX Hourly 210513My first call was to the head of fixed income at a large state pension fund. He wanted to talk about trying to explain fractions to his young daughter, and a meeting he had just finished with his board, so I didn’t get much help there. My second call was to a veteran and cynical hedge fund manager. He had more to offer. He noted, first, that the volatility skew in the SPX options that are favored by institutions have been doing unusual things. He mentioned, for example, that he had been a buyer of July 1710 and 1810 calls, and that the implied volatility was higher on the options that were further from the money, an unusual event. It is also odd when the VIX is rising as stocks are moving higher, and that was the case today. 

His explanation for these moves, however, was that hedge funds are reluctant to cover their short positions, partly because they risk moving the prices against themselves as they do so, and in part because as the market goes higher, they are presumably closer to cashing in when the last share has been purchased by the last buyer, and prices begin to fall. Still, they (and their investors) can do math, although they don’t have to beat benchmarks (unlike unleveraged, “real money” managers) they are expected to outperform the broad indices. That’s been tough to do while short, so to hedge themselves, according to my friend, they are buying large quantities of out of the money SPX calls. 

If you’re still reading, you may be wondering why I’m going into all of this, even if you find the machinations of these institutional investors to be of interest. The answer is simple; it is very easy to become fixated on the vast amount of “information”, much of it erroneous, that we get from television and other media. In this case, we have two almost diametrically opposite explanations of the same phenomenon, with very different implications for future market movements. I’m almost sure that my hedgie friend is correct – he’s certainly better informed – but I can’t be certain of that.

Fortunately, Todd, and Doc, teach us how to use analytical tools that can aid us in identifying what the market’s elephants are doing, and enable us to use that knowledge for our own benefit. The charts that we learn to analyze are like roadmaps of past demand and supply, and that information can help us (changing metaphors here) to skate to where the puck is going to be, rather than to where it has just been (with apologies to noted technical analyst Wayne Gretzky). I find the behavior of market participants fascinating, and I made my living for years assisting some of the largest managers in the world in managing their FX exposures. Even without that information, structuring our trades in the ways that Todd and Doc teach us can help us to ignore the noise, and put the odds in our favor. After all, this isn’t a game; we want to make money. 

Best of luck!

About the Author kevin

FREE DAILY TRADE VIDEOS

Join Over 84,750 Traders Receiving Our FREE Daily Trading Videos