Institutions seem to be betting on trading range

ppteam

The best students of contrarian analysis understand that there are two components that must always be considered. The first is the well known fact that when crowds of investors reach a common conclusion, the extremes in fear (or greed) underlying this "herd mentality" are likely to indicate an inflection point at which bull markets peak and bear markets bottom. An excellent example of this is contained  in this weekend's Monday Morning Outlook,  in which our Todd Salamone noted: "One encouraging sign for the bulls is that in the latest American Association of Individual Investors' Survey (AAII) , published Nov. 5, only 22% of those surveyed were bullish on the market. The percentage bulls last week was the lowest since March 5 of this year, only one day ahead of the 2009 market low, when only 19% of those surveyed proclaimed they were bullish. As I've mentioned in previous Monday Morning Outlooks, those surveyed in this weekly poll have had an uncanny knack for being wrong at major market turns in 2009." To this I would add that while individual investors have been pretty much a non-factor in the 2009 market, their periodic short-term bouts of mania and depression (as pointed out by Todd) have been excellent contrarian timing indicators.

But any attempt at drawing trading conclusions from the collective sentiment of big money players is complicated by the second component that must be considered by contrarians – namely, that the sentiment of powerful players will rule the action of the market until something causes them to change course. This "something" could be that they've committed all available funds to backing their market view, though this can be a very slow process given the depth of the pockets of these players and their sheer number. More often, these "crowded trades" get unwound suddenly and precipitously due to intervening external factors. Or, as Mr. Sears of Barron's nicely summarizes it above: "Many institutional investors are crowded into similar trades, and ... the slightest hiccup could upset the delicate balance."

But almost by definition, no one knows when this "tipping point" will be reached, and in the meantime the ongoing activities of this crowd will exert a strong influence on the market – not in a contrarian sense, but rather in the same direction as the herd is playing it. And this brings us to today's conundrum. As Mr. Sears describes it, a very popular big money "bonus protection" trade these days "involves selling an out-of-the-money call, buying an out-of-the-money put, and selling another put with a lower strike price to cut the cost and offset increases in put volatility." Essentially, they are selling away their price appreciation beyond 10%, in exchange for protecting their downside. But since call premiums are thin, they can't finance the purchase of a put with the proceeds of the call sale unless they sell another, further out-of the-money put against it. And this means they have no "crash protection" – they are only protected down to the strike of the put they sell. So, in effect they've truncated their upside, but they've only partially protected their downside.

I don't consider this to be a particularly intelligent strategy (limited upside combined with potentially huge downside), but the fact remains that there is big money behind it and it impacts the market. In particular, when big money is in effect betting on a trading range through options, this translates into trading-range behavior by the market through the mechanics of the options hedging process. In my opinion, the popularity of options strategies like the one described in this article go a long way toward explaining the range behavior of the market for the past two months, as well as the mind-numbing lack of intraday volatility. The only time the market is relatively free to move is during the 17.5-hour period when the U.S. market is closed (65.5 hours on the weekend) and the relentless hedging activity is interrupted. This would also help explain the brief surge in volatility in the first hour of trading before the market relapses into a coma for the reminder of the trading session (punctuated by a tiny spark of volatility near the close).

At what point this crowded protection trade will abruptly unwind is anyone's guess. The most likely scenarios will be when fear of missing out on future gains will trump the need to preserve past profits, or (less likely in my opinion for a number of reasons) when a market accident defeats the limited protection this particular trade offers and begets a cascade of urgent selling.

SAR

very interesting! thanks for sharing.

天真的冷酷

MMs keep selling, not buying...   Holiday season is coming, I think a new high will be expected.  next year?  dunnt know yet...

90ufo

a very popular big money "bonus protection" trade these days "involves selling an out-of-the-money call, buying an out-of-the-money put, and selling another put with a lower strike price to cut the cost and offset increases in put volatility."
---------这个是9月份的POPULAR TRADE(BARRONS' 9月中旬提过),不知道经过10月初,10月底大跌之后消化了多少了. 记得是SELL 110CALL,BUY 97PUT

10月中旬的POPULAR TRADE 是SELL STOCKS, BUY CALLS,这样如果上涨还可以PROFIT,如果跌了损失也小.

busywind

DING