Hedge Fund Managers Becoming
More Bullish

More Bullish Action by Hedge Fund Managers?

The Significance of ETF Put Buying!

by Ian Harvey

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August 27, 2012

Introduction

The market may have touched its highest point in more than four years this week, but this technical achievement took a back seat to familiar worries that the Federal Open Market Committee won't act quickly enough (or at all) to prop up the economy. While the bulls re-emerged on the scene during Friday's trading, all of the major indexes closed in the red for the week, with the Dow and the S&P 500 suffering their first weekly decline in seven.

The market took a breather, but the CBOE Market Volatility Index (VIX) took a leap, gaining almost 13% on the week. This disparity appears to be "indicative of the fear that lingers in the wake of strong price action." Also, an esoteric options-based indicator may be showing that hedge fund managers are increasing their long exposure to equities.

Hedge Fund Managers and Media Attention

"Hedge funds are betting on disaster"
- CNNMoney-Headline, August 23, 2012

"…..'Most hedge funds I see are carrying lower market exposure than I've seen in some time,' said Brad Balter, founder of investment advisory firm Balter Capital Management. 'This is not to say they are net short. They simply want to conserve their buying power and be ready for major opportunity sets that may arise….."
- CNNMoney-Headline, August 23, 2012

"...now the magnitude of investor concern is rapidly ramping up ... Not only are investors worried that this rally has run too far too, too fast, but some are wondering if the recent downdraft marks the early stages of a larger correction….."
- The Wall Street Journal, August 24, 2012

“…..we are headed into an event-packed September amid a low absolute level of the VIX and a steep VIX futures curve. The takeaway from a majority of market participants is that a low VIX level is a sign of complacency that leaves the market vulnerable. And the conclusion from the steep VIX futures curve is that there will be a VIX spike in the coming months…..”
- The VIX Futures Curve and Stock Market Sentiment, August 20, 2012

The Standard & Poor's 500 Index (SPX - 1,411.13) achieved a new intraday calendar year high this past week, but a new calendar year closing high proved elusive, as the Tuesday "breakout" was greeted with sellers that lasted into Friday morning. Friday's "bullish" reversal day was a mirror image of Tuesday's "bearish" reversal day, as the round 1,400 century mark provided support on the pullback. The 1,400 level is also the site of the index's 20-day moving average, which marked another low earlier this month and could signify that a sharp uptrend driven by short covering remains intact, much like we saw in January.


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TOP OPTIONS TRADES SINCE JUNE 01, 2012

TRADE GAIN TRADE GAIN
HLF July 47.50 Calls 53% APPL Aug 650 Calls 67%
DLTR Aug 110 Calls 32% UIS Oct 17 Calls 79%
HSY Aug 70 Calls 56% TSO Nov 25 Calls 54%
NKE Oct 92.50 Calls 49% HLF July 47.50 Calls (again) 38%
FB Aug 25.00 Puts 500% DISH Sept 30.00 Calls 100%
APPL Jan 13 650.00 Calls 71% CSTR Oct 42.50 Puts 400%
LNKD Aug 92.50 Puts 30% LNKD Aug 100.00 Calls 250%
SLV Nov 30.00 Calls 114%

Meanwhile, 20-day realized volatility on the SPX fell into single digits to rest at 9.19, even as the CBOE Market Volatility Index (VIX – 15.18) pushed back above 15.00. Although the single-digit realized volatility reading is low, it is not yet an extreme, as previous 2012 realized volatility lows of 7.46 and 7.12 were reached in early February and early March, respectively, during the impressive rally that lasted from November through April.

As can be seen from the excerpt above, “The VIX Futures Curve and Stock Market Sentiment,” many market watchers have become nervous after watching the VIX fall below 15. But with the VIX now 5.99 points above historical volatility, one could just as easily observe that the VIX reading is high and has room to fall. Moreover, last week's VIX action is indicative of the fear that lingers in the wake of strong price action. For example, note that the VIX advanced 12.8% amid a very modest pullback of 0.5% in the SPX last week.


Another Indicator for More Upside

An indicator we haven't mentioned lately -- because there was little to say about it other than what we've been saying for months (i.e., hedge funds are underexposed) -- is the combined customer-only, 20-day, buy-to-open put/call ratio on the SPDR S&P 500 ETF Trust (SPY - 141.51), iShares Russell 2000 Index Fund (IWM - 80.74) and PowerShares QQQ Trust (QQQ - 68.29). Note in the graph below how put buying is picking up relative to call buying on these broad Exchange-Traded Funds (ETFs), probably due to hedge fund managers activity.


Conclusion

When this ratio turns higher from low levels, as it is doing now, bullish price action tends to follow. The theory behind this is that hedge fund managers are moving toward a position of having more long equity exposure, either by adding long equity positions or covering some of their short plays. If the first theory is true, hedge fund managers may be buying ETF puts to hedge long equity positions they are accumulating, as buy-to-open put volume has increased 3% since the ratio bottomed. Otherwise, hedge fund managers are covering short positions, as buy-to-open call volume has decreased 9% since this ratio bottomed, perhaps a sign of lightening up on "disaster bets."

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As you can see on the chart, such activity is not yet at an extreme that has left the market vulnerable in the recent past. This implies the current rally could have legs, even as the SPX tries to take out calendar-year highs during a time of traditionally poor seasonality.


Further Articles Relating to the Week Ahead

1. The Week Ahead in the Stock Market, August 27, 2012

2. The Economy and Earnings in the Week Ahead, August 27, 2012

3. The Past Week Stock Market Results, August 27, 2012

4. The Major ETFs in the Week Ahead , August 27, 2012

5. Stock Market Monday and Underperformance, August 27, 2012


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