Market Directioning

I want to expound on a recent point I made to readers of a recent column of mine about the use of using derivatives in gauging market direction. While many do use derivatives to gage morning market direction, they can be a very unreliable source in times of volatility.

For example, where markets have recently traded in bands of intense volatility, derivatives are used differently to where they are used in normal market conditions. Where there is one clear market trajectory – upward or downward – there is a very clear market impetus for using derivatives: to get maximum bang on the buck of trading activity.

In volatile markets however, the reverse is true: traders often use derivatives in their traditional, non-speculative sense as well – as hedging objects designed to protect large positions against wild swings.

If you look at the way in which derivatives are being used right now – in a speculative bearish context – they resemble the former rather than the latter. This tells you something counter-intuitive about recent market concern of volatility – namely, that it is not a truly volatile bearish market – as many have assumed – but one which is highly liquid and speculative.