Give Credit Derivatives Their Due

by Tim Quast
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Moving on, with a barrel of oil and a nosebleed seat at a Sacramento Kings game now at basic cost parity, what's that do to the derivatives trading strategies behind both?
Kidding about the Kings seat - the ones on the lip at the top of Arco Arena still cost more than a barrel of oil. But IROs, the markets last week offered lessons in knowing how trading strategies affect your equities. We pegged the collapse of broad market structure to options expirations. From the 20th forward, order flow starkly showed that first active and then quantitative investors were pelting pell-mell out of town.
What interests us most, it reveals how active investors - those making rational qualitative decisions - are broadly deploying automated risk-management systems (tied to derivatives) to hedge against human error. We believe an imbalance in the credit derivatives market triggered these risk-hedging devices and the rational folks were then quick to sell and retreat. These actions imbalanced the equity markets and triggered quantitative selling too (which we believe contributed to the double-dip down on the Dow). We can absolutely see the laddered movement of these different kinds of order flow.
Back to risk-management derivatives vehicles, how do they work? We have no idea, frankly. But consider this: interest rates on margins for futures contracts are a crucial cost component for those aggressively deploying them. It's not inconceivable that forward resets as options expired were affected by interest-rate changes somewhere in the system...the interbanks? Broker dealers who recently had trouble selling debt for private equity transactions? We don't know. But certainly the structured products traders and the proprietary options shops were wildly busy last week during the correction.
The good news, the order flow sample on Friday as the week closed looked stable despite the down day, with parity between primes and electronic platforms again, which should tell arbitragers that alpha is now nominal. But there wasn't an echoing footstep of a rational investor to be found anywhere. It was all algorithmic.
IROs, you might feel fatigued thinking, "You mean I need to know this stuff about my stock?" But in fact there's far more peace of mind in looking at your order flow and being able to tell management simply, "It's not what we're saying, it's these darned high-frequency traders."
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About the Author
Tim Quast is a fifteen-year Investor Relations veteran and founder and managing director of ModernIR.com, which parses and categorizes over a half-billion shares per week with its trading intelligence systems. More information is at: www.modernir.com