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Derivative Flow


One can't but help notice the increased buying in equities being done toward the end of the day: there seems to be an aggressive push upward in the indexes from some mysterious force. There are two primary sources driving this phenomenon.

The mutual fund flow data still indicates strongly positive inflows of money coming into equities in this new-year. We indicated late last year that this was a likely scenario as people, finding low interest rates unacceptable and given no extraneous shocks, would in general take end of year liquidity and plop it into riskier assets like stocks. We think dried up capital inflows from foreign sources have been replaced, at least for now, with this domestic demand.

When a mutual fund receives this much new money in such a short period of time the most efficient method of investment is to buy the whole market through futures or programs and worry about stock selection later (remember a mutual fund rarely holds any cash these days, so they are always in a hurry to get it into the stock market). These programs are normally executed employing VWAP (volume weighted average price). In order for a broker to achieve VWAP, these programs have the heaviest volume in the last minutes of trading (please refer to my previous piece "VWAP" for more explanation).

A second source of demand right now has to do with derivative transactions, specifically something called "collars". Collars are hedges large investors initiate to protect equity portfolios through options, normally over the counter options. I have described these structures before: an investor shorts an out of the money call to finance the purchase of an out of the money put to protect a long portfolio of stocks.

Several large collars on the SPX are expiring now. The way they expire is in traunches: a portion of the structure expires each day for several days. The over the counter options themselves expire for cash: each day the portion expiring is marked against the closing price of the index and CASH (not stock or futures) is delivered or received. Because the broker who has on the other side of the trade is short physical futures to hedge the risk, they must buy the right amount back each day as the options settle.

Because the option settles at the closing price, it actually behooves the broker to begin buying late in the day and "drive up" the closing price higher than their average execution price: the broker "earns" the difference between these two prices as pure profit. This is as close to free money as you can get.

Derivative trades are structured often with these "free" opportunities in mind. The investor implicitly pays these costs: they either don't think ahead of time when they initiate the trade or they don't care (no one really notices except them).
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No positions in stocks mentioned.

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