Exploiting the Informational Content of Hedging Pressure: Timing the Market by Learning from Derivatives Traders

Spot and futures market linkages are exploited by using commercial and non-reportable hedging pressure as the predictive variables while the linkages between the derivatives and spot markets are exploited using the VIX index, a proxy for implied volatility. Using the S&P 500 and gold as our base assets, we study the performance of these variables by examining both the out-of-sample performance of unconditionally efficient portfolios based on our predictive variables as well as their in-sample performance using a statistical test. Our trading strategies can successfully time the market and avoid losses during the burst of the dot.com bubble in the second half of 2000, as well as during the bull run that followed. The in-sample results confirm our out-of-sample experiments with p-values of less than 1% in all cases. The predictive variables on their own do not perform nearly as well, indicating that it is linkages between these markets that are important for market timing. The VIX provides a signal to change the weight on the market while hedging pressure indicates the direction. We construct variables that combine both of these features and find that these variables provide the clearest signals for successful market timing.