As the chart below shows, from late July the Dow was showing that there was virtually no support at all, and what resistance there was resided at 12700. Sobering.

This study of futures and options might not predict what will happen, but it most certainly predicts what could happen.

Before discussing the Chart perhaps an appreciation of the environment would be useful. Liffe (founded in 1982) merged with LTOM in 1993 and then in 1996 with LCE. So in essence this entire industry has only been old enough to vote in the last few years.

In contrast the LSE is 210 years old and share trading is commonly believed to have started in the late 17th Century.

With this in mind consider that on August 9 2011 there was 1.54m trades carried out on the LSE, the third highest level, ever, and three times the average daily trading volume so far last year. However in terms of values of stocks traded the average daily turnover to the end of July 2011 was £4.8bn.

In contrast NYSE Euronext’s European derivatives business alone in 2010 traded an average of 4.7m contracts a day, representing business with a notional value of €1.2tr.

To research all this activity there seems to be just two schools of thought, fundamental and technical analysis. Both can and probably do work but with all the changes perhaps not necessarily so well on the very youthful futures and options Industry.

Reverting to the original chart above of the Dow covering the August expiry, the main points are that it is based entirely on free published data that is specific to futures and options which is processed algorithmically. The only vaguely subjective part is the substitution of colours for numbers, which is not just aesthetic but for practical observational reasons.

The colours range from yellow to red then black with yellow the least and black the most. The colours reveal the amount (yellow=least to black=a lot) of futures the market must sell or buy to remain positional neutral, or perhaps better explained as, fully underwritten (risk neutral). This is known as the markets hedge ratio, which is something unique to futures and options in this environment.

So in the case of the Dow in the August 2011 expiry where futures and options were concerned there was pretty much no hedge ratio at all, which you may call it price volatility or whipsaw but as the chart below shows, by this new measure, there was nothing to stop it from going anywhere. To which it duly obliged.

So, the extreme volatility in August might have been anticipated, or at the very least understood that the risk of it was there. That month expired on August 19 2011 and was replaced by September, so the chart below resumes from the very next trading day 22nd August showing the first six trading days, and goes through to its expiry on the September 16 2011.

One can immediately see that there is a far higher degree of hedge ratio intrinsic to this market for this expiry.

In J. Gavin’s excellent article “Swimming together” about the increasing correlations between stocks, he cited a recent survey by JP Morgan into US stock markets. This showed that what was referred to as market returns, or the wider direction of the market, was responsible for less than 30% of stock price takings in 2005.

However in 2010, market returns were responsible for 60% of stock price profits. The report notes that 70% of the price performance of an average S&P 500 company in the industrials sector is caused by the S&P 500 direction and only 30% of performance is stock or even sector specific.

Those who can remember back to the market’s infancy they might also remember the old saying “the tail is wagging the dog” used in reference to a price movement that had been subscribed to option activity rather than equity activity. However the respective growth rates in the markets highlighted above may now indicate the reverse is true.

Furthermore in the UK’s markets adolescence some might remember the extreme colour changes on the trading screens, and sometimes movements, as in the last half hour of a monthly expiry as the markets equity hedge ratio was unwound. Of course time moves on and markets develop and evolve and new rules and guidelines are enacted, but at the end of the day any market is about hedging your risk.

So if one can determine what the markets hedge ratio is at any given time then that may lead to a clearer understanding of one of the influences that may be brought to bear on it.

Although in September the DJIA managed a rather impressive trading range of 900 points, it was a lot calmer than August with fewer highly volatile days with extreme ranges. Furthermore as the expiry passed it finished up on the month, whereas August had a trading range of 2100 points and to compound the effect it was mostly in a southerly direction.

It is worth noting that although we have concentrated on the Dow it should not be taken in isolation, as we would say the S&P 500 index options are the more active, then you also have the Nasdaq as well, and both will exert a considerable influence.

Now, we will show how the hedge ratio completed the October expiry in the Dow, and introduce the S&P 500 and Nasdaq 100 into the mix and at the same time explain in greater detail the logic behind this hedge ratio.

As noted above, JP Morgan’s research identified a growing correlation of stock price performance to market direction, being 70% with the remaining 30% being stock or even sector specific we also believe that there is an identifiable correlation in how the market reacts to the hedge ratio across the three main indices in the US.

In essence we see it as a tripartite future and options influence where if one index is encountering a significant degree of hedge ratio it would not necessarily be able to influence the overall market and in most likelihood would only result in a disproportionate relative performance.

However we believe if two or all three indices were to encounter a significant hedge ratio in conjunction, then that could bring a very significant influence to bear.

So how did the Dow finish the October expiry?

Although the potential was there for a mishap, albeit to not such a great extent as there was in August, it could still have been rather more volatile than it actually was. However there were very few days that were sub 100 point moves and just looking at the chart there were considerable 200 to 300 + point movements, so we don’t think it could be classed as a quiet expiry month by any stretch of the imagination.

From the above chart out of the whole expiry, and with benefit of hindsight, the October 4 2011 was the pivotal moment.

To expand on this we would like to introduce Delta, which in the options and futures world is known as “one of the Greeks”. The official definition of this is the change in the price of an option for every point move in the underlying. In practical terms, every strike has a numerical closing delta ascribed to it, although during the day it is a moving target of course, which is in essence the number of futures that should be traded against that strike to remain risk neutral. For example should a trader buy a certain call option that has a delta of 0.5 then the market maker has to buy half a future to be risk neutral.

Of course that is impractical and with the complex stratagems and huge volumes of business being transacted then it is also ridiculously oversimplified; nevertheless it creates the environment that allows mathematical formulae to be applied.

The upshot of this is the hedge ratio of the market displayed on a chart using just three colours, yellow, red and black and which can change daily. The hedge ratio change in colour is the market’s change in delta, so if the market was in a yellow hedge ratio and went up to challenge a red hedge ratio then the markets delta would be to sell futures. If the market was in a yellow hedge ratio then fell down to a red hedge ratio then the change in the markets delta means they have to buy futures.

So looking at the S&P 500 for October, immediately one can see there is a far greater degree of hedge ratio in this index than what was present in the Dow Jones.

The next most important point to draw one’s attention to is the October 4 2011. Any given markets hedge ratio may reveal where there will be a natural occurrence of futures buying or selling to maintain that markets delta, but how the market reacts to this would still be unknown. There are many aspects that affect a market’s movement and momentum and we would not place the hedge ratio above or instead of any other, however we do believe it is significant enough to warrant attention.

So finally the Nasdaq 100 in October 2011.

Although the hedge ratio here on the October 4 is not a strong as that on the S&P it is still significant.

What must be remembered is that in futures and options they have a finite life and that at the end of it they are settled for cash. Furthermore if this research is correct, then, and as the hedge ratio is calculated daily, which therefore establishes the levels of delta (futures) that the market must buy or sell, it should be able to stand the test of real time.

Richard Jones is a former Liffe broker and a director of JTIM LTD