In the first three parts of this series we looked at indicators which give us a sense of the microstructure activity of an instrument. In this last and final part, we will try to put it all in context.

Lets’ start with the first principles, the key to all that we are discussing is to see - if LOB (Limit Order Book)/Microstructure dynamics leads price change? If so, is the lead time ‘tradable’. What I mean here is, if it leads by a fraction of a second, then it’s not easy to trade on that signal, we need a lead time within which we can execute a trade.

Another way of articulating the first principle is - What moves price esp. Index Futures? What is the direction of causality as the academicians would say? Does spot/cash market lead futures or is it the other way round?

The reason it’s important to get a handle on this is, because the tools that one would design or use would need to be completely different.

For instance if the Index Futures lead price discovery, then it makes good sense to use Orderbook/Microstructure information as that would ideally precede the move in price. However, if it’s the spot or the cash market that leads, then you may want to look at indicators that capture the bias within the index constituents.

 If you look at the academic literature that examines lead-lag relationships between index futures and spot, you would find indexes which fall on either ends of the spectrum in terms of their bias, almost all would be bidirectional at some points. It seems the degree of participation from Individual Investors, Domestic Institutional Investors and Foreign Institutional Investors has an effect. I am sure there are many other structural reasons which influence this lead-lag effect.

Evidence for NIFTY suggests a Spot to Futures direction of causality.

Now that we have some sense of the direction of causality, I leave it to you figure out, which indicators (in a shorter time frame) would better predict NIFTY Futures. It’s also worth exploring if this lead time between the Spot and futures market is “tradable”.