Lead-Lag

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Leading Constituents of NIFTY50 | My Counter-intuitive Findings

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If you follow the blog you would have heard me say our NIFTY-50 index is pretty skewed from a weight-age standpoint, top 10 stocks account for close to 60% of the index, top 25 account for close to 80 and the balance 25 stocks account for just 25% of the index weight-age.

Intuition would tell us, so long as we follow the top 25 constituents i.e. (80% of Weight-age) we should be good. Good in the sense we should be able to predict short term (15 to 60 minutes) trends in the index.

To be frank I along with a few others spent several months in that top 25% rabbit hole, only to realize that the action more often than not begins in the bottom 25 stocks.

Here are some visualizations

Before we move to the visualization, please refer the Legends / Descriptors below

Legends / Descriptors for the NS Advance Relative Strength Indicator

As you see in the Legends we have two indicator panels below the NIFTY Fut price chart. The Top panel refers to the top 25 Stocks and the bottom panel refers to the Next 25 stocks.

Now let me take you though a few sample days when the Bottom 25 Stocks lead the top 25 and also the Index, though I have back-tested this phenomena, I am bound not reveal the specifics, but this is the idea and you can test it for yourself.

29th Aug’19 - Look at the Stocks above +1 SD of VWAP - They lead by close to 15 minutes

5th Sep’19 - Look at the Stocks Above VWAP line - They lead almost all through, even though stocks below -1 SD are fairly high on the top 25 Stocks.

12th Sep’19 - Look at the -1SD line crossing over the % of Stocks above VWAP line - Happened in the bottom 25 Stocks way before it did on the top 25

20th Sep - How can I forget this day - Look at the % of Stocks above 1SD line, again led the upper 25 by close to 20 minutes.

During the trading day, I keep an eye on the bottom 25 stocks and if I notice any divergence, I become cautious, as it could a portent of doom esp., if I am on the wrong side of the trade. Time permitting I also tell my mentees on the slack group.

slack.PNG

Something similar happened on the 20th of Sep’19, a day which would be etched in my memory, not because I was positioned on the right side of the trend, but because it was a classic demonstration of almost everything that Mandelbrot says in his book Misbehavior of Markets.

Back to the charts, this phenomena of bottom 25 stocks leading can also be observed through a sectoral index lens, since each of these segments top 25 vs next 25 have a sectoral skew within it, more about it next time.

Before I close -The usual disclaimer applies, don’t use this factor in isolation, there are other factors that I consider before initiating a trade, the purpose of this post is only to illustrate the informational value in tracking the bottom 25 stocks of the NIFTY50 index. About the 20th Sep’19 trade, no I am not saying I predicted it, all that I am saying is the same signal helped me capture a good part of the move.

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Educational Explainers - Lead Lag Effect - NIFTY

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Last week we looked at what Indexes are (Over here).

This week we are investigating the lead-lag relationship between Spot price and Future prices in NIFTY.

So what does academic research and years of observing the market tell us? The verdict is out..

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What moves the Index? - The concept of 'Information Flow' and how it works in ^NIFTY50

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whatindex.PNG

We’ve all wondered at some point or the other as to what moves the Index? 

And if you are an avid Fintwit follower, you would also have heard people saying “The futures are at a discount, looks like market will fall” or “I see some big orders being punched in NIFTY FUTs, the index is going to rocket”, and other similar things.

In this post, Let’s try to deconstruct how an index moves from one point to another.

So let’s start with the basics

What is an Index? - An Index is a collection of Stocks, the prices of which are weighted and together they arrive at an aggregate value. The weightage in case of ^NIFTY50 Index is based on the market cap of the constituent stocks. If you want to learn more about the constituent stocks and their weight-age, this is the place.

So how do we trade or speculate on an Index? - There are two broad ways to speculate on an Index, and that’s is either through Index Futures or Index Options. For Investors though the choices are ETFs and Index Mutual Funds.

For the context of this post we will stick with Index Futures. In our case that would be NIFTY FUT.

What makes the Index move up or down? - Say the average change in the value of an index is 30 points, why does it move so much?

Average change here means the average of the Open-Close value of the index.

For example if the index opened at 11050 today and closed at 12000 we had a change of +50 points. So if we average this value over say 20 trading days, we may arrive at a value something close to 30. So what’s making this move happen?

It moves because the prices of the constituent stocks change. Say for instance if the top 5 stocks, by market cap - Reliance, HDFC, HDFC Bank, ITC, Infy etc. move down, the market will move down, and visa versa. However, there could be other factors which can effect the change as well, for example, in very short time frames like under 5 minutes, in certain indexes, its the Futures which leads the change in the Index value.

Time-frame of analysis and how it can make a difference?

Are we looking at reasons as to why index moved since last week? or are we looking at reasons as to why index moved since last minute?

As you can see, if you are looking at change on larger time frames, its always Constituents Stocks leading the change in Index value, however on shorter time frames it could be Futures leading the change in Index value.

What is “Information Flow” and what is its relevance here?

Information flow is about the direction of causality of price discovery in a given market, due to the flow-of-information (news/announcements etc.) If that sounds a bit wonkish - what it means is, its either the traders of the constituents stocks who react to the news flow first or its the Index Futures traders who do. These two types of reactions cause two different types of Information flows across Indexes (Spot) and Futures.

The two types of informational flows

Type - a) (Stocks) Spot to Index Futures : Spot value changes first leading the Futures prices to change

Type - b) Index Futures to (Stocks) Spot : Futures prices change first leading the change in the Spot value

Like everything else, it’s more about which type of information flow is more dominant in a given market. It’s not necessarily binary.

As pointed out in the research paper below, for ^NIFTY50 its Type (a) which is more dominant (Image below from reference #2).

This however is not true for all markets, for instance the S&P 500 works on Type (b) logic.

excerpt.PNG

So if you are a short term / intraday trader in ^NIFTY it may be of more value for you to know that its the Spot that leads the Futures.

And one more thing

How do the quants/researchers know, which of the two moves first - Index Value (Spot) vs. Index Futures? 

There are different statistical ways of measuring the strength and direction of causality, look up “tests of causality” if you are interested, for further reading, look up Judea Pearl’s work.

As an Intraday trader, the next time you think about - Why did the ^NIFTY50 index move? You might ask well ask - Which of the constituent stocks moved ^NIFTY50?

Trivia

The name NIFTY50 actually comes from the US Markets, more here.

Judea Pearl happens to be Daniel Pearl’s father

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Lead-Lag / Volatility Spillover Effects | Some evidence from academic literature

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One of the most fundamental concepts one needs to understand as an Index Trader is that of Lead-Lag effect. I have been reading through several academic papers to get a grasp of it. Here are some that stood out.

Notice the difference between NIFTY and the other markets, I rest my case here.

Price discovery on the S&P 500 index markets: An analysis of spot index, index futures, and SPDRs -  Quentin C.Chu, Wen-liang, Gideon Hsieh, YiumanTse

Price discovery in the German equity index derivatives markets - G. Geoffrey Booth , Raymond W. So , Yiuman Tse

Domestic and international information linkages between NSE Nifty spot and futures markets: an empirical study for India Sanjay Sehgal Mala Dutt