Tracking correlations between Total Return Swaps trades and cash equity price movements

In preparing for a relaunch of our Total Return Swaps (TRS) product, we’ve been doing more analysis on what the data say. We’re starting to see some correlations between TRS transactions and later equity stock prices. Buyer beware however: not every great leveraged trading idea comes to fruition.

In July 2022 we looked at Digital Realty Trust (DLR), which short seller Jim Chanos had mentioned in a Financial Times article as part of an investment thesis. We researched securities loans, options and Total Return Swaps for DLR to see how the short would play out. Between the three, we found that TRS had the market share. At the time we couldn’t separate longs from shorts, and could only say that the TRS market for DLR was more active than the physical short selling market.

We can now identify that a big TRS short happened on June 14, 2022 (the blue line below), two weeks before the Chanos FT interview. The dollar volume of that trade was an anomaly, coming after almost no big short TRS volume since March 2022. After June 14, we can see that the cash equity price of the stock trended down, ending 28% lower for the year. Into November and December, we saw two even bigger long TRS trades happen, the first that coincided with a spike in the stock price. There was also another short at the end of November as the stock started falling again: this looks like a divergence of opinion in the hedge fund world.

The data suggest a few things to us:

1. Big jumps in long or short TRS activity should be noted as a leading indicator of potential future cash equity price movements. When this happens, someone has taken out a big position on an investment thesis. Since many of these TRS trades are between hedge funds and prime brokers, the logic suggests that the trade would be made by a hedge fund that has done its research.
2. There can be a correlation between big TRS trades and future stock price movements as shown in the DLR case. At the same time, hedge funds get the story wrong too from time to time: before Tesla, Green Mountain Coffee was a great example when the stock price rose relentlessly as the securities lending rate increased and short sales mounted. The shorts were ultimately redeemed but also like Tesla, it took a while.
3. Two big spikes in a row don’t mean much. TRS trades don’t reverse (there is no short that cancels out a long), but they can expire or be cancelled. The chart above does not say what volumes expired or were cancelled, so you couldn’t look at this chart and say that there was a cumulative $80 million in long TRS made in Q4 2022. You’d have to parse through the new transactions, what’s expired and what’s cancelled to reach a conclusion about cumulative exposure from a given date. We have all that data and will be providing a lookup GUI for clients shortly.

US equity TRS represent a large (around US$4 billion this week) portion of liquidity that doesn’t show up in any other market source of data. Tracking daily exposures and correlating against future cash equity prices is the first step to incorporating TRS in a trading strategy.