Derivative-based market indicators

It seems the importance and speculative value of using derivatives as an indicator of risk increased tremendously following the credit crisis, which, for the most part, I think is due to rating agencies maintaining AAA ratings before the panic. Considering the volume of derivatives contracts (MBS, CDO) amplified during the real estate boom, and rating agencies failed to respond and adjust their ratings, investors now view the strategy of financers as a way to judge market risk. The logic: if derivative volume is growing, investors must be preparing for default (or a significant drop in the market).

Some derivatives, such as typical stock options, trade on exchanges.  But many are private contracts between banks or other investors.  As a result, it is hard to know the total volume of derivatives now outstanding. That is both an advantage and disadvantage of using a derivative-based index to measure risk. While price discovery is stimulated and there is a greater degree of market “completeness,” volatility increases since a larger number of derivative participants leads to speculation and raises impulsiveness in the markets (compare historic VIX charts and you’ll see that a majority of spikes have taken place in the last 5 years). Moreover, since OTC derivative trading is still going through massive international regulation, I think derivative-based indicators, as well as other market breadth indicators, should be used with reservations when making an investment decision.

For instance, consider the charts below. The first displays a comparison of OTC derivative markets in 2010 and 2013. The second is a breadth charting showing an Advance-Decline (AD) line for the NYSE.

Short sellers using derivative-based market indicators over the last few years have not profited. The derivative market has grown by over $100B, but AD indicators show no sign of slowing down. We are definitely experiencing a bull market. However, 2008 showed us that breadth charts could move rapidly, and bulls can turn to bears in seconds. A market/bubble “pop” is always something to consider. Who knows, maybe there is another Mike Burry lurking and waiting to capitalize on the next bear market.

A bit off-topic, but since the subject of short selling, derivatives and risk management is on the table, what are your thoughts on inverse and leveraged ETFs?

References used:

http://business.time.com/2013/03/27/why-derivatives-may-be-the-biggest-risk-for-the-global-economy/
http://www.risk.net/risk-magazine/feature/2332503/otc-reforms-numbers-only-tell-part-of-the-story
http://www.financialsense.com/contributors/matthew-kerkhoff/market-breadth-indicators-important