Options Turn Upheavals Into a Mid-Month Sure Thing S&P 500
Aug 29, 2021 22:26:03 GMT
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Post by highskier on Aug 29, 2021 22:26:03 GMT
Bloomberg Markets
By
Yakob Peterseil
August 28, 2021, 4:00 PM EDT
⢠Unprecedented activity spurs hedging by market makers
⢠Skeptics say focus on dealer trades is too tidy an explanationWhat can you say about a stock market grown so predictable that even its bouts of chaos now occur at regular intervals? A lot, when options whizzes get involved.
You saw it in July, when the S&P 500 lurched 2.3% lower over two sessions through the 19th. In June, the index had its largest drop on the 18th. April saw the benchmark swoon for two days from the 19th to the 20th. In February, it dropped 2.5% in the week starting the 22nd. The pattern was reprised this month when equities had their biggest slide of August on the 17th and 18th.
What all these things have in common is they happened around the third Friday of the month, when most stock options expire. While anything that explains the marketâs mysterious moves is bound to get attention, the turbulence around this event -- known colloquially as OpEx -- has become a source of fascination because it upends the traditional relationship between options and their underlying assets. What it suggests is that the stock market has effectively become a derivative of its own derivative -- the tail wagging the dog.
âThe monthly option expiration is what wins people over to the realization that options have a huge impact on the underlying,â said Matt Zambito, founder of analytics service SqueezeMetrics and an early publicizer of the phenomenon.
While specialists say this dynamic has existed for decades, it has intensified over the past year as options activity surges to unprecedented levels. Between day traders buying speculative calls, yield-seekers selling them, and institutional hedgers loading up on protective puts, options volume and open interest are soaring -- leaving market-makers struggling to absorb all the flow.
âWeâve never seen this many people trading this many options, and thatâs a lot for the system to digest,â said Steve Sosnick, chief strategist at Interactive Brokers LLC and a former market maker.
Dealerâs Choice
Like anything in markets, itâs unwise to assume any explanation is the whole story -- but quite a few come back to options dealers when deciphering the mid-month storms. Why dealers? Loath to take on directional exposures, theyâre the most active hedgers in the market. And the thinking goes that their buying and selling has grown large enough to move stocks almost like clockwork.
Hereâs how it works. When an investor buys or sells an option, the other side of that trade is taken up by a market maker. These dealers typically balance their books through buying and selling the underlying stock or index futures.
Itâs this buying and selling that is said to create recognizable patterns around OpEx. In the run-up to expiration, dealers are thought to neutralize volatility by selling into rallies and buying on declines -- and there have been mostly rallies this year. Once those positions expire, that stabilizing force disappears, which is why volatility can gap higher in the immediate aftermath.
In an area famous for its impenetrable jargon, a variety of explanations have sprouted up to explain exactly whatâs going on.
A leading take involves gamma, which refers to how the sensitivity of an option changes as the underlying stock moves. Dealers hedging their gamma exposure are said to contribute to the typically quiet, upward drifting stocks in the run-up to expiry, and the brief bouts of volatility that arise in the aftermath.âWhile it is difficult to generalize, in recent times (2020-2021) market makers were often long gamma going into the monthly option expiration, which led to suppressed volatility during the expiration week (Monday-Thursday), and (relatively) increased volatility thereafter,â Stefan Wintner, portfolio manager for volatility strategies at DUNN Capital Management LLC, wrote in an email.
Another term that crops up is vanna, which measures changes in an optionâs sensitivity to shifting volatility. For Garrett DeSimone, head quant at OptionMetrics, dealers are largely buying and selling stock to manage such exposure.
âGamma is only the tip of the iceberg when it comes to explaining market returns and volatility,â DeSimone wrote in a recent note. âDealer vanna has a stronger relationship with volatility.â
Time Factor
And then thereâs something called charm, or the rate of change in an optionâs sensitivity to passing time.
âCharm is a major driver for support in the markets,â said Cem Karsan of Kai Volatility Advisors, which offers a strategy designed to trade around these flows. âAll of that support is leading up to and accelerating into that Monday-Wednesday windowâ ahead of OpEx. âAnd then the window really opens for lack of support. Itâs not like thereâs a bunch of selling all of a sudden. Itâs a window of non-strength; a lack of these supportive flows that have been there prior.â
Most likely the phenomenon mixes in several of these factors. Yet some skeptics suggest itâs all too tidy of an explanation.
Monthly Muddle
Curnutt points out there are important elements that go unaccounted for in these explanations, such as the impact of over-the-counter options, contracts linked to structured products and Cboe Volatility Index options on dealer books. There are also big assumptions made about what these market makers are actually doing.
Muddying matters is that recent market-moving events, such as data releases and news around the Federal Reserve, seem to have clustered in the middle of the month. âThereâs been a confluence of news occurring over expiration weeks, just to make life a little more complicated,â said Sosnick of Interactive Brokers.
Finally, traders have by now become well aware of the dynamic, and quant strategies designed to trade around dealer flows are even trickling down into structured products. Zambito argues that the whole phenomenon may be over just as itâs becoming widely known.
âIn the past few months, more traders have been âgetting aheadâ of that expiration,â he said. âSo recently, youâve actually been seeing OpEx week in the S&P 500 doing the inverse of what it usually does -- itâs been going down.â