SQUEEZE ME

The September jobs report elicited the usual mixed emotions from the media last Friday. To wit:

Stock Market News, Oct. 6, 2023: Indexes Climb, Led By Nasdaq, After Hot Jobs Report

Stock and bond prices recover to end the week after falling early

Oct. 6, 2023 at 5:30 PM EDT WSJ

September Employment Report: Might Be The Last Strong Economic Data You See

Oct. 06, 2023 1:00 PM ET Seeking Alpha

Instant View: US job growth smashes expectations, raising prospects for rate hikes

Reuters / October 6, 20239:05 AM EDT

Whether the report was “hot”, “too hot”, “cool beneath the surface”, or a “mixed bag” is up for debate. A dozen narratives can be spun to fit one’s point of view.

Some will suggest the stock market “liked” the report given its sudden reversal mid-morning, as shown here:

More likely, however, the rally was borne of a mechanical feedback loop known as a “gamma squeeze” in the options market. Outsized moves frequently occur when extreme option positioning meets a catalyst.

This may lack narrative sizzle, but it’s how the market really works. Let’s go deeper.

Ahead of impactful events large institutional investors (and speculators) hedge by purchasing puts on the S&P 500 to insure against a bad outcome. Then once the event hits they must decide what to do with them.

Into Friday’s report there was heavy put demand which spiked levels of implied volatility. You can see this below on the far left of the graph. Note too, the inversion of the curve (‘backwardation’) which occurs when people fear something.

We can also see the dominance of puts (in red) versus calls (blue) to the left.

Immediately following the report stocks fell hard, then by mid-morning put holders started cashing out. ‘Take-the-money-and-run,’ or risk evaporation from time decay.

Now, about that S-Q-U-E-E-Z-E.

Squeezes occur from rapid transactions that cause a significant increase in the price of the underlying asset, in this case SPX. The impact of gamma on options pricing cannot be overstated.

Gamma represents the velocity of change in an option’s delta, which measures how much the option price will change for every $1 movement in the underlying.

In our example, when a large number of traders start selling their puts, market makers (dealers) buy them and must immediately hedge themselves by buying SPX futures contracts. The buying pressure from dealers trying to adjust their delta exposure creates a feedback loop as higher prices can trigger more buying of SPX as speculators jump aboard.

The surge in volume provides an organic bid which provides price support and prevents any material dips. This is also known as a ‘pain-trade,’ as those on the wrong side have to endure the cascading effect of rising prices.

Strategies that are aware of these mechanical dynamics can be extremely profitable.

Just don’t conflate a squeeze with a larger judgment about the market or the economy.