WAG THE DOG

Stocks have stabilized since the passing of macro events two weeks ago. Election week included a CPI print that triggered a single day 5% rip higher, and we’ve been sideways since. Such is the power today’s options market has over stocks.

Other narratives fall short without this dynamic.

BACKGROUND

The rise in options trading has been parabolic since early 2020.

Activity in very short-term options trading has been a major catalyst. Many market indices and single stocks now have daily expiries, including the S&P 500 (SPX).

Source: The Market Ear

Source: Goldman Sachs

Poor Liquidity Amplifies Impact

The role of professional option dealers is critical because customer order flow prompts a response of opposite direction from dealers.

A dealer is always on the other side of your trade. But dealers don’t profit from market direction, as they actively hedge their positions, buying or selling the underlying to zero out. This activity can spark massive feedback loops creating the 5% days.

While options volume is huge, market liquidity is poor, making it difficult for big players to fill orders. They are often forced to chase price, both up and down. This is occurring across the entire complex of equities, futures, and options, including those for US Treasuries. It’s a prime source of market instability.

Bid/ask spreads are key liquidity measures, as shown below.

Millions of option trades require immense real-time dealer hedging. Dealers are economically driven to trade substantial amounts of the underlying itself or futures, only because the underlying itself is changing, not because of fundamental news and without regard to the liquidity available. This has become a large persistent source of market movement.

Source: SpotGamma

Dealer hedging is both momentum-driven order flow and price taking. Dealers cannot wait on a stock bid getting hit if their risk is high, so they will pay spread and take price, whatever the liquidity environment.

The abundance of short-dated options (0-3 days to expiry) becomes an issue because of lower levels of liquidity. It can amplify volatility in ways we saw following the CPI, resulting in investors trying to draw fundamental conclusions from positional options hedging flows.

HOW THIS WORKS (‘Greeks for geeks’)

The options complex has a fair amount of math, often expressed in ‘Greeks.’ Here’s a quick and dirty from the folks at SpotGamma:

Delta: the change of an option from movement in the underlying asset (exposure to direction).

Gamma: the rate of change of Delta, or 2nd derivative change in the underlying.

Theta: the time decay of an option, which is a wasting asset.

Into impactful events like FOMC meetings and CPI traders hedge by purchasing protection (ie, buying puts). This demand for protection is countered by dealers’ supply. To hedge their risk, the dealers trade in the underlying markets (i.e., futures and stock).

Since downside (put) protection is what was highly demanded by traders, the dealers’ hedging (through their sale of futures and/or stock) of their ‘short put’ risk adds to market pressures.

Once the macro-event passes, and the expected movement traders were hedging against does not happen, then traders may sell their options back to the dealers. This will reduce the dealers’ need to hedge and hold short futures (-Delta). Often a feedback loop in the opposite direction will then ensue.

That’s what happened recently after the elections and CPI. Protective puts were either sold or expired. Dealers then bought back their short futures, giving the market a boost.

At the same time, as markets traded higher, traders bought call options, which solicits more dealer hedging, but this time they hedge by buying stock and futures. The chase is on.

The reverse of what happened on the put side now happens here, which often results in follow-on bullishness. This is known as a ‘gamma squeeze.’

Below is a recent term structure for the SPX. At the short end, heading into events such as FOMC and CPI, options volatility was bid, a byproduct of traders’ demand for protection to hedge against near-term uncertainties.

Graphic: Retrieved from Interactive Brokers.

There are neutral price levels where dealer hedging is not a big factor, known as zero gamma thresholds. This is roughly where we’ve been for the past week.

Yet as we enter December and traders’ re-position into the next CPI report (12/13) and FOMC meeting (12/14), volatility should pick-up meaningfully. These events also coincide with the regular December option expiry on 12/16, the largest of the year.

We can once again expect the tail to wag the dog.