Options Turn Upsets into Mid-Month Sure for the S&P 500

(Bloomberg) – What can you say about a stock market that has become so predictable that even its bouts of chaos now occur at regular intervals? A lot, when the options experts get involved.

A mid-month storm of volatility recently emerged as a semi-predictable event, a presence once recognizable only to scholars, but now capturing the attention of a growing crowd on Wall Street.

You saw it in July, when the S&P 500 fell 2.3% in two sessions until the 19th. In June, the index experienced its biggest drop on the 18th. April saw the ‘benchmark vanished for two days, from the 19th to the 20th. In February, it fell 2.5% in the week starting on the 22nd. The pattern was repeated this month when stocks hit their peak. sharp drop from August 17th and 18th.

What all of these things have in common is that they happened around the third Friday of the month, when most stock options expire. While anything that explains the mysterious market movements is sure to attract attention, the turbulence surrounding this event – known colloquially as OpEx – has become a source of fascination as it disrupts the traditional relationship between options and their underlying assets. What this suggests is that the stock market has indeed become a derivative of its own derivative – the tail wagging the dog.

“The monthly options expiration is what makes people realize that options have a huge impact on the underlying,” said Matt Zambito, founder of analytics service SqueezeMetrics and one of the early diffusers of the phenomenon.

While specialists say this momentum has been around for decades, it has intensified over the past year as options activity reaches unprecedented levels. Between day traders buying speculative calls, yield seekers selling them, and institutional hedgers taking on protective puts, option volume and open interest skyrocket, leaving market makers struggling to absorb all the money. flux.

“We’ve never seen so many people trade so many options, and that’s a lot for the system to digest,” said Steve Sosnick, chief strategist at Interactive Brokers LLC and former market maker.

Choice of dealer

Like everything else in the markets, it’s unwise to assume that one explanation is the whole story – but many of these come back to options brokers when they decipher mid-month storms. Why the dealers? Reluctant to take directional exposures, they are the most active hedgers on the market. And their buying and selling is believed to have become large enough to move stocks almost like clockwork.

This is how it works. When an investor buys or sells an option, the other side of that transaction is taken over by a market maker. These brokers usually balance their books by buying and selling the underlying stocks or index futures.

It is this buying and selling that is supposed to create recognizable patterns around OpEx. As the expiration approaches, dealers are believed to neutralize volatility by selling on rallies and buying on dips – and there have been mostly rallies this year. Once these positions expire, this stabilizing force disappears, which is why volatility may be higher immediately after.

In an area known for its impenetrable jargon, various explanations have sprouted up to explain exactly what is going on.

A headache involves gamma, which refers to how the sensitivity of an option changes as the underlying stock moves. Dealers who hedge their gamma exposure are said to contribute to stocks that are generally calm and drift upward as the expiration approaches, and brief periods of volatility that arise in stride.

Read more: Playing with volatility? Get to know “the Greeks”

“Although it is difficult to generalize, in recent times (2020-2021) market makers often have a long gamma before the monthly options expire, which has caused volatility to be suppressed during the week of. expiration (Monday-Thursday) and (relatively) an increase in volatility. thereafter, ”wrote Stefan Wintner, portfolio manager for volatility strategies at DUNN Capital Management LLC, in an email.

Another popular term is vanna, which measures changes in an option’s sensitivity to changes in volatility. For Garrett DeSimone, chief of OptionMetrics, dealers largely buy and sell stocks to manage such exposure.

“Gamma is just the tip of the iceberg when it comes to explaining market returns and volatility,” DeSimone wrote in a recent memo. “The vanna dealer has a stronger relationship with volatility.”

Time factor

And then there’s what’s called the charm, or the rate of change in an option’s sensitivity to passing time.

“Charm is a major driver of support in markets,” said Cem Karsan of Kai Volatility Advisors, who offers a strategy designed to trade around these flows. “All of this support is leading and accelerating in this Monday through Wednesday window” ahead of OpEx. “And then the window really opens for lack of support. It’s not like there is a bunch of sales all of a sudden. It is a window of non-force; a lack of those streams of support that were there before.

Most likely, the phenomenon is mixed with several of these factors. Yet some skeptics suggest this is too tidy an explanation.

“While the economic logic here is sound – that when professional volatility traders are long options, their collective hedging actions can either dampen or amplify market movements – there just isn’t enough of it. comprehensive positioning information to make robust calculations, ”said Dean Curnutt, CEO of Macro Risk Advisors.

Monthly muddle

Curnutt points out that there are important elements that are not taken into account in these explanations, such as the impact of over-the-counter options, contracts linked to structured products and options of the Cboe volatility index on brokerage portfolios. There are also big assumptions about what these market makers actually do.

Complicating matters is that recent market development events, such as data releases and news around the Federal Reserve, appear to have clustered around mid-month. “There has been a confluence of news occurring over the expiration weeks, just to make life a little more complicated,” said Sosnick of Interactive Brokers.

Finally, traders are now well aware of the dynamics and quantitative strategies designed to trade around reseller flows are even spilling over to structured products. Zambito argues that the whole phenomenon may be over by the time it becomes widely known.

“In recent months, more and more traders have ‘moved ahead’ of this expiration,” he said. “Very recently you saw the S&P 500 trading week do the opposite of what it usually does – it’s down.”

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