(Bloomberg) — Bulls reeling from the still-hawkish Federal Reserve’s slant are about to lose a major force that helped calm turbulence in US stocks during this week’s macroeconomic drama.
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An estimated $4 trillion of options are expected to expire on Friday in a monthly event that tends to add turbulence to the trading day. This time around, with the S&P 500 stalling for weeks within 100 points of 4,000, massive volume provides a repositioning that can fuel market moves. Given the brutal backdrop that has unfolded in recent days, from a series of interest rate increases by global central banks to signs that the US economy is starting to pick up, fears are mounting that expiration will be an air pocket.
This is how David Reddy, founder of First Growth Capital LLC, sees it happen. In his view, the market was mired in a “long gamma” state where options traders need to reverse the prevailing trend, buying stocks when they are down and vice versa.
Friday’s event “could break the tightness of gamma-ray exposure and lead to some scattering, i.e. room for index penetration,” Reddy said. “This would be a downward move given the year-end adjustments to the situation and the overall recessionary view.”
Options tied to the 4,000 level on the S&P 500 account for the largest portion of open interest that is set to mature and act as something of a tether to the index price in the weeks leading up to Friday, according to Brent Kochuba, founder of Spot Gamma.
Stocks were already under pressure on Thursday as the European Central Bank joined the Federal Reserve in raising interest rates and warning of more pain to come. The S&P 500 sank 2.5%, closing below 3,900 for the first time in five weeks.
This makes for a pivotal day, when holders of options tied to indices and individual stocks — whose notional value according to Rocky Fishman, strategist at Goldman Sachs Group Inc. , $ 4 trillion – they either roll over existing positions, or start new deals.
This time the event coincides with the quarterly expiration of index futures in a process known ominously as triple magic. Added to this is the rebalancing of benchmark indices including the S&P 500. The group tends to release single-day trading volumes which rank among the highest in the year.
“Between expiration and rebalancing, Friday is likely to be the last ‘liquidity day’ of 2022,” said Chris Murphy, co-head of derivatives strategy at Susquehanna International Group.
Options traders were bracing for turbulence in this week’s consumer price report and the last Federal Open Market Committee meeting of the year. In a sign of growing anxiety, the derivatives market did something extraordinary on Monday with the Cboe Volatility Index, a measure of the cost of options known as the VIX, jumping more than 2 points while the S&P 500 rose 1.4%. This is the largest coordinated gain since 1997.
“Essentially all options prices linked to Friday were very high, very sensitive to implied volatility (and time fading) because they expire in a few days,” said Kochuba of SpotGamma. “Once the events passed, implied volatility (i.e. the value of those options) subsided, triggering hedge flows that brought a mean bounce back to the markets.”
The dynamic was on display on Wednesday, as declines in the S&P 500 coincided with a slide in the VIX, once again bucking the historical pattern of them moving in opposite directions.
De-hedging removed one market’s support and opened the door to more volatility, according to Danny Kirsch, head of options at Piper Sandler & Co.
“Now that the event has passed, the market is free to move further,” he said. “And the realization of a higher Fed versus a longer one is starting, as well as the high probability of a recession next year.”
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