(Bloomberg) — What 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.
A mid-month storm of volatility has emerged as a semi-predictable occurrence recently, a presence once recognizable only to specialists but now drawing the attention of an ever-larger crowd on Wall Street.
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 market’s 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.
“The monthly option expiration is what wins people over to the realization that options have a huge impact on the underlying,” 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.
“We’ve never seen this many people trading this many options, and that’s a lot for the system to digest,” said Steve Sosnick, chief strategist at Interactive Brokers LLC and a former market maker.
Like anything in markets, it’s 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, they’re 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.
Here’s 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.
It’s 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 what’s 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.
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“While 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,” 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 option’s sensitivity to shifting volatility. For Garrett DeSimone, head quant at OptionMetrics, dealers are largely buying and selling stock to manage such exposure.
“Gamma is only the tip of the iceberg when it comes to explaining market returns and volatility,” DeSimone wrote in a recent note. “Dealer vanna has a stronger relationship with volatility.”
And then there’s something called charm, or the rate of change in an option’s sensitivity to passing time.
“Charm is a major driver for support in the markets,” said Cem Karsan of Kai Volatility Advisors, which offers a strategy designed to trade around these flows. “All of that support is leading up to and accelerating into that Monday-Wednesday window” ahead of OpEx. “And then the window really opens for lack of support. It’s not like there’s a bunch of selling all of a sudden. It’s a window of non-strength; a lack of these supportive flows that have been there prior.”
Most likely the phenomenon mixes in several of these factors. Yet some skeptics suggest it’s all too tidy of an explanation.
“While the economic logic here is sound — that when professional volatility traders are long options, their collective hedging actions can either mute or amplify market moves — there is simply nowhere near enough of a complete information set on positioning to make robust calculations,” said Dean Curnutt, CEO of Macro Risk Advisors.
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. “There’s been a confluence of news occurring over expiration weeks, just to make life a little more complicated,” 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 it’s becoming widely known.
“In the past few months, more traders have been ‘getting ahead’ of that expiration,” he said. “So recently, you’ve actually been seeing OpEx week in the S&P 500 doing the inverse of what it usually does — it’s been going down.”
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