by (Bloomberg) – Bulls reeling from the Federal Reserve’s still hawkish stance are about to miss out on a major force that helped quell the turmoil in US stocks during this week’s macroeconomic drama.
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About $4 trillion worth 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 stuck for weeks within 100 points of 4,000, the massive volume provides a reset of positioning that could boost market moves. Given the brutal backdrop that has emerged in recent days, from a string of rate hikes by global central banks to signs that the US economy is starting to shrink, fears are growing that the deadline will act as an air pocket.
Here’s how David Reidy, founder of First Growth Capital LLC, sees it play. In his view, the market has become mired in a “long-range” state where options traders have to go against the prevailing trend, buying stocks when they go down and vice versa.
Friday’s event “could break the tightness of gamma exposure and lead to some dispersion, ie room for the index to rise,” Reidy said. “That would be a downward move given the year-end position adjustments and the macro-recession view.”
Options tied to the 4,000 level on the S&P 500 represent the largest chunk of open interest set to accrue and acted as something of a constraint on the index’s 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 Fed in raising interest rates and warning of more bad debt to come. The S&P 500 fell 2.5%, closing below 3,900 for the first time in five weeks.
This sets up a pivotal day, in which holders of index-linked and single-stock options — whose notional value according to Goldman Sachs Group Inc. strategist Rocky Fishman is worth $4 trillion — will need to roll over existing positions or initiate new ones.
The event this time coincides with the quarterly index futures expiration in a process ominously known as the triple witch. Added to this is a rebalancing of benchmark indices, including the S&P 500. The combination tends to trigger daily volumes that rank among the highest of the year.
“Between the expiration and the rebalances, Friday will likely be the last ‘liquidity day’ of 2022,” said Chris Murphy, co-head of derivatives strategy at Susquehanna International Group.
Options traders were bracing for the turmoil during this week’s consumer price report and the last Federal Open Market Committee meeting of the year. In a sign of heightened anxiety, the derivatives market did something unusual on Monday with the Cboe Volatility Index, an option cost gauge known as the VIX, jumping more than 2 points as the S&P 500 jumped 1 .4%. This is the largest concerted gain since 1997.
“Essentially all options prices tied on Friday were extremely high and very sensitive to implied volatility (and time decay) because they expire in a few days,” SpotGamma’s Kochuba said. “Once the events have passed, implied volatility (i.e. the value of these options) has increased, leading to hedging flows that have driven a mean reversal in the markets.”
The momentum was on display Wednesday, as a decline in the S&P 500 coincided with a slide in the VIX, bucking the historical pattern of their movement in opposite directions.
The unwinding of hedges has removed a market support and opened the door for higher volatility, according to Danny Kirsch, head of options at Piper Sandler & Co.
“Now that the event has passed, the market is free to move more,” he said. “And the realization of a higher Fed for longer is starting, plus the high possibility of a recession next year.”
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