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Everything You Know Is Wrong, Episode 707
You may know all this already. You may have already attained securities nirvana and read our work merely to amuse yourself at those still on the journey. And to ROFL at anyone whose mind remains steadfastly inside the Securities Matrix. (You’ll know if anyone you meet remains a Matrix dweller. Because they will talk about earnings and valuation and yield and things like that. They have yet to reach the transcendental state which is the final evaporation of any remaining belief that IRL impacts securities pricing. Just give them time. They’ll get there).
If you have cared to look at your brokerage screen today, you may have noticed a larger than usual degree of crimson. In your watchlist even if not your portfolio.
Did the world end? It did not.
Did J-Po whack rates up by 1.5%? He did not.
Did China and Russia just get cozy and agree to hammer the West into submission? They did not.
So what happened?
Opex, is what. Options expiry. Today is September options expiry when approximate one gigatrillion dollars worth of puts and calls in indices, index ETFs, single name stocks and a bunch of other stuff expire. For anyone who has held their options to this late date, now is the time to discover whether they were a good idea or not. And unlike equities you have a counterparty who is very focused on them not being a good idea and doing all they can to make them not a good idea.
This is a theme you will see us expand on a lot in the coming months but for now let’s just lay out the key principles. In amongst the many things not called earnings that weigh on stock and ETF prices is the market for options in that stock or ETF. Indeed the sheer weight of capital in the options market is so huge - and amplified, because one options contract represents 100 underlying shares, remember - that there is an argument to be made that options are not derivatives of stocks, but in fact, stocks are derivatives of options. Someone way smarter than us observed lately that “options are the purest security, because they exist as probability continuums … whereas a stock is merely something where the closing price represents the collapse of the options probability field into a singularity”. Now this is a little self serving since it comes from an options guy. But there is some truth to it. And whether you choose to trade options or not (we do not, since we like our homes), it is absolutely the case that the options market drives the stock market to a far greater degree than is realized by most.
You doubt this? Check this chart. (You can open a full page version, here).
That’s for SPY . You can do the same thing for QQQ and many others.
Nontrivial dates as you can see. And the reason for this is to do with how liquidity is provided in the marketplace. Dealers, or market-makers if you will, sell options to large investors who wish you use them either as in-their-own-right trading strategies or as a way to supplement a stock strategy - using call options for upside opportunites and puts for downside. If the dealer sells a put, the dealer is now long the market; the dealer has to then offset that long with a short position in the underlying stock in order to remain market-neutral. The more puts the dealer sells, the longer the dealer is, so the more they have to short the underlying stock. And remember those puts are being bought by investors for reasons of sentiment. As protective measures. So when investors get spooked, they buy more puts; dealers get longer as a result; dealers have to short more; the market goes down; so investors get more spooked; and have to buy more puts whereupon … ah you see. A spiral of doom.
Now let’s say there is a preponderance of puts with strike X such that if the underlying ETF or stock is below X, those puts are in the money. If you are the dealer that sold those puts, you do not want that. You just want to collect all the premium from selling the puts and then have nothing else to worry about. So to the extent you are able to do so within the law, wouldn’t you be just a little motivated to keep the market a touch above that put strike at expiry? Exactly.
Now the day after options expiry, what happens? Well, the options have expired, so, as regards puts, dealers now have to cover all those short positions, that’s what. And that means buying pressure likely to push the stock or ETF up (or if calls expired, selling pressure down) . Which is why you see major reversals take place around options expiry date.
This is playing out right now on your screen. Monday will bring a truer pricture of the landscape - featuring furious dealer rebalancing trades - Tuesday more so.
So - that’s Part I of a neverending journey through the Options Rabbithole. Until next time!
Cestrian Capital Research, Inc - 16 September 2022.
Love the simple yet educative explanation of what happens at options expiration.
Great note- thank you.