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Positioning
In Physik Invest’s Market Intelligence letter for December 21, we discussed the potential for “pressure on options prices [to] remain through December.” In short, on the odds that “nothing happens through the holidays,” it made sense to sell implied volatility (IVOL) after CPI and FOMC targeting an end-of-month expiration.
The downward trajectory in IVOL remains intact in spite of some pockets of weakness under the hood in index heavyweights like Tesla Inc (NASDAQ: TSLA); expectations of future movement remain mute at both the index and single stock levels. As a result, short volatility trades (e.g., short straddle) in the indexes and near current market prices, expiring later this month, are doing really well.
Part of the equation resulting in this sideways market and tame IVOL environment was discussed in the December 21 letter. Today we add color.
In short, traders’ anticipation of a market drop, as evidenced by them reducing equity exposures into and through the 2022 market decline, coupled with the exploitation of loopholes manifesting increased demand for short-dated exposure to movements (i.e., gamma), and a supply of IVOL that is farther-dated, has put a lid on broad equity IVOL measures like the Cboe Volatility Index (INDEX: VIX) and pushed skew lower.
Consequently, hedges performing well have a lot of +gamma intraday and exposure to realized volatility (RVOL), and less exposure to longer-dated IVOL. The other side of this trade (and those who may be warehousing this risk) has exposure to -gamma and, to hedge that, they must act in a manner that exacerbates realized movement, hence RVOL’s meaningful outperformance.
In fact, RVOL in 2022 is nearly two times the level of RVOL in 2021, all the while the IVOL term structure is basically at the “same place it was a year ago,” according to Danny Kirsch of Piper Sandler Companies (NYSE: PIPR).
In a two-and-a-half-hour Twitter Spaces discussion, Kai Volatility’s Cem Karsan discussed what is the potential cause of this. Some of the blame rests on the way margin calculations (i.e., the loophole mentioned earlier); less cash must be posted if trades are closed the same day, basically.
Anyways, at the macro level, yes, the trends continue. Generally speaking, IVOL is mute and not accounting for the activity in short-dated options, as discussed by The Ambrus Group’s recent paper, while RVOL is about two times the level it was in 2021, making +gamma profitable.
However, at the micro level, so to speak, as we started out this discussion, traders’ anticipation that “nothing happens through the holidays,” has resulted in the supply of short-dated volatility, boosting the stickiness of open interest at current market prices.
Let’s unpack this further and explain why this activity won’t continue forever.
Near current market prices sit large concentrations of options positions. For instance, we have the $3,835.00 SPX strike (the call part of a massively popular collar trade that is rolled every quarter). At $3,835.00 is the short strike of a big collar trade.
This means the trader (or fund owner) is short the call, hence -delta and -gamma. The other side (or counterpart) is long the call, hence +delta and +gamma.
In theory, the other side, in response to this exposure, will buy weakness and sell strength. In other words, to hedge a long call, the other side sells futures. If the market falls, the call’s delta will fall and become less positive. Therefore, the other side will buy back some of their initial futures hedges (reduce -delta from short futures) to neutralize delta risk. If the market rises, the other side will have more exposure to +delta. To neutralize the delta, the other side will sell more futures.
As a consequence, the market pins.
This is a trend, as we discussed on December 21, that likely continues through year-end. After year-end, the market is likely to “move more freely,” per SpotGamma, “because this options activity that is promoting mean reversion will no longer be there,” and, therefore, the indexes likely trade more “in sync with its wild constituents of the likes of Tesla and beyond.”
More on what’s next:
As Karsan dissected, yesterday, there’s a “liquidity premium” that’s getting crowded short; in this less well-hedged market environment, traders’ realization with respect to liquidity and collateral needs for supporting trading activities may provide the context for some sharp drops. But first, it’s likely (though not certain) the market experiences some relief. Knowing that the long-end is cheap (hence near-zero percentile skew) on a supply and demand basis, it does not make sense to sell options blindly out in time.
Technical
As of 6:30 AM ET, Wednesday’s regular session (9:30 AM – 4:00 PM ET), in the S&P 500, is likely to open in the middle part of a balanced overnight inventory, inside of prior-range and -value, suggesting a limited potential for immediate directional opportunity.
Our S&P 500 pivot for today is $3,857.00.
Key levels to the upside include $3,879.25, $3,893.75, and $3,908.25.
Key levels to the downside include $3,838.25, $3,813.25, and $3,793.25.
Click here to load today’s key levels into the web-based TradingView platform. All levels are derived using the 65-minute timeframe. New links are produced, daily.
Definitions
Volume Areas: Markets will build on areas of high-volume (HVNodes). Should the market trend for long periods of time, it will be identified by low-volume areas (LVNodes). LVNodes denote directional conviction and ought to offer support on any test.
If participants auction and find acceptance in an area of a prior LVNode, then future discovery ought to be volatile and quick as participants look to HVNodes for favorable entry or exit.
MCPOCs: Denote areas where two-sided trade was most prevalent over numerous sessions. Participants will respond to future tests of value as they offer favorable entry and exit.
About
In short, an economics graduate working in finance and journalism.
Capelj spends most of his time as the founder of Physik Invest through which he invests and publishes daily analyses to subscribers, some of whom represent well-known institutions.
Separately, Capelj is an equity options analyst at SpotGamma and an accredited journalist interviewing global leaders in business, government, and finance.
Past works include conversations with investor Kevin O’Leary, ARK Invest’s Catherine Wood, FTX’s Sam Bankman-Fried, Lithuania’s Minister of Economy and Innovation Aušrinė Armonaitė, former Cisco chairman and CEO John Chambers, and persons at the Clinton Global Initiative.
Contact
Direct queries to renato@physikinvest.com or Renato Capelj#8625 on Discord.
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Disclaimer
Do not construe this newsletter as advice. All content is for informational purposes.
