Introduction:
The equity market's historic lull has revived a controversial strategy known as selling volatility. However, traders are anticipating fresh turmoil as options expiration approaches on Friday. While the market has experienced minimal volatility and benchmark swings recently, defensive investors remain cautious amidst conflicting economic news and the US debt ceiling drama. The S&P 500 has seen daily moves of less than 1% in the majority of the past 33 sessions, resulting in the calmest quarter since 1993. This environment of tranquility has led to successful stretches for indexes tracking bullish and bearish options strategies, but the upcoming options expiration event may challenge this trend.
Options Expiration and Potential Impact:
On Friday, a significant number of options contracts, amounting to approximately $1.7 trillion, are scheduled to reach maturity. Referred to as OpEx, this monthly event typically prompts traders to either roll over existing positions or initiate new ones, leading to portfolio adjustments that can increase trading volume and cause sudden price swings. Consequently, the market's current tight trading conditions may be affected. Market makers, who engage in options transactions and aim to maintain a neutral position, have recently been in a state called "long gamma." This position requires them to counter the prevailing trend by buying stocks when they fall and selling when they rise. However, after Friday's expiration, it is expected that the S&P 500's overall gamma exposure from options dealers will decrease by nearly 30%.
Anticipated Market Breakout:
The release of long gamma trades during options expiration presents an opportunity for a breakout, according to Nomura Securities International's estimates. Charlie McElligott, Nomura's cross-asset strategist, suggests that this shift in gamma exposure may allow the market to break out of its recent range-bound trading. Thursday's climb in the S&P 500 to the highest level since August, though failing to sustainably breach the widely watched level of 4,200, indicates the potential for increased volatility.
Conflicting Forces and the Persistence of Calm:
While options expiration has the potential to introduce volatility, it does not guarantee an end to the current calm in the market. Similar expectations arose a month ago when market activity was subdued, but subsequent options expiration failed to sustain increased market action. Conflicting forces contribute to this persistence of calm. Rules-based traders have increased their stock positions due to the tranquil market environment, while human traders have remained cautious, concerned about banking stress and the possibility of a looming recession. In the options market itself, there is a tug-of-war between zero-day bets and long-dated contracts, adding to the complexity.
The Rise of Shorting Volatility:
The lack of significant market swings has emboldened the trade of shorting volatility. Options traders and specialists have noticed an increase in the supply of bullish calls and bearish puts. When the market is stagnant, out-of-the-money contracts often expire worthless, allowing sellers to profit from the premium received. Consequently, indexes such as the Cboe S&P 500 PutWrite Index (PUT) and the Cboe S&P 500 BuyWrite Index (BXM), which sell bearish and bullish options respectively, have seen prolonged periods of gains. This trend has garnered increased interest from investors seeking low-volatility products.
Conclusion:
The revival of selling volatility in the equity market has been accompanied by a period of calm and minimal benchmark swings. However, the approaching options expiration event on Friday is expected to inject fresh turmoil into the market. While it presents an opportunity for a breakout and increased volatility, conflicting forces and cautious investor sentiment may persist, prolonging the calm. Traders have taken advantage of the stagnant market by engaging in shorting volatility strategies, benefiting from the premium received from out-of-the-money contracts that expire worthless. As the market navigates the options expiration event, traders will closely monitor the potential for increased trading volume and sudden price swings. The outcome of this event will determine whether the market can break out of its recent range-bound trading and bring an end to the extended period of calm. In the meantime, the strategy of selling volatility continues to gain traction, with indexes tracking bullish and bearish options strategies experiencing sustained success. However, it remains to be seen how long this trend will last amidst the conflicting forces and cautious investor sentiment. As the equity market evolves, market participants will need to stay vigilant and adapt to changing conditions in order to navigate the ever-changing landscape of selling volatility.
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