[00:00:05] The US equity market has recently been dominated by option activity in a way that has rarely been seen before, if ever. Although there has been one major fund that is allegedly behind some of the buying, the majority is still in the hands of retail accounts. What has been the nature of this activity and how is it influencing the US equity market? That’s ‘The Big Conversation’.

In last week’s Chatter section of the Big Conversation, we looked at the increased possibility that the unusual activity we were seeing in the US equity market was increasing the risk of a downside airpocket. Last week I said that “Today we have a large number of technical factors that are screaming for a reversal – and now that doesn’t mean necessarily a major reversal, but it does increase the asymmetric risk of a downside airpocket”.Over the following couple of days, the Nasdaq fell 10% and the S&P500 fell by 6.5% to its intra day low on Friday, and slightly further by Tuesday’s close. What was particularly notable then was the increased level of the VIX, the volatility index on the S&P500, compared to the actual volatility of the S&P500 itself – often called historical or realized volatility. The S&P and the VIX had been rising together. The VIX had reached a level of 25, but the actual 1 month volatility of the S&P500 was closer to 10 at that time. In fact, we saw the highest level of the VIX ever seen at an all time high on the S&P500 in the first part of last week. Whilst we have previously seen the VIX at high levels with the S&P at an all-time high – nearly all these readings were in these last few weeks OR during the Dot Com bubble period of 1999 to 2000. In 2000, However, the underlying index was also moving on a 25 volatility, IN LINE with the VIX which also around 25. The price people were paying for options back then was around the fair value. Prior to last week’s index swoon, the same was not true this time. VIX was being pushed up by outright demand for options, rather than reflecting the ACTUAL volatility of the underlying index. Even now, the 30-day historical volatility of the SPX is just above 17, whilst the October VIX futures contract is at 36. There are a number of dynamics at play, but the primary two are demand and election uncertainty. Firstly, the US Election uncertainty is highlighted by the two VIX futures contracts that straddle this event: October which expires just before the election and November a few weeks afterwards – these are both in the mid 30’s. The difference between the first month and the second month reached the widest levels in 20 years. Normally the VIX futures curve is upward sloping during the good times – when spot VIX is very low indeed and the longer dated maturities have a higher volatility.

It time of stress, the curve is usually downward sloping, because the fear is in the front end which shoots higher with the sudden gyrations and collapse in the underlying index -  this is what we saw in March, where spot VIX reached 80, far in excess of the 1 year contract. So, to see a huge bump in the 2nd and 3rd month contracts versus the front month and the fourth month is very unusual. This bump reflects asset manager demand for protection as the equity market had shot higher as the election approaches and it helped shift higher the front end of the curve for implied volatility. But asset managers and their put buying are not in the driving seat. By now you will have no doubt heard about the influx of retail investors and one large institutional player in the single stock options market, who have all been focused on buying calls – which is an option that gives the owner the right to buy an asset (puts are an option on the right to sell an asset). The size of this call buying is huge. Last week the FT quoted Goldman Sachs, who calculated that the notional call buying over the previous 2 weeks was more than 3 times the rolling average over the 2017 to 2019 period. But who is behind it? Recently, speculation has suggested that a large tech investor has been adding serious amounts of exposure, though this weekend’s Financial Times suggested that the overall exposure of these positions was only $30 billion, far less than the hundreds of billions calculated by Goldman Sachs. Therefore, it would appear that it’s the recent influx of retail investors who have supercharged the options market. This is a pattern that actually kicked off prior to the COVID crisis, with some of the early moves in Tesla, back in February, being helped along by options. There has been extensive coverage of the rise of the retail investor in the options market by research house SentimenTrader. According to Options Clearing Corp data, they calculate that retail investors have bought over $40 billion in premium alone over the last month and this has been primarily in call options that are in lot sizes that are under 50 contracts in size. Now a quick word on terminology: the premium is what you pay for the option contract (it’s just like the premium you pay for insurance). When we talk about lots, one lot is a single contract, which will give exposure to specific number of underlying shares. For the US, there are usually 100 shares per single contract. Therefore 50 contacts gives you rights over 5000 shares of the underlying. These trades are too small and too numerous to be asset managers, though it’s possible that high frequency trading, which tends to trade little and often, may also have jumped on the retail bandwagon.

SentimenTraders notes that ‘The buying of calls to open a new position has in terms of notional, soared to 5 times the level that was seen at the dot com peak, which until February of this year had been reached on only three subsequent occasions, but never properly passed in the last 20 years.’ The demand for call options has been particularly intense in the mega cap tech names such as Amazon, Apple, Alphabet, Facebook and Tesla. Volumes have tended to be higher in names which have an idiosyncratic story that makes them stand out from the crowd in this world where policy makers have been in the driving seat for most assets prices. Furthermore, this tsunami of retail buying has been focused on the near month contracts. When purchased, many of the options have a little more than 2 weeks left before they expire. The large tech investor, on the other hand, appears to be focused on slightly longer dated maturities and call spreads, with less overall market impact. The real Megalodon in the options market is actually the frenzy of retail investors. So why does this matter? The main reason is that the volume of these options and the associated market maker hedging activity can create a self-fulfilling cycle because the buying generates more buying and conversely, selling can create more selling, which is what we’ve seen over the last few weeks on the upside and the last few days on the downside.  

The key dynamics at play are the magnitude of the option demand and the dynamics of the hedging. We’ve already covered the size of the buying. What about hedging dynamics?

Most of the single stock options that have been bought have been out of money. And what does that mean? If the stock is trading at 80 dollars, the 100 dollar strike for a call option would be an out of the money strike, in this case 25% out of the money because it is 20 dollars above the current stock price (and 20 dollars is 25% of the underlying stock price of 80 dollars). The market maker will sell the call to the retail investor, but they won’t then just hold a short call – called a naked position. They will hedge the position by buying stock. But it won’t be the full notional of the stock. For instance, if one option gives the right to buy 100 shares of stock X, the market maker who sells the call may INITIALLY only need to buy 10 shares to be hedged at 80 dollars. The amount of stock required to hedge the position is called the delta. So at 80 dollars the market maker only needs 10 shares as a hedge. If the stock rises to 90 dollars, the market maker may now need to own 25 shares as a hedge – an increase of 15 shares (and these numbers are just an example, they’re not exact). But, if the stock then rises to 100 dollars, the market maker will need to buy another 25 shares to get to a total hedge of 50 shares. Thus, as the stock moves up to and through the strike of the stock, the market maker needs to buy stock at a faster and faster rate, creating upward pressure on the share price. This pace will also increase if the stock is getting closer to its expiry. This change in the speed of hedging the underlying stock is the gamma and gamma increases as we get closer to the expiry. For instance, if we bought the 100 strike option of a stock that was trading at 100 – this is called the At The Money strike, then the delta required to hedge that would be something like 50 shares or half pf the notional (remember each option contract consists of 100 shares).

Now, if we move on to the day of expiry, the impact of gamma can be seen more clearly. If the stock is at 100 or above, the market maker may need to deliver all 100 stocks to the buyer of the option. But if the stock is trading below 100, the market maker isn’t required to deliver anything because the option is now deemed worthless. The market maker could now be caught having to trade around the strike (fully hedged, no hedged, fully hedged and so on), constantly buying or selling the full number of shares as the stock moves in and out of the money. This is a high gamma position. In reality, market makers have a bit more control than that, but it indicates the impact that gamma can have.And this is what we have been seeing in this market. Firstly, the massive ongoing demand for call options (i.e. upside demand) meant that the market makers were having to buy delta as a hedge and…………as the prices of many mega cap tech stocks marched higher, through more of these upside strikes, it built a crescendo of buying, pushing the stocks even higher and triggering yet more gamma stops. Eventually this feeding frenzy runs out of steam. This dynamic can work in reverse and this is what we are now seeing. As is often the case, the moves to the downside are more violent and panicky than on the upside.On the upside we saw the market grind higher and the volatility of the underlying market remained subdued. On the downside, we have seen volatility pick up, but it still remains well short of the volatility implied by the VIX, where election effects are also in play.This volatility dynamic should last until at least the September expiry (which we cover in the Whisper section later).How far can the downside momentum go? Well, it largely depends on the tolerance level of the Fed. They've stepped into every pullback of note over the last two years and it would be unusual if they stepped aside now. In the meantime, we can see that the uptick in volatility in the equity market is starting to spill over into other assets, which we discuss in the next section. 

[00:10:59] Risk assets had obviously been doing well across the board until last week. Central banks had done a reasonable job in dampening down cross asset volatility. But, why have other assets started to roll over now that the US equity market has hit an air pocket? Multi asset portfolios and the rise of rules-based investing such as risk parity has increased the interdependence of many assets. Many portfolios will use realized volatility – that’s the actual volatility of the underlying assets, as a parameter for the level of risk they can take. If volatility in one asset rises, then it may require reductions in risk across other parts of the portfolio.

The volatility to watch is the realized volatility. The VIX had been moving higher in tandem with the equity market for a while. But it wasn’t having an impact because the underlying volatility of the S&P and NASDAQ had remained low. But, once the actual volatility of the US equity market started to pick up, that fed through into many other parts of the framework. Friday 4th September was particularly tricky, indicating that there are very few hedges left. When the equity market was down, bonds were also falling (bonds yields were going up). On that day, Gold was selling off. Crude Oil was selling off. BITCOIN was selling off. THERE WAS NO-WHERE TO HIDE. Normally when there is a decent equity sell off, some of the losses are offset by rallying bonds and falling yields. Not this time. Many analysts believe that there is very little juice in being long bonds here as a hedge to an equity correction. Yields have converged. During the March collapse, yields on bonds that were already in negative territory, such as the German 10 year bund hardly moved in the full round trip, even as US 10 year bond yield collapsed over 100 basis points. Bonds did rally (yields fell) on Tuesday when the Nasdaq fell 5%, but it was only a few basis points of yield. Crude oil has had a very sharp decline – although it doesn’t look like much because of the April move, the front month WTI contract has lost 17% from the recent highs. Many assets have not had the same level of recovery as we had seen in US equities. We can split assets into those that follow the real economy or were saddled with debt, and those which are cash rich or exposed to the new economy. Whilst banks and oil have recovered off their lows, they have not performed anywhere near as well as the mega cap US tech.All this suggests that capital is still being diverted from productive assets and growth into none productive assets i.e. higher equity prices in a small handful of names where the performance far exceeds their profitability. But as we’ve discussed previously, fundamentals don’t matter when performance is dominated by flows.We will also have to keep an eye on the US dollar. It’s been rising, but not nearly as much as might have been expected for a 10% decline in the Nasdaq. Yield convergence with Europe has made US assets less attractive, though when the Euro reached 1.20, we started to get comments from European policy makers that suggests their tolerance levels are being stretched.Recent dollar weakness has really been euro strength. EM currencies have just not joined in the party. Usually when the dollar is weak, it’s EMFX that leads the way. Not on this occasion. A stronger US dollar would impact EM equities and commodities even further.

However, at this stage it still looks like this is mainly a correction in equities with a bit of cross asset contagion, rather than the beginning of a major correction in all risk assets. US high yield credit has hardly budged even as the VIX has marched higher. But a widening of credit spreads would be one thing to watch for, to see if the current equity market swoon turns into something more severe. And equities may simply be feeling the effects of the upcoming quarterly expiry, which we tackle in the next section. 

[00:14:46] As we discussed in an earlier section, options have played a pivotal role in the recent U.S. equity market activity. One of the key options events to watch for is the quarterly expiry. Options and futures contracts have a specified lifetime. It's a bit like home or car insurance that runs for a year before it expires and you have to either renew it or choose to go without. In the world of options, the lifetime of a listed options contract has been standardized. They are defined by the expiry date. For the US and most of European indexes and single equity options, they expire on the third Friday of every month. For this month, September the expiry is Friday the 18th. Now, not all options expiries are equal however. The quarterly expiries usually have far more volume than the monthly expiries. The quarterly expires all the third Friday of March, June, September and December. These are also the months in which the key index futures contracts on the major equity indices also expire. These quarterly expiries are often called the triple or quadruple witching expiries. They constitute the expiries of the index futures, the options on the cash index, like the FTSE or the S&P, options on single stocks and in the US expiries on the options on the index futures contracts, though these have negligible volume. Because volume is concentrated into these quarterly expiries, they are often favored by investors in a virtuous circle of volume. The extra liquidity means that large positions can be built up and managed more easily. The higher the liquidity, the tighter the trading spreads should be so that options around these expires should be slightly better priced all things being equal. Now the expiry times themselves are not all the same time. Index options and futures usually expire in the morning. In Europe, the FTSE 100 options expire first, then the Eurostoxx50 and then the DAX. The US index options of the S&P 500 and Nasdaq expire on the US cash markets opening rotation, when the index settlement price off which the expiring contracts are valued, is worked out. Single stock options generally expire at the cash close in these respective regions. But why is the quarterly expiry so important and why might this one be of particular interest? As we approach the expiry, market makers need to manage their positions. The amount of stocks they need to buy and sell on positions that are close to the money increases. At the money is where the strike of the option is close to the current cash level of the underlying equity or index. And this can result in wild swings in the underlying. We discussed this in the first section. Now it must be stressed that large option positions don't define the direction of the market. But as we approach these major expiries with significant amounts of open interest, it can accentuate any move that has taken place and increase the intraday swings. The low after the December 2018 sell off took place on the first trading day after the December expiry. The low of the Covid crisis took place on March the twenty third, the first trading day after the March expiry. In June there was a sudden swoon in the S&P 500 of five percent a week before the June expiry. We don't necessarily have to have a significant inflection point around these expiry events, but given this huge buildup in option activity, we should expect the higher volatility of the underlying equities and indices to continue over the next week or so as we head into this month's quarterly expiry event with extremely high levels of single stock open interest. 

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