Last year saw a massive increase in activity within the US equity options market, with record volumes being set and a surge in the popularity of small sized options transactions. We saw a spike in volatility into three of the four major quarterly expiries. Although December volatility was subdued, this followed the election spike in the previous month. December still saw extremely strong volumes and this enthusiasm has spilled over into 2021. The March expiry may seem a long way off, taking place on the 19th of that month, but it looks like we need to gear up for yet another high-volume event. With the VIX close to 1-year lows, the equity options market could provide some great opportunities for investors. In this Big Conversation we look at the trends to watch out for into that March expiry.
Listed options contracts all have a specified date when the rights that the contracts confer will end. These are the expiries, and they occur in every month – usually the third Friday, though there are others. So why do we care about the quarterly expiries? It’s because the quarterly expiries tend to be very high-volume events through which markets can pick up momentum.
For the US and most of Europe, the quarterly expiry takes place on the third Friday of a four-month cycle: that’s March, June, September and December. In the US, these quarterly expiry days are often referred to as triple or quadruple witching days. They constitute expiries on index futures, cash settled index options, options on index futures (which now have very low volumes) and single stock options. Many now consider stock futures as 4th element of the quadruple witching. Over time, trading volumes and open interest around these quarterly expiry dates have become self-perpetuating, where the volumes attract further volumes with that extra liquidity helping to reduce the frictional costs of trading, so that investors and traders tend to congregate around these dates.
So why should investors pay attention to these dates? On a number of occasions, we have seen key inflection points occur around these expiries. Now, it must be stressed that they do not in themselves, these expiries, create market direction, but they can accentuate moves that are already in play, which then build momentum into the options expiry itself. If we look back over the last couple of years, we can see some of these big inflection points. In 2018, the S&P500 peaked ahead of the September expiry before selling off and bottoming out on December 24th, the first trading day after that December expiry. The initial sell off had a number of factors involved, such as a deterioration in growth data whilst US 10Y yields were rapidly rising to 3.2%, plus thee was year-end pension selling and the misstep from the Fed when they raised interest rates in their December meeting but the final acceleration lower was influenced by the expiry.
In 2020, the pandemic low was set on March 23rd, which again was the first trading day after the March expiry which took place on the 20th. Clearly the reversal on the 23rd itself was helped by the Fed’s commitment to unlimited quantitative easing, but in a similar pattern to the sell-off in December 2018, the accelerated decline of the US equity market last year was influenced by the expiry and forced the Fed to react. During 2020, we also had minor events around the June and September expiry. The run up and then reversal of the S&P500 in late August and early September 2020 was clearly influenced by options activity. At the time there were lots of headlines with regard a single player in the options market. However, it was the actions of the minnows that were of greater influence than the whale, because the whale was largely trading on a delta neutral basis in which the long option positions were being offset by short stock positions.
But it was clear that retail were really influencing the market and they could well have a similar influence into this year’s March expiry. And this is why we should be thinking about these possibilities today. Goldman Sachs noted that in January 2021, the US has already seen the highest single day notional of equity options trading in history, with more than half a trillion dollars-worth changing hands on January 8th. Average daily volumes of options contracts currently stand at over 40 million for 2021 so far, beating last year’s average record that was just shy of 30 million and over double the record that existed before that. Call volume is far higher than put volume, suggesting that bullish bets are dominating the activity. According to Sentiment Trader, a research house, small trader buying – which they define as sizes of 100 contracts or less – has reached the highest level as a percentage of NYSE ever, at 9% of the total, having rarely touched 3% in the preceding 20 years. It’s worth noting that these small sizes, which have often been linked only to retail, are very likely to also be the result of algo based and high frequency trading outfits like Citadel and Millennium. Liquidity begets liquidity, pulling in more participants and helping to increase the volumes in a virtuous spiral.
If, however, we focus on the retail element, we can see how the momentum can build and how it could also lead to another pick up in volatility. The retail community have generally preferred to buy short dated options – that’s contracts with less than one month left until expiry. Currently we are still more than a month away from the March expiry and yet volumes are already at record levels. It is likely that these volumes will pick up further. If retail continue to dominate with call buying – that’s buying the upside - then the market makers who are selling these options will be buying shares as a hedge. This will put some upward pressure on the stocks and indices today, but the impact becomes much more interesting as we move towards that expiry. Options rarely determine the direction of the market, but they can influence the speed of travel. If the market continues to push higher as we get closer and closer to the March expiry, market makers will need to buy more and more stocks at a faster and faster pace in order to maintain a neutral hedge.
This is what we saw in the latter part of August and very early September 2020 and also in December that year. But this dynamic hedging can also work in reverse, which is what we saw in the middle of September last year. The market reversed and experienced a very swift decline for a few days, with market makers unwinding their hedges and helping to push the equity market lower. So, investors who are looking to use the options market today may want to take advantage of what currently look like subdued levels. The VIX is at the twelve-month low – we could argue that it looks attractive on a one year view. Prior to 2020, however, and we can see that the base level for volatility was significantly lower. And we also need to make the distinction between low volatility and cheap volatility. Here we’re using the VIX as a proxy, which is obviously not the same as the volatility on underlying shares, but it helps demonstrate this difference.
The actual volatility of the S&P today on a 30 day (or one month) view has dropped to around 10, whilst the VIX is over double that level. What we are paying in the options market is the implied volatility. We can compare that to the actual or historical volatility of the underlying asset. The VIX may be low on a 12-month view, but it’s not necessarily cheap. Volatility can be low and expensive. It can be high and cheap. Or high but trading at a fair value. Back in the days of the dot com bust, some of my clients would happily buy single stock options with a volatility IN EXCESS OF 100 if that still looked attractive compared to how the underlying equity was actually moving.
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But back with the markets and perhaps we should currently be selling, not buying options when the difference between implied – which what you pay for the option……… and realized - what the underlying stock is actually doing – is this wide? Alternatively, we could look back at our original chart of the VIX and take a view on the pattern into those previous expiries and the fact that options activity today is building up yet another head of steam. Already, we have experienced a prolonged period of subdued volatility in which risk assets are having a great start to the year. If the option buying frenzy picks up into the March expiry, then we should expect some upward pressure on implied volatility, whilst the underlying market could also be far more susceptible to air pockets in both directions.
In addition, there is also the risk of a market round trip in the first quarter of the year and like with the quarterly expiries, this is not something that happens on every occasion, but it is worth bearing in mind. We have often seen risk assets reverse their initial direction as Q1 progresses. Now clearly, we’ve had some starts where the momentum has kept going such as 2013 and 2017 but many of those other years saw a rise and fall and vice versa in the first few months – though some of these did take four, rather than three months to play out - and that would take us well beyond the March expiry. But given the stella start to Q1, we need to be wary of the potential for a round trip in the early part of this year. We even saw this in 2000 with the S&P initially selling off as rotations into the tech rally took place, before the S&P itself made a final swing higher through the March expiry of that year. But what makes this year even more interesting is the consensus narrative for 2021 that we’ve discussed in previous episodes. Consensus trades can work for an extended period of time, but this consensus has built an inconsistent momentum since the vaccine headlines of November last year. Because the reflation narrative is driven by the dollar, rather than a by globally coordinated growth, a reversal in extreme positioning could combine with options activity in driving a period of outsized moves.
We’ve already seen how many of the dollar-based reflation trades have experienced an extreme build-up of speculative excesses. The CFTC non-commercial positioning in copper is at an all-time high. We’ve also talked about how the US Federal reserve is not operating in isolation. It’s not even the most aggressive central bank at the moment in either relative or absolute terms. Furthermore, moves higher in the Euro, like the current one, have nearly always initiated a response from European policy makers. The euro’s rally will be testing the tolerance levels of European policy makers.And the current lull in volatility across the equity market has been repeated across other asset classes as well. Measures of volatility in FX and Fixed Income are also at the lower end of the range. Lower volatility usually acts as a prelude to higher volatility because investors adjust to the lower returns by increasing leverage.
Other examples of the current extremes are The Panic/Euphoria indicator run by the US Equity Strategy team at Citi Bank which has recently shot to a new all-time high, far in excess of the highs achieved during the dot com bubble. Goldman Sachs have indicated that this move in equities has been driven by an epic short squeeze – their basket of the 50 most shorted stocks has returned nearly 4 times more than the Russell 3000 Index since November last year. Another indicator, the trade volume of penny stocks, has also been hitting records. So all this may simply reflect that dominant market forces are changing from the active institutions to passive products and retail investors. None the less, it may be prudent to start locking in some gains by rolling out of long equity positions and replacing them with call options before the option’s frenzy hits new heights. Stock replacement allows investors to book profits whilst still participating in the upside. Obviously, if markets continue to make new highs, then these stock replacement trades will underperform the underlying assets, but if we do get an air-pocket, this strategy will also keep some powder dry.
Now we can’t say that equity options are cheap today, but premiums are low on a one-year view, especially when compared to three of the last four quarterly expiries. Expiries are not themselves the main event, but they can supercharge prevailing trends. So stock replacement offers some risk reduction at a time when the options market, even if it is influenced by High Frequency activity, shows that retail investors are having an increasingly outsized effect on equity markets around the major option expiry events. So the point is here that the longer the grind higher continues, the greater are the asymmetric risks to the downside. But please keep with us because in the next section, we’ll be looking at the distribution of Emerging Market performance that also suggests that this risk rally is not on a particularly strong footing at the moment.
We’ve seen some remarkable performance out of the emerging markets over the last few months. The Taiwanese index finally overcame an all-time high that was previously set in 1989 – and to put that in perspective, it’s the same time that the Japanese bubble peaked - a level that the N225 has not yet repeated. The Korean KOSPI market has also broken the all time highs, though the wait from the previous record was not as long as it has been for Taiwan. But the performance of these Asian markets is a much to do with their handling of the crisis and the tech heavy nature of these indices – especially Taiwan – as it is about the reflation theme that has become the rallying point for this current bout of risk on.
When we look at some of these Asian markets versus the broad based emerging markets – and we’re using the MSCI EM market here versus its constituents, so that we are comparing apples with apples we can see that performance has indeed been very regional. Korea and Taiwan have outperformed. But when we look in other regions such as Latin America, the performance is far less emphatic. There are fewer signs that this is true global growth and more signs that this is an Asian bonanza. The ratio of the Brazilian market vs EEM looks like it is about to break down even further.
The same applies to the Mexican equity market and to South Africa. If the US reflation was real, then Mexico should be one of the biggest beneficiaries, but it’s struggling to generate any performance. When we compare Brazil and Mexico to the US equity market, there has been some outperformance in recent months, but they have still failed to make back the ground that they lost in the early part of the pandemic. We can also see a similar story in currency markets. The broad based JP Morgan EMFX index (which is inverted here) has outperformed the US dollar, but the performance has been very lackluster when compared to that of the DXY, which is dominated by the euro. True global growth should see emerging market economies and currencies outperforming the lower beta developed markets.
The weakness in the dollar has primarily been about positioning versus the euro and real rate differentials rather than growth. And as outlined in the prior episodes, the growth that is currently underpinning these markets is not well spread and much of it is derived from the weaker dollar, better localized handling of the pandemic and China, which has once again returned to the ‘growth at any cost’ model that has helped create a squeeze in commodities, just when supply chains have been creaking. And that’s not likely to be a lasting effect.
Now we might expect Chinese policy makers to keep up the energy levels into the Communist Party’s 100th anniversary in July of this year, but that will represent demand brought forward, rather than a long-term growth push. The dispersion amongst emerging markets and the lack of growth in many of the former hotspots is another reason for caution. The US might be talking up the fiscal potential, but it will be hard for the US to generate inflation if much of the rest of the world is generating deflation. So in summary, global volatility levels have been lower, but many of the cross asset levels that we looked at in the previous section are at attractive levels, considering the level of dislocation rather than convergence within the global economy.
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