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- Don't Panic!
Good Morning!
This is the Jumping Cholla (CHOY-uh). The newsletter that turns options market insights into a fun, easy-to-read email that helps you reduce your chances of getting pricked while trading!
And even if you don't trade, learning how to think like a trader builds a robust framework for problem solving, taking risks, managing a plan, and just living life.
Quote of the day:
"Please proceed to the exits in an orderly fashion"
C’mon man, you’re telling me there’s a fire on my heels and I need to walk in a single file line?! This fire safety 101 is taught and practiced in elementary schools for a few reasons:
Limited number of exit doors, and trying to jam a couple hundred 3rd graders through an egress will surely cause bodily harm.
Accountability…you know how hard it is for a teacher to keep track of their pupils?!
Emergency Personnel Access. When people exit nicely, those hunks of firemen can easily get in and save the day.
How does this apply to trading?
As an individual trader, panic is not good. We like to call that a personal fast market. Hasty decisions aren’t usually the most thought out with a well-defined plan.
Let’s think about the market as a hole...yes, a big black hole where you dump your money, lmao jk. The market consists of people who own stuff (customers), and people who are willing to buy and sell stuff at all times (dealers).
In this analogy, dealers are the firefighters. The snot nosed kids who sit inside a cinderblock building 8hrs a day thinking they’re learning something, yeah that’s you, the customer.
If a customer wants to sell, a dealer is waiting there ready to buy. You may even say that the dealer provides the exit door. And they typically can do the opposite of what the customer wants because they constantly offset their bets (i.e. dynamic hedging).
This ecosystem is the world’s largest and fastest moving game of hot potato. An asset that someone doesn’t want is passed to an intermediary that then correlates the exposure with another asset and trades that with someone else and so on and so forth. The hot potato only really cools off when another customer wants to buy. Until then, the risk is just constantly managed.
What happens in a panic?
All the customers start selling at once (jamming through the exit), the dealers can’t keep up with demand (can’t get in the building) and keep lowering their bids (fire continues to spread unabated).
Most customers get hurt “trying to squeeze out of the building”, but hey, if you were one of those really quick ones that saw the signs before anyone else, you’re out scot-free!
So, here’s where we can dip our toes into a Volmageddon 2.0 scenario.
In this analogy, the firefighters are just here to help, and they just can’t help people fast enough while everyone’s panicking. Now imagine some of these firefighters think they’re slick and start opening windows and busting holes in walls to get more people out. Sure, a couple more people get out, but that fuels the fire with oxygen and forces the fire into a contagion.
That’s exactly what dealers do!
As people try to sell stock and buy puts to protect their portfolio, dealers need to offset their transaction with the customer by SELLING more stock! Oh, and as the market breaks, those puts they are short need more and more SELLING of stock to remain hedged. As puts are bought and the underlying market moves dramatically, volatility increases…which forces the dealers into even more SELLING!
If the dealers can’t remain hedged, then they can’t provide an “exit” to another customer…they become the customer looking for an exit! It’s the firefighter that becomes trapped in the burning building and starts panicking with the best of ‘em!
The tail (options market) wags the dog (stock market).
Food for thought, who needs the market to be orderly the most? We’ll revisit this topic another day!
BANG for Your Buck:
| 2/23/2023 SPX = 3991.05 | Handles of Movement | Implied % Move |
|---|---|---|
| BANG (intraday) | 56 | 1.4% |
| BANG (weekly) | 123 | 3.1% |
Tuesday’s 2% down day and yesterday’s session with the release of FOMC meeting minutes was very orderly. We are near a danger zone, and people are proceeding to the exits in a single file line…so far.
Options Market Positioning
4200 = major resistance.
This area creates large positive gamma for dealers. They will sell rallies above and buy dips below to naturally dampen volatility near here.
4100 = pivotal.
With large option open interest, staying above it perpetuates the bullish lean.
4000 = critical support and entering large negative gamma land.
A break through 4000 forces dealers to hedge with the direction of the market, which naturally increases real volatility. Ex: as the market breaks, dealers need to sell the underlying.
This does increase the chances of a crash and a large VIX spike, but I think it’ll take a “drying up of liquidity” catalyst by dealers to actually freak out market participants. Like we said before, the ultra short dated insurance offered by 0DTEs doesn’t put much pressure on 30+ day option buying (longer dated options are much more sensitive to volatility and therefore have more potential to move volatility)
If selling begins to build, systematic momentum chasers (e.g. CTAs) will show up to the scene of the fire and dump gasoline on it!
Volatility bets are on!
As we alluded to last week, large VIX trades occurred that essentially bet volatility will go up precipitously (50% to 100% higher from here) into March and longer.
News/Reports
FOMC minutes - Wednesday 1p CT
The market is starting to digest what “Higher for Longer” actually means
GDP Q4 (first revision) - Thursday 7:30a CT
Core PCE - 7:30a CT
This is another inflation measure that the Fed loves to look at. If it’s bad, which it’s estimated to be (see CPI/PPI last week), the market may use this as a catalyst for downside. Hell, if it’s good, I guess we’re going to the moon!