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Event Volatility
How a decrease in volatility after an event can move markets
Jumping Cholla
February 02, 2023
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:
"Reality is merely an illusion, albeit a very persistent one"
- Albert Einstein
You know why I love this quote, because it gets to the root of why markets move. Everyone's perception of reality (specifically their view of the market) is their own persistent illusion built by compounding chart studies, macro analysis, inherent and positional bias, and simple-wild-@ss-guesses!
What we believe to be real is actually just a mental construct that we have created, but it is so persistent and convincing that it can feel like it is real. Post FOMC, the bulls feel like we just started a new bull market, and the bears feel like the market is lying.
A buyer and a seller make a trade because they both believe they will be correct. A trader makes a trade because he knows he can manage the risk better than the other guy!
Today, let's get some insight how "event volatility" affects dealer hedging and moves markets.
BANG for Your Buck:
| 2/2/2023 SPX = 4119.21 | Handles of Movement | Implied % Move |
|---|---|---|
| BANG (intraday) | 46 | 1.1% |
| BANG (weekly) | 102 | 2.5% |
The BANG tells you what the option bookmakers are pricing potential underlying movement.
As the BANG expands (expected volatility in the market), bookmakers are pricing in larger potential underlying movements. As BANG contracts, the expected range of possibilities contract as well. Not to say it’s perfect, because exogenous shocks are what cause the most pain and profit potential… but if you’re doing this everyday, you will see the BANG get satisfied 68% of the time.
For day trading, use the daily BANG to estimate the trading range for the day and act accordingly. Here's an example of how to do that.
End of the Week Events
Feb 1 - FOMC rate decision and press conference
Our boy J-Pow set the tone for the year: giddiness!
Not saying optimism is a bad thing, but c'mon man, your "illusion" of a soft-landing is quite persistent at the very least
Honestly, I have no idea what a soft-landing means for asset prices, but either way we'll be there to trade it!
Fed fund target rate increased by 25bps as anticipated.
Feb 2 - Jobless Claims / Earnings (including AAPL which is ~7% of the SPX)
Feb 3 - Non-farm Payrolls
Large Option Positioning
4100 strike creates large positive gamma for dealers and will act as resistance. A definitive pop and close above 4100 should lead to a volatility collapse.
3900 strike creates large negative gamma for dealers, which will exacerbate movement near there. In general, a break under 4000 gets the dealers to start hedging with the direction of the market and a pop in volatility.
Event Volatility and Dealer Hedging
Volatility approximates uncertainty. "Event Volatility" is uncertainty that expires after a specified event.
A planned event that has the potential to change the market's paradigm inherently must add uncertainty to the market. After the unknown is known, people become more comfortable with their "illusions" and volatility reduces.
How Does This Relate to Dealer Hedging?
From a supply/demand perspective, customers may want to buy "insurance" for this type of situation.
Puts
In equities, people are generally afraid of the downside because they are long the underlying, so they buy puts. Dealers sell puts to them, and hedge by selling the underlying (Remember C.O.P.S.?)
What happens when "the range of possibilities" gets reduced post-event? Well, the dealer is over-hedged and needs to reduce his hedge by buying back underlying.
The beauty and danger on the short put side of the market is that dealer re-hedging (dealer negative gamma) exacerbates market moves. I.e. they need to chase the market (in either direction) to stay market neutral.
Calls
People generally own the underlying equities, and sell calls against it create a diversified return stream and generate "alpha" from option premium.
This FOMC was a bit different, because the market was very close to large call open interest at the 4100 strike. Recap on dealer hedging a long call.
So, dealers are long calls and short underlying as a hedge to stay market neutral. What happens when "the range of possibilities" gets reduced post-event? Well, the dealer is still over-hedged and needs to reduce his hedge by buying back underlying.
As you can imagine, on the call side of the market, dealer re-hedging activity (dealer positive gamma) actually dampens market movement because as the market rallies, they need to sell, and as the market breaks, they need to buy.
In equities, where dealers are net long calls and short puts, rapid volatility decreases force them to buy the underlying in order to stay market neutral!
The reason we focus on dealers so much is because they are half of the options market and they react predictably. It's all about the ecosystem that supports multi-billion-dollar betting, and not necessarily about the bets themselves!