Great Expectations

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:

"Take nothing on its looks; take everything on evidence. There’s no better rule."

For those of you who finished high school, you may remember a book by Charles Dickens Great Expectations. The core theme of the book is that our own expectations shape and distort our lives…oh yeah, and that option volatility distorts underlying price action and vice versa!

Jaggers advises Pip to be cautious in his expectations of others and to base them on the evidence he gathers through his interactions with them. Similarly, we need to be cautious of what the option market is implying, and consistently reassess what its telling us!

Why Short Dated Bets Matter

I’m sure you’ve heard that short duration option contracts are accounting for 50% of all options transactions on a daily basis. The average daily notional value of these contracts (i.e. total value of bets) equates to over $1 Trillion. Let’s ballpark the total value of US stocks at around $30T with an average daily transaction value of $1T…

Why trade stocks when you can trade options?! Check out our writeup on 0 Day Degeneracy? So, derivatives trading seems to be where market participants are getting their underlying exposure, and dealers are happily supplying these asymmetric intraday bets.

Some people are scared of this phenomenon, but not us! This means that the option market must be extremely well priced on a continuous basis and the dealer hedging feedback loop is indeed wagging the dog!

If we understand the empirical data coming from the options market, we can set better (not great) expectations!

Let’s look at today as an example:

1. There was an aspect of Event Volatility with our boy JPOW finishing his testimony to Congress (quick recap: after the unknown becomes known, volatility drops, and dealers “lighten up” their hedges. In the equity market, risk is generally to the downside so they “buy back some of their shorts” hence giving some bullish support to the underlying)

2. Dealer gamma scalping and its effects on volatility. Review Open Interest and Hedge Rebalancing.

Firstly, the 4000 level has massive open interest. On net, we anticipate dealers to be neutralish gamma here, so their hedging requirements are most likely dictated by ultra short term bets. Short term bets tend to suppress volatility due to dealer hedging.

Option volatility anticipated ~50 handle range (we’ll use VIX as a surrogate in the lower pane). Notice how volatility decreased after Powell was done testifying (the event was over) and the underlying got it’s well anticipated boost.

As volatility decreased, so did the anticipated range. Remember, dealers try to stay market neutral and earn their “theoretical edge” by actively hedging against directional movements. If expected range is compressing, dealers need to be more aggressive with dynamic hedging. This is a viscous cycle of vol dampening, see: hedge rebalancing (but don’t worry since most the options expire at the end of the day, tomorrow anything can happen!)

Notice how every abrupt move was bought/sold with very consistent volume. This is a tell-tale sign of option market maker gamma scalping.

We started the day with great expectations and basically ended unch’d. You saw what the option market had to do, and were paid if you scalped the compressing range (or if you sold the 0DTE strangle on the open and went to get a haircut!)

BANG for Your Buck:

As we said Monday morning, “Generally, exuberance through large call open interest dampens upside moves, and the market hovers slightly lower / around the call OI. In this scenario, that lines up with the 4000 level in SPX.”

Yippee, we got one right! But now what happens from here…All we know is that the option market can absorb a lot of bets right here, but will freak out 100 handles lower. Going to up without a “cool story” will take some effort based on dealer hedging expectations as well…no man’s land it is!

Options Market Positioning

• 4100 = large open interest resistance

  • Over 4000, open interest dictates dealers hedging against the flow of the market. So, a move up to 4100 should be a grind with further volatility compression.

• 4000 = critical support and entering large negative gamma land.

  • Under 4000, dealers will hedge with the flow of the market. They’ll run into some speedbumps, but under 3900…look out below!

• 3950 = speedbump

• Volatility bets are still on!

  • Over the past few weeks, large VIX trades occurred that essentially bet volatility will go up precipitously (50% to 100% higher from here) into March through June.

News/Reports

• 3/10 - Non-farm payrolls

• Pi Day (3/14) - CPI

• 3/15 - PPI

• 3/17 - OPEX

  • Technically a “quad witching” since this is the quarterly roll. Stock Options, Futures Options, Index Options, and Futures contract roll

• 3/22 - FOMC Rate Decision / Press Conference

As always, pursue the process NOT the profits!