Open Interest and Hedge Rebalancing

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:

"Concentration is the key to winning in life"

Focus and dedication allows you to achieve magnificent successes in life!

And concentrated exposure by option market participants leads to self-fulfilling support and resistance levels that become reinforced by dealers' market neutral rebalancing needs.

Damn Vince, you know your stuff!

Let's combine what we learned this week about open interest and directional hedging to understand natural support and resistance levels created by the options market.

BANG for Your Buck:

Wow, we nearly pinned 3900 yesterday!

The butterfly lotto ticket has hit twice (almost 3 times) this week using a 10 handle fly on the 3900 and the 4000 level...that, uh...doesn't happen often. Here's the dollars and cents: if at the start of the week you bought a 3900 strike lotto for every day this week and also a 4000 strike lotto ticket for every day this week, that cost less than $500 bucks total and it's already paid out almost $2000. Oh, and you still have 2 more chances to make $1000 more today!

Better than buying scratchers...maybe I should "rethink my inks" on playing the lotto!

Weekly Wrap-up

• Option expiration today (OPEX) Watch for increased effects by large open interest!

• Large shorter term option positioning at 3900 and 4000 level in SPX

• VIX started the week < 20 & implied volatility via options was less than realized volatility via underlying movement.

  • VIX has now inched over 20 and is N'SYNC with realized volatility as the market sold off a bit. Thanks for the layup, option market!

• Reports / News

  • Couple of Federal Reserve talking heads spewing rhetoric

    • Paraphrasing: "F*ck your puts, f*ck your calls, JPow has you by the ballz!"

  • Retail Sales

    • Report: Not good. consumer spending is slowing, even though "inflation is cooling"

  • Manufacturing numbers 

    • Manufacturing orders worse than expected i.e. economy slowing down

  • Bank of Japan

    • They are leading the way in trying to bale out their boat without fixing the hole first!

  • Homebuilders, building permits, building starts, and jobless claims

    • Mortgage rates have come down for 3 weeks in a row, yet no one wants to buy or build because they aren't sure they'll have a job!

  • Bunch of Q4 earnings reports

    • "We are preparing for economic slowdown" / "layoffs are starting" type comments on earnings calls

Open Interest + Bookies' Hedging = Magnets

I bet you didn't learn that formula at your top tier university!

Okay, to take this course, you need a few prerequisites:

• Put/Call Parity with the Underlying

• What's Open Interest

• Directional Hedging of a Call/Put

Who am I kidding, I'm not sure that you can even read?!

The Theory

1. People use options to place bets on where they think the market will go.

2. Bets are placed with bookies (in high finance, we call them dealers).

3. Dealers don't want to bet which way the market is going, they just want to make the spread, the juice, the vig, the cut, the house edge, etc.

4. Any and all bets that are still open are known to the market (imagine looking at a craps table in Vegas)

5. Thesis: By seeing the open bets, determining the dealers' bet exposure, and knowing that they want to stay neutral, we can find areas of support and resistance in the market driven by the dealers' hedging feedback loop

Large Call Bets

Through order flow monitoring, we can make the assumption that dealers are net LONG calls. The gambler is betting that the market will not get higher than the call strike price.

Here's a way to think about it intuitively. 1) most people own stock 2) selling a call on their stock allows them to sell their stock at a higher price (which is good) or not have to sell their stock but still make some money via option premiums (still good). 3) even if their stock gets "called" (ding dong) all they forgo is even more profit (boohoo, you could've made more money)

Remember this hedged call chart?

The hedge only lasts for a limited amount of underlying movement and must be rebalanced as time and volatility change as well.

The green curve slopes upward as the market moves away from the red X. Slope (i.e. the derivative) is negative when the underlying price is below the red X and positive when it's above the red X. (math people call this concave up or convexity | finance bros who want to sound smart just call it convexity)

This means the hedger (the dealer who is LONG a crapload of calls) has to BUY the underlying as we move lower, and SELL the underlying as we move higher!

This naturally causes mean reversion to the red X! Sounds like a magnet to me... (or for you chartists: support/resistance)

You literally just figured out how half of the entire option market needs to react to large call open interest!

Now, let's crank up the magnetism!

• As time passes, the volatility of the underlying distribution decreases

• Decreasing volatility forces the call to act much more like the underlying OR not like the underlying at all!

• The dealer's offsetting hedge only works for an even smaller change in the underlying before the need to re-hedge! (look at the pink curve)

So, dealers' hedging decreases volatility due to mean reversion trading AND time passing decreases volatility!

This is a positive feedback control system that helps the market gravitate to large call open interest!

Here is a prime example of dealers long a crapload of calls on Dec 30th, 2022 expiration. Supply Creates Its Own Demand | The Jumping Cholla

This seems like enough for a Friday, but I will get into the Put Open Interest next week, because it's not more of the same thing!

As always, pursue the process NOT the profits! See you tomorrow!