- The Jumping Cholla
- Posts
- Supply Creates Its Own Demand
Good Morning!
This is the Jumping Cholla. 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!
Quote of the day:
"Supply creates its own demand"
- John Maynard Keynes
I know what you're thinking "isn't this the crap that got us into this whole economic mess in the first place?!" Yeah, probably... but I'm not referring to Keynes logic of supplying capital to banks, then banks lend to stimulate the new business, new business fill an unsatisfied need, and voilà demand increases.
I'm talking about the supply of options at specific strikes, what that tells us, and why they can act like magnets for underlying market direction.
BANG for Your Buck:
SPX ref = 3839.50
BANG (daily) = 52 handles of movement ~1.3%
BANG (weekly) = 115 handles of movement ~3.0%
In the coming week, this section will be beefed up with even more relevant and actionable data such as: weekly bang review, overnight expectations, gap probability analysis, and more! Believe it or not, the market just kinda tells you all this stuff, if you know where to look...
Quick Review
Examples to satisfy the BANG:
The BANG tells you what the option bookmakers are pricing potential underlying movement.
Market opens at 3840, and chugs upward to 3892, which is 52 handles higher. Or market opens at 3840, goes to 3850, then down to 3808 (10 + 42 = 52 handles). Any variety of underlying movement scenarios can satisfy the option implied volatility required to justify current option prices.
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 every day, you will see the BANG get satisfied 68% of the time.
This is why we like to call it BANG for your buck. If you are long options and the market exceeds BANG, you got a good deal. Granted, to actually profit off this sweet, sweet deal you got, you have to manage your position in very specific ways. Stay subscribed because we are getting into all that soon!
Today's Learnding Moment
Date:12/30/22 (the last trading day of the year) | SPX open ref = 3829 | BANG = 52
So how does "supply create its own demand"? Today was a picture perfect example and here's why:
An expiring option position near where the underlying was trading caused a 1%+ move within the last hour of the day!
The Details
Someone has a massive position in the 3835 calls that expire TODAY! and by someone, I mean these guys JHEQX – JPMorgan Hedged Equity, lol. The high financiers like to call it the "JPM Quarterly collar roll" and it's a very well-known trade that occurs near the last day of every quarter. FYI, you remember Bernie Madoff (rest in pieces!) and his "split strike conversion strategy"...it's basically the same thing, except these guys actually do it!
Buy insurance (put spread) and offset the cost by selling insurance (call option)
JPM is long a crapload of stocks. To protect themselves if the market goes down, they buy an insurance policy that limits their losses to 5% in a single quarter. As literally ever single adult on the planet will tell you, insurance costs money.
But these highly sophisticated portfolio managers think "wouldn't it be great if we didn't have to pay for that insurance?" To do that, they need to sell something to offset the cost.
Hmmm, what can they sell?
Why insurance, of course!
They write a policy that will cap their gains at 5% in the quarter.
Example of the payoffs: If the S&P is up 10%, they make 5%. And if the S&P is down 10%, they only lose 5%.
You can easily employ this strategy in your personal portfolio, but before doing so, go take a peek at their Sharpe ratio or other risk measures...
Now let's get into it!
Look at what happened towards the end of the day. The market rallies 40 handles right into the massive call position!
But why?
Who did JPM sell those calls to months ago? Dealers. The dealers are long 45k calls that expire in a few hours.
Dealers do not want directional exposure; it's not their game. In order to be long calls with no directional exposure, they also needed to be short the underlying. They must "dynamically hedge" their offsetting short position as the probability of the calls expiring in-the-money (ITM aka market closes above the strike) changes.
But being that this stuff expires today, hedging becomes more binary. If the market is below the strike, they don't need any offsetting shorts. But if the market is over the strike, they do. Some like to call this "pinning" the strike.
What do they do with their offsetting shorts when the market is 30 handles lower than the strike with an hour left in the day?
Get rid of 'em of course! i.e., buy back the underlying.
And bingo bango bongo, there's a mad scramble by dealers to buy back their own short exposure because the second that call option expires, they have no need for it. And like we said, they are not in the directional business and definitely do not want directional exposure over the weekend!
Remember, it's the ecosystem that supports taking and making all these insurance policies (who are we kidding, they're bets) that gives us insights, not necessarily the positions themselves! Here's a refresher on dealer hedging and feedback loops.