Wagging the Dog

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:

"When the tail wags the dog, the administration becomes the whip."

Usually, the "tail wagging the dog" is used to highlight that government bureaucracy can become larger and more powerful than the people's will in which they are supposed to serve.

But in general, it's a good reminder of "second order thinking" aka situations where minor or secondary elements have a disproportionate impact or influence on the overall outcome. This type of thinking is essential to being a trader, finding "edge", and being successful in life.

If the dog is the underlying stock market, then the options market is the tail, and dynamic dealer hedging becomes the whip!

BANG for Your Buck:

Large Option Positioning

• 4065 strike creates positive gamma for dealers and will act as resistance.

• 3900 strike creates large negative gamma for dealers, which will exacerbate movement near there.

Things to Look for This Week

• Implied volatility via the option's market less than realized volatility.

  • This usually signals a "topping process" (I'll take a P, as in pneumonia!)

  • But, major catalysts, like below, usually force "instantaneous repricing" at a target new level.

• Feb 1 - FOMC rate decision and press conference

  • This could set the tone for the rest of the year. The bond market is pricing in a recession that will officially hit the books in Q3 this year and commensurate rate cuts will follow. JPow keeps saying rates will be "higher for longer", and "his main mission is to fix inflation while maintaining high employment."

• Follow the Momentum

  • No one knows where the market will go from news or a press conference, just go with the flow.

  • Watch for pushes into the start of day BANG. If you don't see volatility e.g. VIX remaining elevated, the push beyond (in either direction) will be harder.

• Stock Earnings

  • McDonald's, Exxon, AMD, Pfizer, Meta, Amazon, SoFi, Qualcomm, etc.

  • These give insight into what companies are preparing for and how the consumer is doing. Remember, last week MSFT said they see "economic uncertainty" and cut their forecasts in anticipation of lower business demand i.e. an incoming recession

The Tail (SPX 0DTE Options) Wagging the Dog (ES Futures)

Last week was a good example of the dealer hedging positive feedback loop.

Multiple days last week, customers bought roughly 400k 0DTE calls within hours of the close. 

FYI, if 400,000 SPX out-of-the-money calls go in-the-money, they become the equivalent of long 800,000 ES futures. ES futures trade roughly 1.7m contracts daily...seems a bit agressive, right? (maybe even the fuel for flash crashes)

Let's recap Friday, January 27th

There was a large concentration of call buyers at the 4100 strike.

Remember C.O.P.S.? Call Opposite Put Same. Dealers sell the calls; therefore, they need to buy the underlying i.e. buy ES futures.

Intuition Builder (negative gamma)

• As the market gets closer to the strike, the probability that the 4100 call ends in-the-money increases.

• When that probability increases, the dealer needs to add to their hedge.

• As the market rallies, they need more futures for their hedge, and as it breaks, they need less futures for their hedge.

On initiation of the trade, dealers' hedge buying coincides with the market rally, helps attract more momentum chasers, and feeds the rally even further.

Then, dealers need to buy even more ES, because there is a chance those 4100 Calls end in-the-money. (chart: green line)

This is not all due to options hedging, but systematic and algorithmic traders start seeing momentum build and they add to it as well. (remember the dog-pile?!)

But the market pauses shy of 4100. Once there is confirmation that 4100 is not in play today, the market starts to pull back. (chart: purple circle)

This leads to a positive feedback loop to the downside now, as dealers no longer need their long futures hedges! (chart: sharp red line)

As you can see, dealer hedging impacts are crucial to market dynamics...and we like to refer to it as the "tail wagging the dog." Somedays it shakes more than others!

Thinking further about last week's rally and 0DTE options. Price did move higher, but were there actually more bullish positions?

Like I said last week, the beauty of short-term options is that at the end of the day, they cut you a check for your profits and you have no position on. Without a position, I'd consider you neutral or as financial d-bags say "opportunistic."

Well, what about the dealers and all those long futures? Anything they didn't sell after the 3p CT close, they can unwind via a somewhat simple swap with other dealers/institutions/funds. So those positions are gone too.

So, what actually creates the conditions for longer term trends?

How the hell would I know! But I can tell you that having a bet on for a few hours doesn't really instill confidence!

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