Last Friday, as market participants scrambled to discern the extent of systematic selling pressure during Wednesday’s U.S. equities rout, JPMorgan’s Marko Kolanovic released a brief afternoon note in which he assessed option hedging’s role in the drawdown and weighed in on its prospective impact going forward.
“In terms of systematic strategies that drove the selloff, by far the biggest selling pressure was from option gamma hedging on Wednesday”, Marko wrote, before delivering the following forward-looking assessment of that risk:
[It] can turn into a positive impact, i.e. option hedgers buying equities. For instance, if the market were to hold its gains during the day, it could result in a squeeze higher by end of the day from gamma hedging flows.
Later that evening, in a sweeping piece that sought to dispel what, to my mind, was a pretty egregious stream of misinformation being force fed to market participants by those of a persistently bearish persuasion, I noted that Marko’s call for a late-session rally to close the week did indeed play out. Here, specifically, is what happened in the hours after Kolanovic’s note started making the rounds:
Fast forward a week and Marko is out with another brief post, and in it, he quickly runs through the impact of option hedging has it’s played out over the course of the last five sessions.
“Option hedging is a temporary impact (intraday momentum) that tends to revert”, Marko writes, adding that “consistent with this, we saw Monday US morning weakness, a large Tuesday rally and end of the day squeeze, a Wednesday US morning reversal, and yesterday acceleration on the downside – all significantly driven by dynamic hedging of index options.”
The yellow dashed lines are SPX hedging flows into the closing bell on Wall Street, the solid orange lines are hedging flows into the European close and the dashed orange lines indicate a reversion following the close across the pond.
Marko argues that all macro narratives aside (and God knows there are a whole lot of those), systematic flows explain most of the price action this week. The fact that stocks are up 1.5% since last Friday to Marko represents confirmation of his week ago call that fundamental flows (e.g., discretionary and buybacks) would offset (and then some) what was left of the systematic selling.
Kolanovic’s Friday call:
Given the rapid selloff yesterday, the reverting feature of yesterday’s option hedging impact should have a positive market impact today.
Going forward, Kolanovic says increased buyback activity and month-end rebalancing (i.e., rebalancing flows into stocks following the drawdown) could provide tailwinds, although, as ever, geopolitical headwinds are gale-force right now, so plan accordingly.