On Wednesday afternoon, in response to a reader comment, I noted that although the impact of options-related flows on the market obviously varies from session to session, it’s never completely absent. Lately, it’s been extreme. Absurd, even.
Each day has become “its own ecosystem,” as Nomura’s Charlie McElligott put it Tuesday, while editorializing around day trading in very short-dated options and the extent to which such behavior is no longer the sole purview of retail investors.
Fast forward to Wednesday evening and, in a rare “special” edition note, McElligott documented what he described as “unprecedented ‘weaponized gamma’ from the ‘institutionalization’ of 0-1DTE index and ETF options trading.”
The associated intraday fireworks, which manifest in “chase” flows, are shocking. “We’ve never seen the likes of [this] previously,” Charlie said. He was very emphatic.
“YOLO’ing into 0- and 1-days-til-expiration (DTE) options has now been ‘institutionalized’ by vol traders at many of the largest funds on the Street,” he wrote, in what will surely be remembered by McElligott’s following as an instant classic. “The proof is in the pudding,” he said, calling the use of 0- and 1-DTE options over the past month “absolutely biblical” on some days.
For example, on September 20, more than half of total SPX options volume was from 0-days-til-expiration options. The figure (below) gives you a sense of how acute this phenomenon is on some days.
This matters, and it matters a lot. This behavior, when piled atop a highly unstable macro environment, and considered in a negative gamma regime wherein dealer hedging flows would already be acting as accelerants into directional price action, is gas on the fire — almost literally.
In you pan out to a five-year view, you can see the trend. It’s astounding (figures below).
Over the past three years, the shortest of short-dated options have gone from comprising virtually no share of overall daily volumes, to being dominant.
“Daily options expirations have made ‘weaponized gamma’ the only game in town,” Charlie wrote.
He was unequivocal. “Institutional entities are now the most prominent users creating all this extreme daily market convexity with their usage of ultra-short dated options,” he went on to say. “The big boys’… have become full-tilt day traders.”
The figures (below) show how this has progressed over the past decade. The visuals use a quarterly rolling window so as to smooth out the noise. Again, the increase in 0- and 1-DTE options usage is remarkable, to put it mildly.
Recall how I described this daily chase on Tuesday, in the linked article above. I wrote that monetizing downside into weakness and negative market catalysts is a must, but because everyone realizes that, the next move is to front-run the expected knock-on. Once the downside gets monetized, you pile into same-day upside optionality not just to play the squeeze, but in fact to facilitate it. Note the italics.
In his Wednesday evening feature, Charlie was even more direct than I was on Tuesday. Institutions, he suggested, are “using the certainty of dealer hedging flows that their orders create to then amplify the intended directional market move, before closing out positions mere hours later by end of day.”
Crucially, when you think about the impact of this behavior and the associated dynamics on equities over the past several manic sessions, note that the amount of negative front-Delta headed into Op-Ex is on par with some of the most infamous events in recent market history, including the February 2018 implosion of the VIX ETN complex (which played out on Jerome Powell’s first day as Fed Chair, by the way), the Q4 2018 selloff triggered by Powell’s “long way from neutral” communications faux pas and the original COVID meltdown.
That’s “acting as further shadow convexity in the market and then commingling as part of the feedback loop… from the ‘same day’ options flows,” McElligott remarked.
These are your markets in 2022, ladies and gentlemen. As I told one reader on Wednesday afternoon in the same response mentioned here at the outset, when you look at stocks these days, you’re seeing a derivative. But not just any derivative. Stocks are a derivative of their own derivative. That’s not a theory, and it’s not “controversial,” as Bloomberg described it in August. Rather, it’s a fact.
McElligott had just one question: “Are you not entertained?”
Frenzied trading is not capitulation.
I am lacking a sense of urgency to dive back in this pool I can’t see my secchi disk and it isn’t very deep. Sounds like the sharks are active though. No fomo at the momo, ya know.
Agree, no need for a niskin bottle here, the sample would clearly stink despite being of a depth that would break one’s neck.
In math terms, the derivative of the second derivative is also called jerk (measures change in acceleration). Anyone else feel that way in recent days? Only 2 trading days to monthly op-ex. Grab the Dramamine. Thanks, H. The summaries on Charlie’s work are succinct and well done (and does not require a Ph.D in higher mathematics).
Jerk is the third time derivative of position (derivative of acceleration) in physics.
The derivative of the second derivative is just the third derivative, in general terms.
Now, in finance, a derivative of a derivative (a compound option like a call on a call) is just a derivative. Using functional analysis terms: a derivative is a fixed point of a derivative.
With interest rates rising this fast, it’s hard not to be in cash. Or short. But you need balls of steel to do that in this market.
Do you know what it takes to sell real estate? It takes brass balls….
If institutions are using the certainty of dealer hedging flows why are they still writing the options? Options are a zero sum game so someone is getting fleeced.
Away from the zero date option party, I see that equity ETFs have had impressive inflows in the last couple months. More not capitulation.
We’ve discussed this before, but I’m still undecided if capitulation is absolutely necessary. After all, this has been an openly and deliberatedly created market downturn, it is expected to end when Fed tightening ends, each Fed tightening move is well advertised in advance, and the Fed’s end destination is also well advertised.
So perhaps investors aren’t going to panic when the cause, pace, and extent of the market pressure is so well known. If something truly off-script happens – serious breakage in the US financial system, inflation surging so that suddenly we need to price in a far higher terminal rate, or the bottom suddenly falling out of the economy – then probably investors won’t be so equable.
All in all, I don’t think we can absolutely require capitulation, but without it we should need to see a lot more to believe the bottom is in.
Whether you jump out the window with your hair on fire or calmly walk out the door – you’ve still left the room.
This volatility is great for picking up stocks that are cheap on fundamentals. This is the time to get those stocks into your portfolio that will give outsized returns over 1-3 year period.
A pernicious development resulting in a lot of sound and fury signifying nothing. So much capital being used so unproductively — it makes an ordinary Joe want to scream. Seems like a perfect time to introduce a financial transaction tax that ratchets higher based on the number of transactions and dollar amount of the trades/derivative contracts, etc. (the more trading/contracts executed by a firm, the higher its rate). Would do a lot to improve market structure, imo.
Certainly appears that the casino needs some limits. On many days the market feels like a cat ‘playing’ with a mouse.
Good idea mfn. But they’ll all squeal about how it would reduce “valuable” liquidity. (More like reduce their bottom line.)
How far we have drifted from financial markets being a venue for capital providers and those who need it to meet. Middlemen played a role but did not dominate the markets. Now they’ve become a glorified casino where the house outnumberw the customers.
What percentage of GDP do financial “Intermediaries” represent now? And perhaps more importantly, what percentage of political donations do they account for?
Agree. A lucrative activity with no societal utility – perfect place to extract tax revenue that can go to useful things.
Between ETFs and manic options trading, how long until the underlying — actual stocks — starts atrophying in lower volumes and illiquidity? Meanwhile, surely others have noticed that longer dated out of the money calls and puts — you know, the ones formerly used for actual hedging by little guys like me — have become illiquid, often with ginormous bid-ask spreads that make them nearly impossible to employ without using limit orders and hoping someone meets you somewhere near the middle.
If the big boys are playing 0dte, presumably it’s a profitable strategy. Given the volumes involved, the daily P&L must be in the billions. But I don’t hear of any hedge funds hitting the lights out, so where’s the catch? H – can you please shed some light?