The rally was largely driven by mechanical trading action as fundamentals took a backseat
Options traders have helped fuel the latest recovery in stocks.
The S&P 500 has enjoyed an epic rally over the past five days - but the advance may be more mechanical and driven by options positioning, rather than by an improvement in investors' fundamental outlook.
A rapid shift in dealer gamma positioning, falling implied volatility and heavy activity in bullish call options appears to have amplified the move.
The trigger for the rally - the S&P 500 index SPX has risen by about 6% since this latest winning streak began - was the July 29 Federal Reserve meeting.
'Gamma' exposure pre-Fed
Heading into the latest batch of earnings reports and the Fed's July 29 decision on interest rates, options positioning appeared to have left dealers with significant negative-gamma exposure. In a negative-gamma environment, large moves in either direction are easily amplified. Gamma measures how quickly an option's delta changes as the underlying index moves, while net dealer gamma estimates how market makers' exposure to the contracts they have sold, or bought, may influence their hedging activity.
In a negative-gamma environment, dealers generally hedge in the same direction as the market - buying as prices rise, and selling as prices fall - which can amplify price moves and increase volatility. By contrast, positive gamma typically leads dealers to hedge against market moves, helping to dampen volatility. The big move higher in the S&P 500 was likely reinforced by the negative-gamma positioning.
However, the market has now returned to a positive-gamma regime, meaning market-maker hedging flows move against the market's direction and can help dampen volatility. When the S&P 500 rises, these hedging flows can suppress further gains as market makers become sellers. The market no longer has the tailwind that helped initially to push it higher.
Adding fuel to the rally
Another factor that may have played a role in the recent rise was the high level of implied volatility. Following the Fed meeting and a heavy round of earnings, the Cboe Volatility Index VIX, better known as the VIX or Wall Street's "fear gauge," has fallen to around 16, from about 21 previously.
When implied volatility declines, put premiums fall and lose value. As a result, investors may then choose to unwind those positions, which causes dealers to adjust their hedges. The result is that this action can help to mechanically push the market higher.
Additionally, a surge in S&P 500 net call volume - that is, trading volume in bullish calls minus volume in bearish puts - over the past few trading sessions likely helped fuel the rally further.
If dealers were taking the other side of that call buying, their hedging activity may have reinforced the index's advance. As the market rose, dealers who were short those calls may have needed additional hedges for risk-management purposes - creating a feedback loop in which rising prices generated increased demand.
However, the market now appears to have reached a potentially significant resistance area. Gamma positioning has turned positive, and call positioning around the 7,800 strike price appears particularly heavy, based on calculations using options data from LSEG.
Additionally, the put wall, which is the level with the greatest concentration of put gamma, is at 7,400 - just above where the market began its rally following the Fed meeting on July 29.
A failure to clear 7,800 could leave the S&P 500 vulnerable to consolidation or a pullback. On the downside, the next substantial concentration of options-related support appears near 7,400. Positive dealer gamma could buffer a decline, as market makers may help cushion the decline due to hedging flows. But if the index falls below the positive-gamma threshold and dealers return to negative gamma, selling could accelerate and erase a larger portion of the rally.
From oversold to overbought
One way to demonstrate this setup from a technical perspective is by looking at the S&P 500 and its Bollinger Bands. The index went from being oversold and trading below the lower Bollinger Band to being overbought and trading above the upper Bollinger Band.
The market has gone from one extreme to the next in a matter of days.
None of this means a selloff is imminent. Positive dealer gamma could help stabilize the market and keep daily moves contained. But it also suggests that the options-related forces that accelerated the rebound are fading.
This report contains independent commentary to be used for informational and educational purposes only. Michael Kramer is the founder of Mott Capital Management and a long-only investor focused on macro themes. He analyzes long-term macro trends and short-term market risk using technical analysis, fundamentals and options-market positioning. Readers can find additional disclosures here.
-Michael Kramer
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