- Third Friday of each month brings wave of derivatives activity
- Potential rate rises, Netflix among factors driving volatility
Aside from the rout in stay-at-home stocks and gyrations in bonds lurks another key force behind the market turbulence this week: More than $3 trillion of expiring stock options.
The phenomenon -- generally known as OpEx -- has taken place like clockwork for about a year now. Around the middle of most months, American equities lurch lower, usually near the third Friday -- the day that most stock derivatives expire.
The dynamic has been blamed on dealers in the options market balancing their exposures by buying and selling underlying stocks or index futures. And this month’s OpEx is a big one.
All told, Goldman Sachs Group Inc. estimates about $3.3 trillion of U.S. equity derivatives are set to expire Friday. That includes roughly $1.3 trillion across single stocks, the firm said. About $1 trillion of S&P 500-linked contracts will run out, and $240 billion in options tied to the world’s largest ETF, the SPDR S&P 500 ETF Trust (tickerSPY).
Options are not the only driver of stocks, of course, and there is plenty of uncertainty around their influence. But they may have added to volatility as the likes of Netflix Inc. and Peloton Interactive Inc. slumped on miserable outlooks while the rates-driven rout tightened its grip on pricey growth stocks.
“Today’s expiry could be important for stocks with large open interest in at-the-money (ATM) options,” Goldman strategists including Vishal Vivek wrote in a note. “Market makers’ delta-hedging large options portfolios will be active. This flow is likely to dampen volatility in some names while exacerbating stock price moves in others.”
This OpEx dynamic is far from new, but it’s thought to be growing alongside the boom in options trading. A surge in retail investor participation in the market and rising hedging by institutional pros have spurred an increase in dealer activity.
This dynamic has become so large that some speculate the relationship between stocks and options has been upended, with derivatives now driving the equity market instead of vice versa.
Brent Kochuba, founder of analytic service SpotGamma, observed that last week and earlier this week, the existence of many large in-the-money single-stock call positions had led to a large positive delta skew -- the theoretical value of stock required for market makers to hedge the directional exposure resulting from all options activity. As most of these positions closed, that has contributed to recent market volatility. Now, Friday’s expiration has a relatively flat delta position.
In other words, dealer exposure is now close to neutral, so the effects of the expiry should ease.
“Call have been closed, puts have been purchased and stock prices have dropped precipitously,” Kochuba said. “As a result of this shift, we think that some of the selling in single stocks may now subside as we head into Wednesday’s FOMC.”
The process works roughly like this: When an investor buys or sells an option, the other side of that trade is taken up by a market maker. These dealers like to neutralize their exposure, which they do by trading the underlying.
In the run-up to expiration, depending on where dealers’ overall positions are, they can act as a stabilizing force or a volatility accelerator.
However, it’s a complicated picture, and the exact dynamics depend on the options expiring, new ones created and moves in the underlying assets.
U.S. stocks have already endured a tumultuous start to 2022.
The Cboe Volatility Index, a measure of expected price swings in the S&P 500 known as the VIX, has jumped about 10 points to 27 points since the start of the month. Investors are adjusting to the prospect of tighter monetary policy by ditching expensive-looking stocks, and those whose expected profits are far in the future.
The three main equity gauges dropped again on Friday morning as of 9:44 a.m. in New York.
“Is options expiration a contributor to the selloff? Yes. Is it the prime driver? No,” said Chris Murphy, co-head of derivatives strategy at Susquehanna International Group. “The Fed and deleveraging is the reason for the selloff.”
