To The Moon

A year after being shaken awake by an ultra-aggressive Federal Reserve, the stock market has gone back to sleep. Analysts trying to explain how it happened say dynamics in derivatives trading may be playing a role.

While cooling inflation and better-than-feared earnings have helped promote calm in a market less vulnerable to valuation shocks after last year’s declines, fresh research is being published almost daily into how newly popular varieties of stock options act as forces for and against equity volatility.

The latest to weigh in are strategists at JPMorgan Chase & Co., who argue that the interplay of zero-day stock options — fast-expiring contracts whose use exploded in the last year — and more conventional longer-dated ones is combining to dampen big and decisive moves in the broader market. A possible consequence: The roughly 150-point trading range that has prevailed in the S&P 500 since March has gotten harder to break out of.

As befits an inquiry into microstructural forces, the evidence is technical, boiling down to a few observations about hour-to-hour tendencies in stock indexes. Specifically, the researchers found, gains or losses in the S&P 500 have lately shown a habit of doubling-back on themselves in early trading hours, and then to shift course and get amplified as the session approaches the close.

The play book flips at around 3 p.m., they wrote, when — in quant parlance — the mean reversion underpinning the session’s early hours switches to trend following.

While the shift can be a result of many forces, JPMorgan strategists including Peng Cheng attribute it largely to a growing dynamic in the options world where contracts with zero-days-to-expiration, or 0DTE, dominate the flows in morning. It’s not until most of these flashy derivatives were unwound or netted off that long-dated contracts made their impact — often the opposite of 0DTE — felt in the market.

“In our view, investor positioning in 0D as well as longer dated S&P 500 options are likely factors that have contributed to the divergence of intraday price patterns,” Cheng and his colleagues wrote in a note Monday.

The JPMorgan analysis is the latest to highlight conflicting forces that have conspired to sap movement in the stock market this year. Others have cited diverging postures of human and computer-guided investors in explaining the stasis.

The study also offered a new lens into the 0DTE trading boom. While the rise in these high-speed contracts has spurred warnings for potential market crashes —- including one flagged by JPMorgan earlier this year — the firm’s latest study showed the implications can be more nuanced.

At the center of this split in intraday momentum is market makers who are on the other side of options transactions and need to buy or sell stocks to maintain a market-neutral stance, a process known as gamma hedging.

With investors becoming a net seller of 0DTE options this year, market makers are often mired in a “long gamma” position where they have to buy stocks when they fall and sell stocks when they rise. Their daily net gamma exposure has risen to $50 billion, from $20 billion at the end of October, JPMorgan estimates show.

The mounting long gamma exposure means the broad market is vulnerable to being whipped around by zero-day options — until their impact dissipates around mid-afternoon and the influence of long-dated options kicks in.

Thanks to jitters around risks such as US debt ceiling, traders have lately been wading back into options with a shelf life longer than one day, leading to a “short gamma” profile among market makers that requires them to go with the prevailing trend, buying stocks when they rise, or vice versa, Cheng and his colleagues found.

“We have observed more selling of 0DTE options, which has led to more intraday reversal behavior,” they wrote. “On the other hand, investors’ accumulation of longer-dated gamma has led to a strong end-of-day momentum. It is likely the outcome of these two opposing market forces that has contributed to the divergence between intraday and EOD price patterns.”

By Lu Wang