Make-or-Break Volatility Event Is Looming in Options Expiration

(Bloomberg) -- For all the big ideas taking up space in investor minds right now, from the presidential election to a resurgent virus to government aid to the economy, a potentially bigger driver of turbulence in U.S. equities is an event of decidedly less momentous proportions.

With memories of August and September fresh, stock traders remain obsessed with derivatives markets, where the end of this week brings the expiration of monthly options on equities, indexes and exchange-traded funds and notes. Attention on the contracts is intense after several recent sessions where speculation by individual investors and the associated reaction of options dealers appeared to stoke turbulence.

While the pace of buying is less frenzied than in August and early September, analysts have spotted a worrying pattern heading into Friday’s expiry. Much of the action remains concentrated in bullish call options in the FAANG shares, the software and internet megacap bloc that has soared 11% over three weeks. Both gains and losses have the potential to feed on themselves when options froth whips up and dealers must take action to hedge.

“If we were to continue rallying into Friday’s expiration, there will continue being a ton of stock to buy for the dealers to remain delta-hedged and extend the melt-up,” Nomura Holdings Inc. strategist Charlie McElligott wrote in a note. (Terms like gamma and delta are types of options market price drift that sellers attempt to offset.) But should tech stocks continue to head south -- and that’s what they’re doing now, with the Nasdaq 100 falling for a third day -- “there would be a massive puking of all that dealer delta hedge, just like the August turn into September expiry.”

Call open interest in Facebook Inc., Amazon.com Inc., Netflix Inc., Alphabet Inc., Apple Inc. and Microsoft Corp. has averaged 12.9 million contracts over the 30 days through Wednesday, the highest since early 2019. Roughly 3.7 million options contracts tied to Apple traded on Tuesday, almost double the 20-day average.

Calls on Apple grew in popularity ahead of the company’s new product announcement this week. The stock has roughly 67,000 of open interest in $120 calls, 99,000 of open interest in a $125 call and 91,000 in a $130 call expiring on Friday. After closing at $121.19 on Wednesday, shares fell 1.4% early Thursday to $119.55. Analysts say those expiring contracts have the heft to rattle the stock, which is the largest member of the Nasdaq 100.

“If you assume retail is net long and not gamma hedging, and dealers are net short and gamma hedging, then moves below $120 will result in incrementally more selling by dealers and moves above $130 will result in incrementally more buying by dealers,” said Chris Murphy, co-head of derivatives strategy at Susquehanna International Group.

Not everyone is convinced that this most recent episode of options enthusiasm will end in tears. For one thing, overall speculative mania has yet to reach late summer’s heights. Additionally, the breadth of the rally had broadened out heading into this week, with the Russell 2000 small-cap index outperforming the Nasdaq 100 in the past month, notes Sundial Capital’s Jason Goepfert, whereas August’s tech surge had been driven by a handful of megacap names.

“It’s hard to see how this kind of behavior gets rewarded - markets simply aren’t that accommodating,” Goepfert wrote in a note to clients. “But given last week’s impressive, and important, recovery in major breadth metrics, this options activity isn’t as big of a worry as it was a month+ ago.”

Meanwhile, the recent resurfacing of a large buyer of tech calls dubbed the Nasdaq whale has put some traders on edge. However, in the eyes of QVR Advisors’s Benn Eifert, the return of retail traders to the options market has bigger implications for tech gyrations. Short-dated call options -- which tend to be purchased by individual investors -- have much more power to accelerate dealer hedging pressures, he said.

“If the ramp in short dated option buying by retail continues to grow, it will accelerate volatility,” said Eifert, chief investment officer of the hedge fund. “The most common path is a trendy rise followed by a quick puke.”

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