How ‘OpEx’ Is Shaking Up the Third Week of the Month
(Bloomberg) -- Since January, U.S. stocks have lurched lower in the third week of most months. That happens to be in the run-up to the date on which most stock options expire, the third Friday of the month. While it’s not guaranteed to happen again, the turbulence around this event -- known colloquially as OpEx, for options expiration -- has become a source of fascination to many market observers, because it upends the traditional relationship between options and their underlying assets. What it suggests is that the stock market has effectively become a derivative of its own derivative -- a tail wagging its dog.
1. What kind of market move have been tied to OpEx?
In July, the S&P 500 lurched 2.3% lower over two sessions through the 19th. In June, the index had its largest drop on the 18th. April saw the benchmark swoon for two days from the 19th to the 20th. In February, it fell four days in a row through the 19th. The pattern was reprised in August when equities had their biggest slide of the month on the 17th and 18th.
2. Why are options playing a role?
Options are contracts that allow the holder to buy or sell an underlying stock at a given price. Call options confer the right to buy the underlying, while put options grant the right to sell. Changes in share prices influence the value of options, but the opposite dynamic sometimes also surfaces. It has intensified over the past year as options activity surges to unprecedented levels. Between day traders buying speculative calls, yield-seekers selling them, and institutional hedgers loading up on protective puts, options volume and open interest are soaring -- leaving market-makers struggling to absorb all the flow, and putting them in a position to have a big impact on the market.
3. Why would dealers be at the center of this?
Like anything in markets, it’s unwise to assume any explanation is the whole story -- but quite a few come back to options dealers when deciphering the mid-month storms. Why dealers? Loath to take on directional exposures, they’re the most active hedgers in the market. And the thinking goes that their buying and selling has grown large enough to move stocks almost like clockwork.
4. How does that work?
When an investor buys or sells an option, the other side of that trade is taken up by a market maker. These dealers typically balance their books through buying and selling the underlying stock or index futures. This helps them to remain neutral and avoid being overly exposed to fluctuations in the market. It’s this buying and selling that is said to create recognizable patterns around OpEx. In the run-up to expiration, dealers are thought to neutralize volatility by selling into rallies and buying on declines -- and there have been mostly rallies this year. Once those positions expire, that stabilizing force disappears, which is why stocks can turn volatile.
5. What else is involved?
Mathematicians use letters from the Greek alphabet to denote concepts in calculus equations. Several were popularized among options traders when Fischer Black and Myron Scholes laid out their math (the Black-Scholes model) for the dynamics at work in this market in the 1970s. Traders have since added their own Greek letters, and some non-Greek bits of jargon. Here are three terms for how options dealers measure their risk exposure that are under scrutiny now:
• Gamma refers to changes in the sensitivity of an option as the underlying stock moves. Dealers hedging their gamma exposure are said to contribute to the normal pattern of a quiet upward drift for stocks in the run-up to options expiry, and the brief bouts of volatility that arise in the aftermath.
• Vanna measures changes in an option’s sensitivity to shifting volatility. Dealers both buy and sell stocks to manage their exposure.
• Charm is the rate of change in an option’s sensitivity to passing time, which also prompts hedging trades by dealers.
6. What impact does all this have on markets?
Dealer hedging is thought to create recognizable patterns in the stock market. Traders have started anticipating the moves, with some firms creating strategies to ride the wave. Even retail investors now have access to instruments that trade around these flows.
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