Hey There Income Hunter,

 

CPI gave the market an early Christmas present yesterday … 

 

• Headline year-over-year CPI came in at 7.7% vs 7.9% expectations 
• Core CPI came in at 6.3% vs 6.5% expectations 

 

 

Stocks saw a pretty incredible move, with every sector finishing higher as this report was the first sign that inflation may be heading down.

 

Elsewhere, Wednesday’s crypto crash triggered heavy put buying, which had the market offsides coming into yesterday’s report. That fueled a double-dose of short covering and new buying that resulted in the best one-day move in 2-years  …

 

So, what condition does this leave the markets in?

 

Well, the bottom is in for 2022, but there will be plenty of volatility ahead … 

 

Today, we’ll take a look at what to expect heading into next week’s monthly options expiration. 

 

Rally Reason

 

Yesterday’s  rally was driven mostly by the repositioning of hedges to short-term put options that were demanded during Wednesday’s crypto crash. 

 

Here is how that works …

 

• Short-dated options are highly sensitive to changes in implied volatility (IV), market direction, and time … 

 

• The CPI print came out, which sent stocks higher, driving IV and putting values lower  … 

 

• This forced option dealers, who had sold the short-dated puts to rebalance their short put/short stock, delta-hedged position by buying stock.

 

The  SpotGamma chart below clearly shows this dynamic in action. Notice how yesterday’s Invesco QQQ Trust Series 1 (Ticker: QQQ) rally was fueled by the double positive delta flow of put selling and call buying …   

 

A few observations from yesterday’s trade …

 

• QQQs opened strong yesterday morning and at noon started trading lower. At 12:30 large call buying and put selling drove the ETF price higher.
• The important point is that the options flow of call buying and put selling ignited the second leg of the QQQ rally …
• This is due to the options dealers (market makers) on the other side of the trade, meaning short calls and long puts, both negative delta positions, needing to buy stock to delta hedge those trades.
• So, notice how as QQQs were making their lows the call buying /put selling flows had already turned positive then the delta hedged buying kicked in.

 

The dynamic explained above is expressed as the risk market makers must manage day in and day out, depending on the option flow they are counterparty to. 

 

This risk is measured by GAMMA, which is the change in Delta for a 1% change in the price of the underlying stock.  

 

Gamma is becoming the most important indicator of the impact option flow has on stock prices. It is a tradable dynamic and gives traders an edge over market makers when gamma risk hits extreme conditions. 

 

We are now a week away from the monthly expiration and are seeing very large open interest at the 4000 strike. This can act as a magnet today and into next week. This is especially true during the monthly expiration cycle

 

 Here is a chart of the last three monthly expirations .. 

 

 

Notice each time during the August, September and October expiry either at on the day of expiration or the day after, the market moved counter to the trend leading into OPEX.

 

Not only does following the changes in gamma offer insight into trend changes through expiration … It also provides insight into how volatility may be impacted based on the changes in gamma as dealer positioning changes.

 

Gamma’s Impact on Volatility 

 

• When dealers are long gamma that means their delta hedged position will get longer in an up move and shorter in a down move …

They love that position because they can monetize those moves by rebalancing the hedge. This flow reduces volatility …

• When dealers are short gamma the opposite occurs. They get shorter on up moves and longer on down moves … This means they must sell into a down market and buy into an upmarket … This flow increases volatility. 

 

So, knowing the changes in gamma positioning can give you an edge, allowing you to beat the dealers at their own game …

 

For example, as the market moves higher, by knowing the strike at which gamma will shift from negative to positive you can shift to option strategies that will do well when vol decreases and vice versa..   

 

Here is a snapshot of all expiries and their current gamma and delta nationals in dollars. Notice how much larger the monthly expiries are versus the weeklies. Nov expiration has 18% of total gamma expiring and then Dec. has 21%. These are large expiries and could impact stock flows significantly. 

 

 

 

Bring It Home

 

As option volumes have grown and even surpassed the volumes of underlying stock, gamma analysis has become a valuable technical tool.

 

Changes in the net positive (long gamma) or negative (short gamma) positioning can have a significant impact on volatility of the markets. This is especially true around option expiration (OPEX).

 

SPX options open interest has been growing for many years and can reach 25% of market cap during monthly and quarterly OPEX dates. Option volumes leading up to OPEX can increase 10-20% as well.

 

For some stocks, option flow dominates their stock trends … Here are a couple of examples for today’s weekly expiration: PLUG, WYNN, AMC, COIN, VIX, ARKK and LYFT, just to name a few.

 

Understanding Gamma impact can set up some great trades for you …

 

Stay tuned for more on trade ideas based on gamma’s impact on volatility.

 

Until then …

 

Live and Trade With Passion My Friend,

Griff