Hey There Income Hunter,
We know Jerome Powell needs asset prices to go lower to help the Federal Reserve drive inflation down.
When stocks and bonds are lower in price (and, woof, the bond market), it tightens financial conditions for Powell and may keep the Fed from having to do some heavy lifting.
As I’ve said for a number of months, the biggest trade to catch will be to position for a Powell pivot back to quantitative easing.
Well, what we saw in the aftermath of Wednesday’s Fed meeting is the type of reaction that will speed up that process.
The Powell party was simply a negative gamma-driven VIX crush trade that we knew was coming anyway.
Today, I will review gamma because it provides critical insight into the impact that option hedging flow has on the market.
Gamma, Gamma, Gamma
Gamma is so valuable because market makers mostly delta hedge their options with the underlying stock. So gamma refers to the exposure market makers have in aggregate, and heading into expiry this information can give you an edge.
Net gamma will tell you when market makers are exposed to negative or positive gamma.
- Negative gamma indicates MMs are net short options, which increases volatility because MMs are forced to sell stocks when they are falling and buy when they are rising to rebalance the delta hedge.
- Positive gamma indicates MMs are net long options, which reduces volatility because MMs are forced to buy stocks when they are falling and sell them when they are rising to rebalance the delta hedge.
Gamma becomes really important in bear markets because it can show you when the market is susceptible to a vicious short covering rally.
Like Thursday, for instance, which was a “short gamma” squeeze.
So, heading into the Fed meeting real money accounts were buying puts to protect their equity portfolios. Their counterparts on the trades are the MMs who sell them the puts and sell stock.
Over the past few weeks the open interest grew so large at the 400 strike that when SPY tested that level, real money accounts sold some of their puts, MMs bought them and then had to buy stock to close the hedge …
This price action caused a short squeeze and SPY rallied nearly 3% from that level.
The graph below illustrates the major strikes in SPX that impacted the market this week. Once the market traded below 4,300 last week, volatility started increasing. Then on Monday prices plunged near the highest option open interest strike at 4,000 and prices squeezed higher.
By the end of the day on Wednesday SPY rallied back to the resistance at 430 (SPX 4300) and this trade removed much of the negative gamma that had built up in the weeks prior.
With more balanced gamma, macro fundamentals took over …
Then, on Thursday, BOE raised rates and acknowledged that they were raising rates into a recession. Plus Q1 US unit labor costs were reported at 11.6% – well above consensus of 10.5%, and real money accounts came in with very heavy selling.
This wiped out the entire Fed rally, building much more gamma that may retest SPY 400 and SPX 4000.
We will be analyzing gamma in more detail because bear markets are notorious for these vicious short covering spikes that gamma can help you anticipate and make you as much money on the way up as you make on the way down …
Bring It Home
Now with the Fed out of the way until June 15, the inflation numbers next week will be market movers.
Until we actually see inflation come down, the volatility should remain high and selling rips will continue to be the winning trade.
The wild price swings we have been seeing are great for trading but not so much for investor confidence, and eventually I think it will lead to financial system stress that will force the Fed to pivot back to QE causing a massive swing back higher.
Understanding gamma will help your timing on when these swings are likely and Power Income will keep you on top of it every step of the way.
Live and Trade With Passion My Friend,
Griff