Have We Reached A Bottom?

The Option Pit VIX Light Is Yellow: Volatility Is Going To Move.


Hey Traders,


We are still at a yellow light … but barely.


We are in a high-leverage couple of days for the market.


Everyone is watching the Consumer Price Index,  and on top of that…


We have one trading day until VIX futures expiration, and only three trading days until S&P 500 (Ticker: SPX) and S&P 500 futures expiration (and their corresponding options).


This event is called Triple Witching (“quadruple witching” if you want to add in Equity options that afternoon).


One of the things people ask me is “What’s the deal with Triple Witching? Why is it important?”


Here is your answer …


Witch Way Will It Go?


Triple Witching is when SPX index options on CBOE, and index futures and futures options on CME expire at the same time.


It is a big day of trading every quarter.


Traders often ask me why it is so important.   


There are several reasons.


It starts with the futures …


Every single option market maker last week was hedged with S&P 500 futures expiring on Friday.


If they bought an option expiring in two years, they still hedged the delta with a September future.


Now that the September future is expiring, these traders need to ‘roll’ their positions.


Rolling futures can be messy.


It can be done in two main ways:


      1. Traders can execute a futures roll selling Sep and buying December.
      2. OR they can execute a ‘jelly roll,’ covering their September position using combos (synthetic futures created using options), and creating a new futures position in December combos.


This is happening at the same time that market makers are starting to get huge delta drift.


Delta drift is the change in a trader’s exposure to the underlying caused by the passage of time.


Think about it this way …


On Monday, the SPX Sep17 4500 calls expired with a delta of 30.


If the S&P 500 stays below 4500, by Thursday night, those options will have a delta near zero.


Over the course of the next few days, traders that are short those calls will have to buy futures to cover drift.


Traders that are long those calls will have to sell futures.


If the whole pit and upstairs market makers are positioned the same way,  there can be a race for the exit.


This is happening at the same time that all those rolls being executed are reducing September futures and options open interest, which reduces liquidity.


So we have traders all trying to either buy or sell futures at the same time liquidity is drying up.


That is going to cause an increase in volatility (similar to what we saw intraday over the last few sessions).


Now we are heading into Tuesday,  but the end of the day position in VIX will be mostly flat, and positions in September futures and options will begin to wane …


In addition, new positions in October, November, and December will start to take hold of what is happening …


This causes the market to stabilize …


Thus the pattern we have been seeing over the last few months begins to form:



This pattern is being exasperated by the skew index …


With traders bidding up cheap out-of-the-money options, the deltas of all those baby puts market makers are short are going to start to die …


Market makers will cover many of those cheap options (which is a smart move).


This will cause buying.


The same thing is going to happen with out-of-the-money and at-the-money calls where market makers are long.


This will also cause buying …


Thus, while Monday’s price action was weird, and we barely staved off five days of straight selling …


I am starting to ask myself if this is a bottom …


And if so, what is going to happen with VIX expiration on Wednesday?


And what will happen to the VIX futures curve?


The pink curve is where VIX futures were five sessions ago. The blue curve is Monday:



In that time, the VIX is up about 3 points … the October future …a measly $0.75. 


By the way, this is why we don’t automatically buy iPath S&P 500 VIX Short-Term Futures ETN (Ticker: VXX) and ProShares Ultra VIX Short Term Futures ETF (Ticker: UVXY) in anticipation of VIX when the curve is wide.


The spread between October has gone from almost 4 points to less than 2 points … all because of the cash VIX.


If VIX falls, what will the future do?


And will the same pattern happen AGAIN next month?


Expiration is the 15th …


It’s not triple witching, but we do have some decent positions open in October …


Just saying …


With how we are down today …


I may very well be a buyer.


Your Only Option,


Mark Sebastian

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