Hey There Income Hunter,

Yesterday’s S&P 500 failure at 3800 shows how important it is to understand and follow the delta-hedged option positioning and changes to the gamma risk those positions create.

3800 is the current level – or pivot – where the net gamma among all strikes for options expiring at the next monthly expiration date (Oct. 21) is neutral.

This means that the net negative gamma created by all put and call positions below 3800 equals the net positive gamma of all put and call positions above 3800.

This makes it somewhat of a bullish/bearish line in the sand … 

So, heading into next week’s most important CPI it should be a tug-of-war by each side …

But coming out of CPI, we should have a strong move one way or the other.

Today, we’ll take a closer look at how the flows have been changing this week for clues as to where we may be headed.

Dealin’

Now, dealers are simply bank and non-bank option dealer desks and their goal is to maximize the bid/ask spread on their algo driven option markets. 

They build up a very large book of option positions hedged with offsetting stock positions, meaning delta hedged positions.

The risk they must manage is called the gamma risk … 

Now, we know put positions dominate option flow because large institutions that drive underlying stock prices buy puts to protect their portfolio.

So, in a bear market, the put flow can be a massive driver of underlying stock prices as dealers hedge their delta neutral exposure or gamma.

For example, if a dealer sells a block of puts and buys the underlying stock, he has negative gamma exposure, which means he gets longer stock as the market trades lower.

He will need to rebalance his book to offset that or lose a lot of money as he gets longer at lower prices. 

Now, as the market trends higher, his short hedge will increase and he must cover an amount of his short stock hedge to rebalance .

The key is negative gamma creates greater volatility and is a contributor to the VIX rising in a down market. 

Negative Gamma Can Be the Cause of a Short Squeeze

So, as we saw yesterday around noon, the market started squeezing higher and failed right at the 3800 level. 

Sure enough, the end of day open interest report for Oct. 21 expiration revealed an increase in positive delta, meaning the bulls won the tug of war for the day.

Here is a snapshot of the positive/negative gamma profile for Oct21 expiry 

So , if the market can break above 3800 it will shift the negative/positive balance to neutral …

However, notice the 3835 level …

Clearing 3835 brings in the largest absolute positive gamma 3850 strike into play.

That move higher will force massive buying of stock as dealers who are short puts that are losing value as stock prices rise cover the short stock that was accurately hedging the puts at lower levels. 

What’s the Trade?

Sentiment is still bearish. CPI next week should give the bears what they need – a CPI result next Thursday above 8%.

The top bearish plays right now in my opinion are SPDR Select Technology Sector ETF (XLK), the iShares High Yield ETF (HYG) and the iShares Russell 200 ETF (IWN).

I have bearish strategies on both the HYG and IWM, and I will be watching closely to see two things …

1. What is happening in the UK and EU. Remember the recent rally in the dollar will cause more pain in both areas, which the Fed is also worried about from the standpoint of global financial system risk. 

2. The levels discussed above. No matter what happens politically or fundamentally sentiment in the market is overly bearish and higher prices may force even higher prices …

Bring It Home 

I have worked hard during my career at checking my emotions at the door to become a more objective trader.

An important rule of trading is that if you hear something or see something related to the market, it is already priced in.

The greatest information we can trust are the market internals and following gamma. What is happening with dealer positioning is hugely helpful.

We can fall fast below 3800. So, being short from today’s levels is a good location and offers excellent risk/reward.

You just always want to have an exit strategy because a deer in headlights is frozen and that is when you can get caught with unforeseen losses that set you back …

Here is to always being prepared so you can live to fight another day, which will allow you to always …

Live and Trade With Passion My Friend,

Griff