How To VANNA

Awareness and understanding how activity in the option markets impacts liquidity flows into & out of equities can lead to a powerful trading advantage. Specifically in the S&P 500 we can see these supply and demand pressures cause significant changes in price all the time. This can be a powerful edge for active market participants, as these flows and their pivot points are often predictable

Implied Volatility plays an important role and looking at the days around the US elections, we can see an incredible example of how a hedging feedback loop and its unwind can exacerbate market movements.

Vanna flow buying pressure trumps uncertainty

On the day after the 2020 US presidential election the stock market ripped higher in the face of the worst possible outcome: no clear winner on election night combined with a high likelihood of split power between Senate & House. Instead of trying to conjure up an explanation of how the worst result is suddenly great in hindsight (the common, useless financial media tactic), I think that real insight can be found looking at liquidity flows around the event as a catalyst.

Specifically interesting is the extraordinarily high level of implied volatility that had been priced into the event for months – culminating in a VIX spike above 40 in the week before the election. In the course of the market rout a lot of put options on the S&P 500 were bought to protect portfolios against a worst case scenario (fears including widespread disruption and unrest, all the way to a possible civil war). These expensive, mostly near-dated puts were sold by options market makers who needed to hedge their exposure by selling S&P 500 futures – this action further pressured prices down and implied volatility up in a negative feedback loop.

The stage was now set by stretched exposure to near-term put options and inflated option prices through high demand for protection – market makers setting high prices directly translates into higher implied volatility and a higher VIX.

On Monday before the election the tiniest relaxation in fear – be it by traders perceiving a great deal to short volatility going into the event, a positive outlook for a good election outcome or simply decreasing demand for put protection (all possible causes for an initial suppression of volatility) – got the positive cascade of changes in Gamma exposure and Vanna rolling.

A simple explanation of options complexity
Vanna describes the influence of a change in implied volatility on an option’s delta (the option’s rate of change compared to an underlying). For our practical example this means: dealers are short puts (and/or long calls) and therefore are long Vanna. When implied volatility increases their deltas are rising and they must short more futures to hedge. This puts downward pressure on stock prices – inversely when implied volatility falls, equities rise.  
Charm or Delta Bleed: the time to expiration influences option price sensitivity to changes in the underlying. Short-dated OTM options will need to be hedged a little less every day going into a major options expiration date. The two weeks before OPEX on Nov. 20th have a natural tailwind to stock prices as short future hedges are unwound into expiration.
Finally the main dealer hedging mechanism it all boils down to is Gamma Exposure (how fast the sensitivity of an option’s price to the move of the underlying security changes, while its price moves closer to or farther away from the strike price): short futures positions are bought back by market makers as the market moves up from short gamma exposure into long gamma exposure – accelerating the rally.

(You can find a list of previous posts at the end, if you want to freshen up on further intricacies & practical use cases of gamma exposure and option expiration.)

A paper by Squeezemetrics dives deep into the significance of changes in option deltas

the post-election rally

The negative feedback loop began to unwind in the opposite direction as the previous week on Monday before the election. VIX started to fall and stock prices to rise and dealers could start to unwind their high levels of hedging by buying back S&P 500 futures. Short Gamma exposure lessened causing even more buying pressure. 

On election day everything was calm – no unrest, no violence, no significant disturbance of the elections – and implied volatility (VIX) dropped significantly as the worst fears did not materialize. As votes were counted uncertainty about the election result did cause some wild gyrations in the futures market, but overall nothing really unexpected happened.
The day after the election VIX collapsed further simply because everyone stayed calm. And so, despite an outcome that was less than desirable from the market’s perspective, stocks roared higher as market makers scrambled to buy back hedges and more & more traders jumped onto the train as significant resistance levels in the market were broken one by one.

This mechanism is quite reliable and has played out again and again around important events – key is identifying the potential tipping point when the extreme of a negative feedback loop has been reached.

Vanna & Charm price cycle

A very useful takeaway is the monthly Vanna & Charm price cycle playing out underneath the surface of the market. If there are no other significant catalysts, this soft tailwind has the power to drive markets predictably. 

In the weeks before monthly option & Vix futures expiration (the higher the open interested the stronger the mechanism) Charm erodes option delta and out-of-the-money put options lose value – short future hedges are continuously unwound into expiration. This in turn causes implied volatility to fall, Vanna kicks in and even more hedges are unwound supporting stock price.

Cem Karsan gives great real-time ideas around this concept on Twitter.

As the trader’s saying goes: „never short into options expiration“.

More articles on Gamma Exposure and OPEX

Good luck with your investments & thank you for reading!

David

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