Tradable Effects of Options Market Liquidity Flows

In recent months, the analysis of specific liquidity flows in equity markets, which are driven by the structure and the increasing size of the options market, has developed into a central source of edge for my trading. These flows have simply proven to be more powerful than anything else in the current market.

The best trading edges arise when major market participants are forced to act predictably – and that is exactly what is playing out beneath the surface of the market in the case of options dealers.

In this post, I want to step back and look at how we can take advantage of structural liquidity flows, caused by forced, price-insensitive buying and selling through options dealers, as they adjust their hedges. This 10,000-foot overview provides a valuable addition to the toolkit of active traders, representing a compilation of all the useful effects I’ve found in my current research.

The basic inputs influencing options dealers’ delta hedging requirements — a deep dive in a  paper by Squeezemetrics.

For definitions and more detailed background explanations, please refer to the list of articles at the end.

The OpEX Gamma Timeline

Monthly options expiration dates (OpEx), which occur on the third Friday of the month, provide a timeline for many of these effects to play out in two major ways:

(a) Mean Reversion: In an environment where market makers are long gamma — usually in a stock market uptrend — equity index prices (primarily the S&P 500) have a structural tendency to revert directional moves, as options dealers’ hedging activities run counter to price momentum. 

Long Gamma: Options dealers adjust hedges by buying more of the underlying asset with each point it falls (and vice versa), and thereby suppress volatility.

The Gamma Dip
One simple setup, therefore, has a high probability for success in any long gamma regime: a lull in momentum, when price falls over the short term within an uptrend, gives a buy signal. Momentum and gamma mean-reversion now work in concert to push prices back up — a mechanism that is the core principle of my “Buy the Gamma Dip“ trading strategy.

The OpEx Pin
About one week (5 to 10 trading days) before OpEx, price tends to become “pinned” to levels of high options open interest (OI), where the largest concentration of gamma is situated. This means that any deviation from the pin has a high probability to revert back to that magnetic price level until a large amount of gamma exposure expires on OpEx Friday. A wealth of opportunity is waiting to be exploited by nimble traders: the key is to determine where to enter short positions at prices above the most significant gamma level, and where to go long below, as well as to set parameters for a take-profit exit (for example the high gamma pivot point) and a stop loss level.

Case Study: The 10 trading days before the February 2021 OpEx are an example of a wide, pinned range around the largest concentration of gamma exposure at SPX 3900. A strong momentum move in the beginning of February was reined in by the high gamma level, overshooting it by 35 points. On the lower end, the range was then limited by a pullback to 3885 (on Feb 10 as well as Feb 18), with 3900 as an intermediate level that provided intraday support several times.
On the Monday before OpEx (Feb 15, a market holiday), the futures market failed in its attempt to start a new momentum move, and on Tuesday the S&P 500, after reaching an overnight level of 3964, opened significantly lower to fall back to 3901 on Wednesday. After bouncing back to 3940, the lower end of the range (3885) was touched once more on Thursday, before reverting back above the key 3900 level to 3935 on Friday. The weekly close finally settled at 3902 in the after-hours market.

Case Study: A typical OpEx pin with a 50 – 75 point trading range in February 2021.

(b) Directional Trend: Monthly OpEx Friday is the central date of the month, as the expiration of a large amount of options’ gamma marks a major change in the nature of underlying supply and demand from options dealers’ hedging. 

The OpEx Release
Often, the “unpinning” from gamma exposure through expiration releases the market to start a new directional move, which can either take the form of a continuation of an existing trend or mark a decisive turning point in the market.
Of course, February 21, 2020 sticks out as the major example of a decisive turning point, as it initiated the March 2020 crash. But other recent expiration dates are more typical: For example, August 21, 2020 saw a release from a very strong gamma pin (a 10-day pre-OpEx consolidation) to start a blow-off rally leading up to the September correction, which paused in the period before September OpEx. The second part of this 2-month corrective move saw a significant down leg beginning after October OpEx. 

Short Gamma: Options dealers adjust hedges by selling more of the underlying asset with each point it falls (and vice versa), and thereby increase volatility.

Short Gamma Liquidity Spiral and the End of Downtrends
In a short gamma environment, usually coinciding with a volatile pullback or correction, a downward spiral, caused by a broad number of market participants selling into a falling market (margin calls, trend following strategies, de-risking risk parity funds, dealers’ hedging, etc.), is often halted by options expiring.
Market makers play a major role in exacerbating volatility, because their short gamma positioning implies that they increasingly have to hedge their short put positions in a falling market (as these positions move in-the-money) by continuously adding short futures exposure. The speed and magnitude of falling stock prices is increased by these hedging activities (conversely, upward reversals are also likely to be violent, because short futures positions are covered into the move). Come OpEx, dealers suddenly cease to put pressure on prices, as they close their hedges on expiring put options.
It is no coincidence that we saw major bottoms in recent years on March 23, 2020 (the day after March OpEx) and December 24, 2018 (the day after December OpEx).

Case Study: Decisive turning points in the market around monthly OpEx dates in 2019 and 2020.

Of course, these effects do not play out cleanly every single month, as options market liquidity flows are just one force among many and may be overrun by other catalysts. But these flows do give us a strong probabilistic edge, as they are inherently predictable (e.g. a correctly calculated long gamma exposure level tells us that option dealers will have to buy a certain amount of S&P 500 futures with every percent the index falls and vice versa).

Zero Gamma and Gamma Squeeze

The Zero Gamma Level
At a certain point in a falling market, long gamma switches to short gamma. This defines a key area around which market behavior can change dramatically.
Approaching this zone, we often see a predictable reversal to the upside, because the level acts as a strong support area. But, if price manages to break through to the downside, we can expect much larger daily moves in either direction than we saw before. Danger in the market increases, and exposure to risk should be reduced decisively.

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Call Roll Gamma Trap
The opposite effect of a short gamma liquidity spiral plays out as a gamma squeeze: a self-reinforcing positive feedback loop, which can often be observed in individual stocks with a low float and high short interest. (Recent examples include meme stocks like GME and AMC.) 
Market makers sell call options to traders, who are betting on a fast rise in a stock using short-term, OTM options. These dealers now have to hedge their risk by buying the underlying stock, which leads to a negative gamma position. They now must buy more of the stock as it rises and those call options move in-the-money. This cycle first triggers a constantly rising demand for the stock, and it spikes violently. But chances are high that the stock finally rolls over into a correction, when a reverse feedback loop is instigated, as large amounts of call options are sold by traders or reach expiration.

As these parabolic moves are hard to anticipate (though certain stock characteristics and growing option open interest can be an indication for an imminent move), the main advantage lies in the observation that such a meteoric rise proves to be unsustainable the majority of the time. As options dealers will quickly raise call prices to counteract increasing risks in such a gamma squeeze, very high option premia can be used as an indicator to trade such a situation systematically. Fading a parabolic move is very risky and a bear call spread is a risk-controlled method to take advantage of bloated option prices and a high-probability expectation that stock prices will return to more reasonable prices soon.
(Bear call spread: One sells an ATM call and buys an OTM call with the same expiration, risking the difference between the strike prices minus the premium paid at a maximum.)

GameStop: Is one of the most extreme gamma squeezes & collapses in recent history repeating?

Vanna and Charm

Two less well-known option greeks, with noticeable effects on the stock market, are Vanna (implied volatility influences option price sensitivity to changes in the underlying) and Charm (time to expiration influences sensitivity to changes in the underlying).

Event Effects
Before a known event with an unknown, risky outcome (e.g. the 2020 US presidential election), investors often protect portfolios temporarily against a worst case scenario. This action pressures stock prices down and implied volatility up in a negative feedback loop, making protective puts, which dealers hedge by short index futures, expensive.
Any other outcome than the worst case scenario is now likely to start a supportive Vanna feedback loop, as implied volatility drops significantly and dealers continuously close hedges by buying the market.

As hedges were reduced, when volatility deflated in the week after the US presidential election, positive Gamma, Vanna, and Charm liquidity flows were triggered.

Overnight Returns
Since 1993, all of the S&P 500 returns have occurred outside regular market hours. This tendency comes and goes in waves and often reverses in times of market stress. An interesting new theory makes Vanna and Charm influences responsible for a large part of this effect. They cause supportive hedging flows, which in normal times are mechanically executed, primarily when low overnight liquidity increases with the open of European markets. In stressful market environments, however, the overnight effect of Vanna is often reversed. 
This idea is supported empirically by backtests of strategies that take advantage of overnight returns. Strategy returns are greatly enhanced by filtering out times of market stress (using an inversion of the Vix futures term structure as a signal, for example) and by concentrating on the time of the month when Vanna and Charm effects are strongest.

Since 2017, all of the SPX returns have come from the overnight session, even though the March 2020 crash saw an outsized overnight drawdown.

Vanna and Charm Cycles
If there are no other significant catalysts, the monthly Vanna & Charm price cycle plays out beneath the surface of the market, and this soft tailwind has the power to drive markets predictably. There has been a tendency for markets to rise in the weeks before the monthly and quarterly option expiration dates. The tailwind then “expires” to rebuild over the following week.

Window of Potential Weakness
All other things being equal, in the time around OpEx the market stands on weaker legs, as the traditional Vanna and Charm support fades temporarily.

Option Models and Resources

Accurate options data is expensive, and good models are mathematically complex and usually proprietary or subscription based (e.g. www.spotgamma.com). However, a lot of great information can be found on Twitter (e.g. by @jam-croissant, @spotgamma, @SqueezeMetrics and others), and the gamma exposure index GEX can be found here.

NOPE: Indicating Corrections and Intraday Reversions 
A group of young data nerds around @nope_its_lily recently developed a model for the Net Options Pricing Effect (NOPE), which is a freely available options-based indicator. It looks promising, although I am still in the process of taking a closer look. Lily gives an overview on how SPY NOPE may be used to predict likely large stock market corrections, as well as intraday mean-reversion in SPY. 
These are her key findings:

  • Several days ending with a high, positive SPY NOPE (40+) are correlated to worse 14 and 30 day returns (this is likely indicative of a crash or correction event), and high end-of-day readings increase the likelihood of a negative return for the next day.
  • High magnitude negative end of day NOPE (< -30) indicates that a market bottom may be increasingly close.
  • When intraday NOPE exceeds certain thresholds (positive as well as negative), a reversion becomes likely. Similarly, divergences between the indicator and the underlying SPY price can be used to generate short-term trading signals

PREVIOUS ARTICLES ON OPTION BASED LIQUIDITY FLOWS

These ideas are based on my own observations and background research — please test them yourself before putting money at risk!

Good luck with your trading, and thank you for reading!

David

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