Options markets continue to play a highly influential market role and cause a variety of structural flows into or out of stocks. Market maker hedging activity is executed in a mechanical way, which can lead to predictable stock market behavior in certain environments. This can be an excellent trading edge, as we witnessed during the week of the Evergrande Debt Debacle, followed by the announcement of a tapering schedule after the FOMC meeting on September 22nd.
One of the best trading setups centers on highly anticipated events with an uncertain outcome, which are widely thought to have a major influence on equities. Important is that many investors believe in the influence of the event and therefore fear its worst case outcome — it is irrelevant whether or not that belief is actually true.
Examples are: The Brexit vote, US presidential elections, or (as in this case study) certain FED policy announcements.
For this edge to play out, we need to see a significant volatility spike going into the event. This happened last Monday, the day before the FOMC meeting began: Vix exploded by 64% during Friday and Monday, aided by a coincident event: The Chinese Evergrande Debt Debacle.
Vix extremes are often reached somewhat in advance of the actual event, as traders and investors try to hedge themselves against a potential worst case outcome (via S&P put options in most cases) before puts get too expensive. Their put buying activity forces the dealers on the other side of the trade to hedge their exposure by selling S&P futures, which puts pressure on the market. In a negative feedback loop, falling prices in return increase investor’s anxiety and their demand for hedges — and so on.
Knowing what is likely to happen next, enables traders, who are aware of the pattern, to confidently accumulate long positions during a falling market in the days before an important event takes place.
What makes this setup highly predictable is that we will surely have a change from a state of uncertainty to one of certainty when the event finally takes place. Barring extremely negative surprises, even a “bad” outcome to the event will be a certain outcome, which will lead to deflating volatility, because to the market it is still preferable to the previous state of uncertainty.
Case in point is the FED announcement on Wednesday, September 22nd, which was fairly hawkish as it presented a tight tapering schedule. This signaled a slowdown in the flow of unlimited central bank liquidity for the first time since the Covid Crash of 2020. Nonetheless Vix went into free fall (interestingly this already began in the morning before the actual announcement — maybe some inside information or rumors circulated early?), while the S&P 500 initially seesawed back and forth digesting the bad news.
Falling volatility triggers Vanna flows, as options dealers must buy S&P futures to reduce their hedge on put options that are getting increasingly cheaper with lower IVol (Vix is a measure of 30-day implied volatility: IVol), and this pushes the market up reflexively. The re-hedging process even takes place at predictable times, when market liquidity is particularly good. We can see strong ramp-ups at the next day’s EU open and, strongest of all, at the US market open.
This pattern plays out with high reliability, and led to the well-known adage: “Sell the rumor, Buy the news.”
By the end of the week, the majority of the Vix collapse had taken place, and the Post-Event Vol Crush dynamic had largely played out. From Monday’s peak in fear to Friday’s close, Vix dropped by almost 40% — back to lows that were last seen on the previous Friday. Which made this one of the most significant volatility spike and collapse events in the history of the Vix index.
After highly anticipated events (as, for example, the last US presidential election), falling volatility can support the market for a week or even longer.
Now, another well-known pattern has an elevated probability to play out: A volatility spike rarely remains an isolated event, and it is likely that a second (often smaller) rise of the Vix happens, while the S&P falls again.
Volatility has a distinct tendency to cluster.
PREVIOUS ARTICLES ON OPTION BASED LIQUIDITY FLOWS
- The basics: What do you mean – Gamma Exposure?
- Practical trading ideas: Option Expiration, Gamma Exposure and all the rest.
- More evidence for the increasing importance of option markets: Gamma – a Market Force Getting Stronger Than Ever.
- Vanna and Charm create predictable monthly liquidity flow cycles.
- A broad overview of liquidity’s role in today’s markets: Liquidity Signals.
- Overnight effects result in The Magic of Overnight Stock Market Returns.
- And an update with additional Tradable Effects of Options Market Liquidity Flows.
Good luck with your trading, and thank you for reading!
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