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Rapid Declines and Squeeze Scenarios

The financial markets depend on dealers/market makers to maintain liquidity and stability. Whenever you purchase or sell an option, it's highly probable that a dealer is taking the other side of the trade. These dealers aim to remain directionally neutral and will establish long and short positions that offset each other. This approach creates buying and selling pressure based on options positioning in the market.


To mitigate the delta risk inherent in their options positions, dealers employ a strategy known as delta hedging. As the underlying asset's price, implied volatility(vanna), and time(charm) change, the delta of an option also changes. Therefore, dealers must continually adjust their delta hedge to remain neutral to these changes. This process is referred to as the gamma hedge. These hedge flows exert a substantial influence on intraday price action.


Let's investigate the week ending April 28, during which we observed very active hedging which significantly amplified movements in both directions.


Week Ending April 28, 2023

Let's start on April 25th, when the SPX broke our Gamma Flip level, leading to a 15% surge in the VIX and a 2% drop in the SPX. On that day, perhaps in response to upcoming earnings or the debt ceiling debacle, fear gripped the market, prompting participants to purchase puts in large numbers, as evidenced by a surge in the Put/Call ratio.


Put/Call Ratio

When a participant buys a put option, the dealer takes a short position in the option, leaving them vulnerable to the risk of its value decreasing if the SPX drops. Consequently, dealers hedge this position by shorting the underlying asset. In this case, they would short futures contracts.


Hedging Flows

Now dealers need to maintain a delta-neutral position by adjusting the number of futures contracts sold based on changes in the SPX's price and implied volatility. If the SPX price falls, for instance, the dealer will need to sell more futures contracts to ensure they remain delta-neutral.


This negative feedback loop exacerbates downward price movements, intensifying selling pressure in the market.


Fear & Uncertainty

What triggers this cycle is typically fear or uncertainty in the markets. Participants may seek to bid up volatility or demand puts in anticipation of or in response to key events such as economic releases, earnings announcements, geopolitical risks, or FOMC.


It's worth noting that Implied Volatility (IV) is mean-reverting, which implies that there must be a valid reason for IV to remain elevated. If the level of volatility is unjustified, participants will come out and sell volatility, leading to a contraction in volatility metrics. Additionally, when the fear subsides, participants may quickly dispose of their downside hedges (puts). This is often because participants tend to purchase puts at high IV levels, meaning they overpay, and the IV crush quickly drives down the option prices, resulting in significant losses for the put holders who bought them at inflated IV levels.


For instance, let's take the example of April 27th and 28th, where the SPX exhibited a 3% surge while the VIX plummeted by 16% within two trading days. The market received a significant boost from the better-than-anticipated earnings and an uptick in tax revenues. Goldman Sachs announced a substantial overnight surge in receipts, which pushed the debt limit deadline back to the end of July, thus alleviating a great deal of market uncertainty (volatility). This development encouraged market participants to sell volatility, shed their put protection, and purchase calls.


When a participant sells their put option, the dealer's short put option is simultaneously closed, eradicating their exposure to downside risk. As a result, dealers can eliminate their short futures hedge by purchasing back futures, which generates additional buying pressure in the market.


Hedging Flows

In case the SPX keeps climbing, dealers will need to buy more futures contracts to sustain their delta-neutral position. .


Generally, these rallies also trigger call buying, which, in turn, force dealers to buy even more futures.


This positive feedback loop intensifies upward price movements, and results in what is known as a "squeeze."


Conclusion

When IV/VIX increases dealers sell, when IV/VIX declines dealers buy.


Usually, extreme movements in IV/VIX persist throughout the day with prices grinding into the close.


These days can pose a challenge in trading, especially if you miss the initial move, since the market tends to stay at extremes for the whole day (i.e., cycle high/cycle low). Chasing the move can also be risky, as it can result in quick losses if there is a reversal.


Our observation shows that if these “extremes” are to reverse significantly, it usually occurs within the first 30-40 minutes of the session, particularly when IV/VIX is elevated. This is because if implied volatility is elevated at the open but the market fails to see continued downside, options start to get repriced lower and participants feel more comfortable selling volatility (short options).


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