Stock Market Chaos Revved Up by Options Dealers Rushing to Hedge

Jan 31, 2022


(Bloomberg) -- Two days of big stock rallies have investors wondering: Is the new year’s selloff over? Maybe, but a couple researchers are pointing to below-the-surface dynamics that may be exaggerating moves and leaving investors exposed to more volatility.  

At Goldman Sachs Group Inc., strategists including Rocky Fishman found that the market’s ability to absorb orders worsened rapidly during last week’s turmoil. Liquidity evaporated so much that a measure based on the bid-ask spread of S&P 500 futures widened to levels not seen since the 2020 pandemic crash.

Over at JPMorgan Chase & Co., strategists led by Marko Kolanovic observed a similar deterioration in liquidity, and noted that options dealers who buy or sell stocks to hedge their derivatives holdings are now in a “negative gamma” position that requires them lean into existing market trends in a big way. (Roughly speaking, gamma refers to the rate of change in an option’s sensitivity relative to the changes in the price of the underlying asset.)

“As long as S&P 500 remains below ~4600, gamma is negative with dealers buying on strength and selling on weakness,” Kolanovic wrote in a note. “This would amplify market moves, especially in the current low market liquidity/depth environment.” 

Moves in the market continue to be extreme. Stocks rallied for a second day Monday, with beaten-down shares such as small caps and risky tech leading the recovery. A Goldman basket of tech firms that have yet to make profits surged 10%, the most since at least 2014, while the tech-heavy Nasdaq 100 advanced more than 3%, rounding out a two-day, 6.6% jump that’s the biggest in 15 months.    

The bounce came after a week of extreme volatility during which the S&P 500 saw three of the biggest intraday reversals of the decade. Stocks whiplashed as investors struggled to deal with a newly hawkish Federal Reserve and its potential impact on the economy and corporate earnings.

Selling tends to have an outsized impact in bouts of weaker liquidity, meaning the number of equity contracts that an investor can expect to trade without moving the underlying market diminishes -- sometimes at an exponential rate.

Rising investor demand for protective hedges also contributes to market turbulence. Dealers providing such contracts either buy or sell en masse in a bid to balance their fast-moving exposures -- a dynamic known as “gamma hedging.” These market-makers have ended up contributing to stock volatility, according to Wall Street analysis.

While agreeing that hedging activity from options dealers exacerbated market moves last week, Charlie McElligott, a cross-asset strategist at Nomura Securities, suggested the impact would be smaller going forward given such “short gamma” hedging demand appeared to have passed its peak. For instance, his model showed the group’s net gamma exposure was cut in half into Monday.

“We are considerably off the worst levels of the dealer ‘short Gamma’ hedging dynamic felt last week,” McElligott wrote in a note. “That erratic trading fueled by ‘accelerant’ flows too is greatly reduced and should contribute to a more ‘stable’ dynamic.”

Read: Dip Buyers Wade Back In as Nasdaq Nears Worst January Since 2008

Thinning liquidity is both a cause and consequence of increased volatility, which makes assessing its exact role in fomenting market turbulence impossible. Reticence normally rises among market makers when prices are swinging, but which is causing which is never quite clear. Still, charting liquidity against past episodes of stress can give an idea of the depth of the uneasiness now. 

To Goldman’s Fishman, a lack of market liquidity is the team’s “biggest technical concern” at the moment. 

“On-screen liquidity has become so poor that futures have been more than one tick wide over 20% of the time,” he wrote in a note to clients. “Weak liquidity means flows matter more, and leaves the potential for outsized market moves (in both directions).”

(Updates for additional details on gamma hedges starting in the seventh paragraph)

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