The following is a guest post courtesy of Michael Kramer of Mott Capital Management.
Hard Landing Worries Are Driving Volatility
Volatility in the market has been high as traders and investors look to hedge risks associated with the Fed and the potential for an economic slowdown. The concerns seemed to evolve, starting with inflation and growth worries. Now the fears are around the potential for the Fed’s monetary policy to result in an economic hard landing. The volatility in the market is only likely to increase as options expiration approaches this Friday, May 20.
Options expiration has served as a thorn in the side of both the bulls and bears in recent months. It is estimated that greater than 30% of SPY gamma is expected to roll off at this week’s expiration, as noted in the SpotGamma Founder’s Note on May 16 (accessible to subscribers). Additionally, the Fed minutes are due on Wednesday, May 25 and the odds seem high that traders may need to quickly re-establish hedges ahead of the release of those minutes.
As noted in last month’s commentary, the minutes have served as a trouble spot for the markets and a sell-the-news event. The minutes will be released on May 25 and could present the start of the next big leg lower in the S&P 500.
Unwinding Hedges Helped to Support the Market
In April, options expiration came after the Fed minutes, and options expiration helped support markets. Despite the hawkish Fed minutes, the S&P 500 traded within a 3% range and was supported by positive delta flows. Even on April 7, with the S&P 500 dropping by almost 2%, delta flows in the S&P 500 ETF were positive, suggesting that market makers were helping to support the markets.
From the April 7, 2022 PM Founders Note
Once options expiration lapsed and gamma levels dropped, the delta flows changed dramatically. By April 18, the delta flows started to turn profoundly negative, indicating that traders were looking for protection once again and were buying puts and selling calls.
From the April 18, 2022 PM Founders Note
Nervous Traders May Quickly Establish New Hedges and Trigger A Sharp Market Drop
In May, the Fed minutes will come after options expiration, which means that traders may start looking to place hedges again ahead of the Fed minutes, putting potential pressure on the equity market in the days ahead of the release of the minutes. If the minutes are not as hawkish as feared, it could even result in a relief rally for the stock market, as delta flows turn positive and traders sell put options.
Of course, if the minutes are more hawkish than feared, it could exacerbate the situation. It would result in more puts being added and delta flows remaining negative and may even lead to the next major leg lower in equity prices.
Given that markets have taken these minutes very negatively since the beginning of the year, the significant risk is clearly to the downside. Once the minutes pass, the market will begin to focus on the June Fed meeting again and the projections that come with the quarterly meetings, which may prompt plenty of negative option flow in the weeks ahead, causing the VIX to rise and pushing stock prices lower.