The following is a guest post courtesy of Michael Kramer of Mott Capital Management.
The September monthly options expiration, which also happens to be a quarterly quadruple witching, occurs just days before the next FOMC meeting.
As noted previously, the market appears to be anxious about this upcoming meeting, and it is easy to understand why. The prospects of a new course in monetary policy lie ahead. It could stir up a great deal of volatility leading into the Fed meeting on September 22, especially if the monthly patterns persist, which constitute a stock market that typically sells off a couple of days before the options expiration date.
Every month since January, except for April, has witnessed a pullback in the S&P 500 around the monthly options expiration date, which occurs on the third Friday of every month. This is likely due to the unclenching of gamma that has built up over the month in index options and as out-of-the-money call values in individual stocks begin to sink, resulting in market-makers unwinding some of their hedges.
The Trading Band
Taking it one step further since the May expiration date, the lower Bollinger band, which measures two standard deviations from the 20-day moving average, has served rather nicely as support for the S&P 500 during each of these brief pullbacks around that expiration date.
It creates the potential for volatility to ramp up, especially if we get the typical pre-options expiration dip in the S&P 500 that again tests that lower bound of the Bollinger band, which coincides with the 50-day moving average. It is possible that during this same time of monthly volatility, a layer of risk management gets thrown into the mix as investors look to buy puts to potentially hedge their risk exposure heading into the FOMC meeting. This type of hedging would help push the VIX higher, pressure the S&P 500 lower, and potentially create a threat to break that all-important cycle of bouncing off that lower Bollinger band or 50-day moving average of the S&P 500.
If The S&P 500 Breaks 4,440
SpotGamma Equity Hub notes that 4,440 is the essential level of support for the S&P 500. A break below 4,440 in a drawdown can start pushing the market lower, especially from a gamma perspective. The next significant level of support in the index does not come until 4,250, if 4,440 breaks. This would amount to a drop of around 6.1% from the current value of approximately 4,525 on September 7. A typical monthly drop to the lower Bollinger band would place the index at around 4,400.
A lot of this will depend on whether the monthly cycle of pre-options expiration volatility returns to the equity market. If it doesn’t, the transition to the FOMC meeting is likely to be smooth and could turn out to be a non-event for investors. Ultimately the decision and the news from the Fed driving the direction of trading from that point forward.
Supposing the monthly 2-3% dip does arrive and right on time about 2-3 days before expiration, it seems entirely possible this dip could turn out to be something altogether different given the backdrop. Especially given the sensitivity investors have towards the Fed and the monetary policy framework that may be laid out.
It may not be wise to assume that this coming dip will be like the rest; it may very well turn out to be very different.