The big question: Was that rally all put covering? Signals in SpotGamma’s custom SPY GEX say “Yes”
This week the S&P500 rallied ~3% to close the Liberation Day downside price gap (red horizontal line). This led the S&P500 to notch a 9-day win streak – the longest such streak since November 2004.
With that, the VIX hit post-Liberation Day lows near 22.5. This price action suggests big bullish sentiment change as Trump softened on various tariff stances, along with strong earnings results from MSFT & META.
But…one can’t help but feel like the buying was a bit, well, indiscriminate?
If everything is in the clear, then we should see investors rolling out of puts and into calls, and volatility should contract.
But is that happening?
Determining market maker options positions
When we break down S&P500 positioning, we want to look at both prime S&P500 assets:
SPX and SPY.
SPX is often seen seen as the most dominant asset from an options positioning perspective, due to its institutional attention and large notional values (i.e. SPX trades at 5,600 to SPY’s 560).
In this case though, what our proprietary Gamma Exposure (GEX) modeling shows is that SPX positioning is “not much.”
You can see this light positioning in SpotGamma’s GEX curve (below).
There are essentially just 2 large positions:
- A big “short straddle” strike at 5,800 (May & June expirations), which generates -$5bn of market maker (MM) gamma.
- Several large MM positive gamma strikes in the 5900-6000 range, which serve to offset some of the 5,800 negative gamma.
The result of these concentrated, tight positions is a very large gamma kurtosis – that is to say the deepest of the negative gamma is very local to 5,800.
If you look down <=5,600, you see gamma is very flat (±$100 million) – suggesting that traders have closed the downside put hedges they had on in April, and have yet to establish much of anything new…including long call positions.
Now we turn to SPY – and this is where things get much more interesting.
Historically, options gamma models made brute assumptions around market maker positioning. These “naive” models would largely mark all puts as MM short positions (from traders buy puts to hedge), and calls were seen as MM long positions (from traders selling calls).
SpotGamma has greatly improved the understanding of how options MM’s are positioned, with our new custom GEX/OI models.
What we see now in SPY GEX is a very large, persistent negative gamma position all the way from 530 up into 590 (yellow box). We see this position as the primary supply of gamma in the S&P500 – larger than that of SPX.
Negative gamma is associated with high volatility.
Why? For MM’s to hedge in a negative gamma environment they likely need to buy stock as the S&P500 goes up, and sell stock as the S&P goes down.
This means that all the way from SPY 530 up to and into 590, MM’s would likely have had to buy stock as equities went higher.
That model is quite interesting as it pertains to the current 9-day winning streak in the S&P, which started last week with the SPY pivoting just below 530. Price then trended straight up through this negative gamma zone to 566 on Friday.
All puts, no calls
Understanding that negative gamma may have been a key driver of this substantial volatile rally is certainly helpful – but what happens next?
If you break down what is supplying the SPY negative gamma, what you find is that it is almost 100% from market maker short put positions (negative blue bars). This means that SPY traders are long puts as their predominant position.
Calls (orange) are quite sparse below the 600 strike area, and the calls above 600 are mainly market maker long call positions (i.e traders have shorted calls >600).
As an aside, from a sentiment perspective, we wonder why traders have not been buying calls into this rally…
From a positioning standpoint the significance of this put-driven negative gamma is as follows:1) The implied vol premium has now gone negative (we have done a substantial amount of writing on the fact this fact) – said another way: the VIX has likely hit an interim low.
As a refresher, below you can see the current spread between realized volatility (red), and 1-month implied volatility (blue).
Realized volatility is not contracting because the market has been rallying with such strong force – which we argue is a symptom of big negative gamma. In spite of the sticky realized volatility, traders continue to price in much lower volatility in the future.
The decline of implied vols has been quite destructive to put values, with MM’s being primarily short SPY puts. Declining put values allows MM’s to, in theory, buy back stock at a faster rate (i.e. vanna).
Put hedging obligations decline as the market rallies, as put values move to zero. If long call positions were dominant, dealers would still have negative gamma from short calls, but those call values would increase if stocks continue to rally. Higher call values would likely increase upside hedging obligations into higher stock prices.
What does all this mean?
We see the recent rally as a massive short cover, with traders having maintained long put positions and not shifted into long calls.
This means that the fuel to drive renewed downside remains in place, which leaves this market with a lot of risky positioning. If downside sparks, volatility (i.e. VIX) rising into negative gamma could create a slippery slope.
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