There are a lot of talks about tariffs made, then pause/withdrawn. There were also a lot talk about military tensions in Europe and Russia. The weird thing is that the more talk of impending tariffs, and war the better Mexico, Europe and China seem to do and the worse the United States seem to do.
There is definitely more uncertainty and the market is pricing in more risks rapidly.
What made the market weaker is probably more to do with what is happening in the current options market dealing complex.
This guy sought to explain to us in more layman terms how the S&P 500 options positioning and its potential effect on the market. Generally February to March is a window of weakness, or the market position is such that it is more conducive for a move down.
You would realize that this move down coincides with the major options expiry window, which is at the Friday of the third week of the month:
The S&P 500 chart above shows a light blue arrow marking when that Friday in February was at. There are windows with a lot of options at key levels expiring on that Friday. After that, the forces due to these derivatives is gone and the market can move more freely.
But that doesn’t mean the markets will move down (or up). You need fresh information, that probably isn’t priced into the market yet. And with so much uncertainty out there, both on the geo-political and economic front, this creates a good environment for repricing both at the index and below.
We are now below the key put option support level of 5800. That puts us slight in negative gamma territory. When we are in positive gamma territory, if prices go down MORE, options market dealer will buy more of the underlying index securities, which means they are long. This creates a counterbalancing effect, which means the market doesn’t go down.
However, when we are in a negative gamma category, if prices gets triggered by fresh information to go down MORE, options market dealer will SELL instead of buy more of the underlying index securities. As they sell causing more underlying supply with the same demand, prices move down more, then more people sell, the market dealers sell more, than more people sell, than market dealers sell more.
So you get… what we seen in Covid 2020:
While people focus on the news of QE or money stimulus announced in March of 2020, what investors may not realize is that this coincides with the end to the third week of March 2020, or options expiry. After the options expire, that removes the strong negative forces that amplifies the move down.
The announcement of stimulus is important but the absence of the strong forces in the derivatives market is just as important.
This is basically what happen to GameStop but in reverse.
And now we sit right at the end of week 1 with two weeks to go.
The same guy lists the bullish versus bearish scenarios:
Bearish Case:
- S&P 500 below 5800 = risks of further breakdown
- Negative gamma = dealers exacerbating downside moves
- 6200 remains a strong resistance zone
Bullish Case
- S&P 500 reclaims 5800 and then stabilize, before moving to 6000
- There is a possibility of a short squeeze if the market dealer positioning shifts to positive
I think all eyes are on the dealer positioning or the DEX.
Does it feel like I just told you some fxxk shit? Basically, if there are some geo-political escalation that spook the market more when we are below 5800, don’t be surprised we end up 12% lower more from here. If things get dissipated and the market have more time to process the information, and reclaims 6,000 we would be okay.
3-Month VIX Index / Spot VIX Tell Us That Volatility Should Cool Off in the Future
While we are still near the highs (although at one point tonight we were down 7.45% on the S&P 500 from the highs), many sentiment indicators like the AAII survey was really bearish, which is usually an indicator of an absence of froth.
Another indicator that we might reach a point of intermediate low is if we take the 3-Month VIX Index divide by the Spot VIX. The VIX measures the implied volatility of the S&P 500 and a high reading means that the S&P 500 is more volatile.
A 3-month VIX indicates what the market is pricing the volatility of the S&P 500 three months out.
If we do such a ratio, if the ratio is higher, it means the current VIX is low, relative to the 3-month. That looks like a normal futures curve that is upward sloping (or in contango).
This means indirectly that under current market conditions, they are expecting volatility to pick up a few months out.
If the ratio is lower, it means current VIX is high, relative to the 3-month. The curve is more downward sloping.
This means indirectly current volatility is elevated but market is pricing in that the volatility will go down in the future.
The S&P 500 chart below has the 3MVIX/VIX ratio in pink at the top against the S&P 500:
I drew a dotted blue line joining a lot of of the common ratio turning points. You would notice that a low ratio number coincides with many intermediate bottoms. Prices usually turn up again.
You can see how low this reading is.
Another thing to notice is that the ratio doesn’t stay permanently low, which indicates that volatility doesn’t stay high, but they can be in a higher regime.
Here is another chart but with a longer timeframe:
You would notice that this is not a really good timing or bottom indicator (see the Covid period in 2020).
It should indicate to whether you are now low volatility with higher chance of going to higher volatility or the opposite.
Longer term investors can use such a ratio to optimize their yearly investments into buy and hold strategy if they feel more psychologically comforted they are buying more cheaply.
But remember that it is more to manage yourself behaviorally because it is not a longer term risk management signal or a longer term buy signal.
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Kyith worked as an IT operations engineer from 2004 to 2019. Currently, he works as a Senior Solutions Specialist in Insurance Start-up Havend. All opinions on Investment Moats are his own and does not represent the views of Providend.
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