Public companies shouldn’t report financial results during index-options expirations because the numbers are large.
The law of large numbers says that as the number of random events increases, the probability that the outcome moves toward the mean increases.
Is that manifesting in the stock market?
Let’s walk through it. The notional value of trading in the US stock market – the dollar-value of volume – is about $1 trillion thus far in October.
Wow, a large number.
It’s been running over a half-trillion dollars per day for a long while and spiked back in April during the Tariff Tantrum. But quietly here in recent weeks it’s back to April levels.
Yet there’s a very small number in the midst of it: Spreads versus midpoint.
That is, if the mean is the middle, the average, the reference price at the end of the day (where we’ll get reference prices if trading becomes continuous on a 24-hour cycle is something to ponder), how much are prices moving above or below it?
Not much.
Since Sep 2, SPY closed at most 0.40% over the midpoint (on Sep 2 in fact), and at worst closed 0.18% below the midpoint, which happened two of the last three days. That’s an interesting development that merits exploration.
But not here. Let’s stick to large numbers.
The question then is WHY that’s occurring. And I’ve got a theory. The notional value of stock-trading is $1 trillion daily in October. Guess what the notional value in zero-days-to-expiration options JUST on the S&P 500 is daily?
Yeah, larger: $1.2 trillion.
And according to CBOE, the sponsor of 0DTE options, an estimated 60% of the volume comes from retail traders.
Here’s another small number amid large ones: The average exposure or risk in these positions is $500 says the CBOE. Institutional exposure is much larger ($20,000) because there would be no yield on a big trade without more risk. And institutional horizons are longer (rolling 0DTE contracts, more exposure to monthlies).
And unlike the rest of the options complex generally, 0DTE options settle like European options in CASH. Not in securities. Index options expiring monthly on typically the third Thursday and last trading day of each month also cash-settle.
What we’re seeing in the stock market starts to make sense.
You know what Gamma-hedging is? It’s part of “the Greeks,” the terms used to describe the behavior of options prices. Delta is the change in the price of an option producing a one-dollar change in the price of the index (or stock or ETF).
Gamma is the rate of change or acceleration of Delta. Gamma-hedging then involves trading the underlying securities to mitigate the impact of Delta.
Is your head spinning? A LOT of traders understand these things. It’s public companies that don’t. Our profession supposes the movement of prices is a reflection of fundamentals.
If the notional value of trading in options that expire the same day they’re bought or sold is more than the notional value of trading in the underlying, what is the probability, under the Law of Large Numbers, of a convergence of influences?
Well, pretty damn high. Right?
We need one more piece of information. WHO is hedging Gamma? The other side of the trade. Susquehanna, Citadel, Hudson River Trading, Jane Street, Optiver, etc. If a retail trader sells an option, she is SHORT Gamma. The trade is profitable if the movement is minimal because the aim is to keep sales proceeds.
It’s a buy-write strategy. Buy the index, sell an option on it. And 0DTE options are the cheapest in the market because they have no time-decay longer than a day.
If you’re LONG Gamma, or buying an option, you benefit if the price of the underlying changes.
Son of a gun.
The movement of the price of the index is about 0.7% per day, and much less than that – about 0.10% — versus the midpoint.
But the movement of the underlying stocks is more than 200% greater: 2.4% the last five days, and 2.5% the trailing 200 days in the 500 stocks comprising the S&P 500, which is 90% of market cap.
Let’s put it all together. Big high-speed traders move the prices of stocks all over the place to hedge Gamma, and profit on that hedge. While retail traders selling options just want to keep the premium.
So long as that relationship remains intact, it works. But if it breaks down, say when you report results, public companies, somebody could get HAMMERED in that equation. And probably retail money. There is an enormous amount of cash at stake.
It explains the apparent placid surface versus underlying turbulence. It explains motivation. It explains mechanics.
And monthly index-options expirations matter most because institutional horizons are longer and their exposure is bigger, and assets actually move for more than Gamma-hedging. Avoid them when reporting earnings.
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