July 21, 2021

Optional Chaos

So which is it?  

Monday, doom loomed over stocks. In Punditry were wringing hands, hushed tones. The virus was back. Growth was slowing. Inflation. The sky was falling!

Then came Tuesday. 

Jekyll and Hyde? Options expirations.  Only CNBC’s Brian Sullivan mentioned it. As ModernIR head of client services Brian Leite said, there wasn’t otherwise much effort to explain where the doom went. One headline said, “Stocks reverse Monday’s losses.”

WC Fields said horse sense is the thing a horse has which keeps it from betting on people. We could have used some horse sense.  I Tweeted this video.

Anyway. What must you know, investors and public companies, about why options cause chaos in stocks? (I’m explaining it to the Benzinga Boot Camp Sat July 24, 30 minutes at 1220p ET.  Come join.)

It’s not just that options-expirations may unsettle equity markets. The question is WHY?

Let me lay a foundation for you. Global Gross Domestic Product (GDP) is about $85 trillion. The notional value – exposure to underlying assets – of exchange-traded options and futures is about the same, $85 trillion give or take, says the Bank for International Settlements. The BIS pegs over-the-counter derivatives notional value at $582 trillion.

So call it $670 trillion. All output is leverage 8-9 times, in effect.

Now, only a fraction of these derivatives tie to US equities. But stocks are priced in dollars. Currency and interest-rate instruments make up 90% of derivatives.

All that stuff lies beneath stocks. Here, let’s use an analogy. Think about the stock market as a town built on a fault line.  The town would seem the stolid thing, planted on the ground. Then a tectonic plate shifts.

Suddenly what you thought was immovable is at risk.

Remember mortgage-backed securities?  These derivatives expanded access to US residential real estate, causing demand to exceed supply and driving up real estate prices.  When supply and demand reached nexus, the value of derivatives vanished.

Suddenly the market had far more supply than demand.  Down went prices, catastrophically. Financial crisis.

Every month, what happened to mortgage-backed securities occurs in stocks. It’s not seismic most times. Stocks are assets in tight supply.  Most stocks are owned fully by investors.  Just three – Blackrock, Vanguard, State Street – own a quarter of all stocks.

So just as real estate was securitized, so are stocks, into options, futures, swaps.  While these instruments have a continuous stream of expiration and renewal dates, the large portion ties to a monthly calendar from the Options Clearing Corp (our version is here).

Every month there’s a reset to notional value. Suppose just 1% of the $50 trillion options market doesn’t renew contracts and instead shorts stocks, lifting short volume 1%.

Well, that’s a potential 2% swing in the supply/demand balance (by the way, that is precisely last week’s math).  It can send the Dow Jones Industrials down a thousand points.  Hands wring.  People cry Covid.

And because the dollar and interest rates are far and away the largest categories, money could leave derivatives and shift to the assets underpinning those – BONDS.

Interest rates fall. Bonds soar. Stocks swoon.  People shriek.

Marketstructureedge.com – Broad Market Sentiment 1YR Jul 21, 2021

Options chaos.  We could see it. The image here shows Broad Market Sentiment – DEMAND – for the stocks represented by SPY, the State Street S&P 500 Exchange Traded Fund (ETF).  Demand waxes and wanes.  It was waning right into expirations.

In fact, it’s been steadily waning since Apr 2021.  In May into options-expirations, Sentiment peaked at the weakest level since Sep 2020. Stocks trembled. In June at quad-witching, stocks took a one-day swan dive.

Here in July, they cratered and then surged.  All these are signals of trouble in derivatives. Not in the assets.  It’s not rational. It’s excessive substitution.

We can measure it at all times in your stock. Into earnings. With deals. When your stock soars or plunges.

In 1971, the USA left the gold standard because the supply of dollars was rising but gold was running out. The derivative couldn’t be converted into the asset anymore. The consequence nearly destroyed the dollar and might have if 20% interest rates hadn’t sucked dollars out of circulation.

High interest rates are what we need again. During the pandemic the Federal Reserve flooded the planet with dollars. Money rushed into risk assets as Gresham’s Law predicts. And derivatives.

When the supply/demand nexus comes, the assets will reprice but won’t vanish. The representative demand in derivatives COULD vanish.  That’s not here yet.

The point: Derivatives price your stock, your sector, your industry, the stock market. Adjustments to those balances occur every month.  We can see it, measure it. It breeds chaos. Pundits don’t understand it.

It’s supply and demand you can’t see without Market Structure goggles. We’ve got ‘em.

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