Thursday, October 13, 2022


Remember back in 2018 when the VIX exploded and again in 2020? I will now explain why that happened...

First off, I am not an options dealer nor have I ever worked in that industry, however for years I have traded options on my own account. In order to do so wisely, one needs to have a general understanding how the options market works. This will not be a perfect explanation, but good enough for self-directed traders.

Step back for some perspective. The options market allows traders to rent capital for a certain period of time to increase leverage and manage their risk exposure. A put option is a much safer way to bet on downside than a naked short position. Even though as we will see below the underlying dynamics turn out to be very similar. 

The option buyer has the right to exercise or sell the option at a profit. However, most options get sold ahead of expiration. Why? Because selling an option ahead of time is usually more profitable and it's much safer than waiting until the date of expiration. The only way to survive as an options trader is to be aggressive about taking profit and always assume while you may be directionally right, your timing could be WRONG. The only way to control for that risk is by rolling over in time and price. 

Options market makers are on the other side of every trade. Their goal is to collect premium and maximize profit. They are the equivalent of the "house" and they usually win because the odds are mostly in their favour. 

When an option is opened, the market maker determines the amount they need to hedge their exposure by based upon the various option parameters ("Greeks"). Theta (time), Delta (rate of change), Gamma (2nd derivative delta) aka. convexity. A put option is hedged by shorting the underlying, whereas a call option is hedged by going long the underlying. 

For options that are out of the money, the probability of profitable exercise (in the money) goes down over time. This creates a natural bias towards profit for the market maker. 

When many options are clustered at a certain level, this creates a "wall" that paradoxically reduces the chance of option profit. 

Take a put wall below the market as an example. As the puts get bought, the market makers short the index/stock towards the common strike price. However, as the strike price approaches, delta and gamma approach "1" meaning that hedging is 1:1. Market makers are fully hedged AT the put wall. Therefore any momentum away from the put wall, including time expiration, lowers the overall probability of exercise and causes the hedges to unwind. Shorting then turns into buying. Buying turns into more buying and momentum drives price AWAY from the put wall. This is called a Gamma squeeze because it's very similar to a short squeeze.  

A call wall above the market works the same way. It is very difficult to penetrate because the dynamics of hedging accelerate towards the wall and then go in reverse at the wall. 

When pundits speak of "Dealer Gamma" they are referring to the total hedging exposure dealers have at a given strike price. It's a means of describing the directional bias and magnitude of the option buffers that are above and below the market. 

There's the background. All quite logical when you think about it. Now throw in weekly option expiration which is a relatively new options market. Weekly opex seemingly allows algos to "control" the market and otherwise dampen volatility between the call wall and the put wall, all the time.  

Which would explain why I have noticed recently that VIX gaps are large on Mondays which is the day after weekly opex and negative on Wednesday's which is VIX opex. 

Coincidence. No. 

All is well that ends well. However, as Rick Santelli pointed out this morning, derivative based strategies only work in continuous markets, because they use historical volatility to predict future volatility. Yes, you read that right. Therefore, they do not function well in discontinuous markets. 

What does this all mean to a Black Swan trader? It means that the market is binary. It will function well until the day it doesn't. When volatility explodes, the market makers will step aside and there will be no one on the other side of the trade. 

Which is what happened in March 2020. Except back then the Fed reinitiated QE on March 15th and when that did NOT work, they initiated QE infinity on March 23rd, which was the bottom. THEY were the buffer below the market. Now, they are on the side of reducing liquidity and increasing volatility. 

The key takeaway in all of this? Market stability is an illusion that will not withstand global RISK OFF. Volatility expansion will accelerate downside momentum as the majority of large players realize they are underhedged according to their traditional models. 

In summary, despite what many bulls are saying, NO ONE is positioned for what's coming - the consequence of 14 years of continuous bailout.

If you believe that the FOMC who are now diametrically opposed to easing will come in to support the market more quickly than volatility algos can go RISK OFF, then your amnesia precludes memory from three years ago. 

This will be March 2020 without the Fed put.