It would be senseless in today’s volatile environment to write about individual option trades or flows. By the time anyone read my posts, the market and option prices are likely to have moved significantly, making the information all but worthless.
What I would like to describe is behind the scenes option hedging that you won’t read about in the mainstream financial media. During 2020, up until three weeks ago, flows in the option market were dominated by two predominant trends: 1) Outright upside call option buying in huge size (although granted, some of it might have been part of a stock replacement strategy, selling the underlying shares to book profits, but buying call options just in case the upside momentum continued), and 2) the prevalence of bullish “risk reversal” trades, whereby investors/traders/dealers bought upside call options but funded the cost by simultaneously selling below the market put options. (Note: bearish risk reversals would be the opposite, buying put options and funding the cost by selling upside call options).
The bullish risk reversals essentially mean that the owner is short put options, betting that the market wouldn’t drop too far and cause them to have to own the shares at the underlying strike price (or cover the short puts at a big loss). With the dramatic fall in the markets over the past two weeks, these participants suddenly found themselves enormously exposed to massive stock purchase risk at prices far above today’s distressed levels. In option land, this is known as the “negative gamma” effective, meaning the measure of the options price sensitivity to the movement in the underlying shares (know as its “delta”) explodes higher and moves massively against the short seller. To hedge this exposure, the only real solution (other than closing out the short at huge losses) would be to sell stock even at prices well below the short put strike price, just to limit further downside losses. This activity has been gigantic, and been a significant contributor to the sell off, as it compounds the regular selling by ETF’s and portfolio managers looking to reduce stock market exposure.
Essentially everyone is now in the same side of the boat (sellers of stock), with few people trying to catch the proverbial falling knife by buying stock given the huge downdraft and continued uncertainty with the coronavirus and OPEC rift.
At this point, it feels almost certain we will be retesting Dec. 2018 lows around 2350 in the S&P 500, but that is an opinion for another day!
Be careful out there!