The OPEX Effect | February 2024 | Helping Long-Term Investors Understand Options Flows

[00:00:00] Welcome to the OpX Effect, a joint podcast from excess returns in spot gamma, where we take a deep dive into the world of options and the flows to generate in the markets.

[00:00:06] Join Brent DeChuba and Jack Forehand every month on Options Exploration Week as they look at the major developments in the options world and how they impact all of our portfolios.

[00:00:14] No information on this podcast should be construed as investment advice.

[00:00:17] Security is discussed in the podcast, maybe holdings of clients.

[00:00:19] So Brent, this is just the general idea here is that as options positions build, we have record call there was obviously the Monday after options expiration. We saw something like that at the lows in June 2020. This past year, we actually had a high in July right after a big options expiration. So you could see a lot of positions shift. What's interesting about this particular expiration that's coming up is that there's

[00:03:03] a tremendous call bid. And what I mean by a tremendous call bid is what we're seeing now. So, you know, over the last month, really, since December, excuse me, over the last two months since December, S&P's up over what, 20%, I think it is. We're at this big magic 5000 level in the SPX. And, you know, there's a lot of positions sitting here and staged here, and it's a very interesting point

[00:04:21] for markets that we're gonna discuss.

[00:04:24] Yeah, it's interesting.

[00:04:25] Going back to the whole idea of them being turning points, how much of these flows could potentially have an impact on how everything plays out? Yeah, I think the takeaway from that is that options are leverage. And so, you know, you can spend a smaller relative amount of money on a call or put, and that in parts or in forces, a larger, you know, buying or shorting requirement on

[00:05:40] the dealers and market makers that are hedging those positions.

[00:05:43] And so, you know, just like to that downside into the COVID crash, there was a lot of movement. So, yeah. Do you see any evidence that people decide to front run this now? So, if they see an expiration like that coming and they know, you know, all these positions are going to come off and the market's going to be free to move either up or down, you know, those positions are all in one direction. Do we start to see it like in advance of the optics now because people see that it might be coming?

[00:07:03] Yeah, it's a great question. We did about these dynamics. It's out there. I think that if you know you can set your watch to these market movements and the market is doing these obvious things, there might be dealers and market makers on the other side who have some negative edge around these events and they can change the way that they're

[00:08:21] behaving.

[00:08:22] For example, that could change the area of investing. Markets are complex systems, ultimately. And if there's an easy way to make money, that easy way is going to change because people are going to go make the money. But the other token here, these are real flows. I mean, these are real things that impact the market. And so they're going to happen to some degree.

[00:09:41] So as much as people are front running them,

[00:09:42] or they're changing, this is not like something

[00:09:45] people have made up.

[00:09:46] These are real flows that have to happen That might be a little bit stale, so put an asterisk next to that. But the point is that there's a couple of really big entities that do the bulk of the flow, the bulk of the trading. They have this informational edge, and I think they can constantly be shifting and adapting to how markets are trading, and the type of flow they're seeing and those kinds of things.

[00:11:02] It's a dynamic game, but ultimately, these positions have to be hedged.

[00:11:07] They can't take a limited risk. different things like that. So, we see correlations in volume, but you're talking about billions of dollars of flow per day that has to shift and adjust, right? And so, for example, if I was to look up today with the biggest name is I have Rocket Mortgage, for example, and over, let's see a period of about 30 minutes, there was $5 million worth

[00:12:26] of Delta traded in that stock. or mid cap to mega cap stock, you're hundreds of millions to billions of dollars of daily options, of daily options hedging for those, excuse me. So going back to the next slide with the current expiration, a couple of takeaways I think, and you can correct me if I'm wrong with either of these. It seems like this is a smaller expiration than the one we dealt with last month,

[00:13:41] but it also seems to be a little more maybe call heavy,

[00:13:43] although I think there are different types of calls.

[00:13:46] So maybe you could explain that part of it. and we'll go over this in a minute, but that the general expert was driven by these long, these leap positions, right? Like banana to Pelosi trade. She'd buy these calls and then they would, over the course of a year, go deep in the money. These February positions are short dated, meaning that somebody bought these weeks ago, maybe at best. And there's been a real chase.

[00:15:01] So people are really running into these call positions

[00:15:03] as the month gets closer, more call along

[00:15:05] is pick up, this kind of ties what we were just talking about, but generally you have when call positions build up in the S&P 500, that brings what we

[00:16:21] call positive game into the market.

[00:16:23] And that's to the right of this chart.

[00:16:24] And what that generally means if you're listening to this is that volatility tends to contract going up a little bit. I mean, have you seen, I know you can see like things like fixed strike vol that I can't see. Like, have we started to see a little spike in volatility with the rally? Yeah. I mean, you could just look at the VIX, right? The VIX is at 13.5 and, you know, there's a VIX expiration on Wednesday, which can often shake things up. And so the VIX has been very stable at that level and implied vol had been at, you know, 11ish one month, sorry, one

[00:17:43] month realized vol had been like an 11. We're generally what you would see if the market in the SPX. So that's nothing, right? Like literally 40, 100 was last week. But the point here is that when you have these chase scenarios, stock up, vault up, the corrections can be very violent. Now that dip could very well get bought. And then later this year, we make new highs. But your point is the point is the same is that if you have this chase to the upside, when that chase snaps

[00:19:00] and breaks, you get downside momentum that can be just as violent. If you think about this axiom

[00:19:04] that the biggest rallies occur during bear markets, expired, we had the view that there could be some downside consolidation after that big January options expiration. And instead of what happened, as you can see in this chart, that right on that day, January 18th,

[00:20:20] the options expiration, the market just launched, right?

[00:20:25] Volatility completely expressed violent to the upside. And we were looking admittedly for a little bit of a move lower. So we're back here and I'm laughing about this kind of boy who cried wolf scenario because I'm saying, hey, I think we're due for another correction here. I'm going to get into why.

[00:21:42] In the dynamics are a little bit different, but I do realize that, hey, the positions, I think, like that because if they're trying to flip flop in and out of these hundred thousand lot, you know, put positions or call positions, dealers got a hedge dad. They're going to adjust their books. It creates a lot of kind of just, I think, chaos oftentimes. So usually you'll just get the quarterly is being the biggest. There's always a lot of big put positions on in December, you know, just as a people

[00:23:01] hedge for the year. January, you get the this, a lot of VIX downside right now, there's a lot of volatility selling. And so the general idea is that when you hit VIX expiration, that's, that's a, that destabilizes the current trend of flows. So, you know, usually you'll have, uh, I shouldn't say usually oftentimes you'll

[00:24:24] have equity options expiration before VIX expiration, right?

[00:25:25] the largest VIX call premium spent ever for, I think it was even February options expiration. So there were these huge VIX call positions that got rolled that brought just a touch

[00:25:30] of market weakness, but the VIX suddenly spiked.

[00:25:32] I remember that because I was feeling great that the market was getting weak around this

[00:25:36] window that we were pointing out.

[00:25:37] I have a lot less explaining to do what the market just does what I think it should do.

[00:25:42] Whereas in this case, we're coming back up with the VIX were in the 20s, not all that long ago. So, you know, people don't think it's going to be as impactful anymore, which I think is probably, you know, I don't have a bone to pick with that. Uh, but if there is a little bit of a hot print or something like that, there's very little room for air in terms of what people's expectations are. People are expecting, you know, 50, 60, 75 basis points, maybe of daily movement

[00:27:03] in the S&P, you get a hot print and we print a 1% move or at least a 100% right. A lot of these flows are people hedging a portfolio or doing something simply because it's in their mandate as opposed to an expression of bearishness. The most famous, I think, Vix buyers 50 cent. That person specifically, I think it was a European fund manager, was trying to express a trade

[00:28:20] and generate alpha from the trade

[00:28:22] as opposed to hedging something.

[00:28:23] And the general idea there was he just kept buying

[00:28:26] Vix calls that were 50 cents.

[00:28:27] I think they generally be like a month out. That flow not all that long ago, but as far as the systematic buying of a 50 cent option, that hasn't been around for a while. So as we moved to, we did a little bit of this, but as we moved into our, what's moved a second minute here, we always take it back and what we said from the previous one before we talk about some of the things we're seeing for this one. So yeah, here were your views going into the January optics.

[00:29:40] Yeah.

[00:29:41] So the first line is funny because I said, you know, that the momentum of these names at least shifted quite a bit. So, look, I thought this would actually lead to much more downside performance. I fully admit that, but now a lot of these stocks are up in the case of the video. It's up, what, 30, 40% since in a month. It's really pretty crazy. And again, we just talked about this. The VIX did spike

[00:31:05] January. We had this moment after FOMC where in the matter of a couple of weeks. So,

[00:32:21] you know, this is a this is a very extreme dynamic and seemed to kind of spook the market a little bit, vol was getting sold, which tells us, particularly that lower strikes, as you can see here to the left of the grid, people sold vol into the event, into the move, I should say. And so if you had thought that the FOMC had actually changed the paradigm or said,

[00:33:42] hey, whatever Powell just said is really starting, right? That's the volatility of the wherever the index trading. So if the index goes up 2% or down 2%, that at the money input is changing as a result, right? And so what happens in the VIX is it starts to incorporate SKU a little bit.

[00:35:02] It's not actually telling you how vol has changed. It's just sort of like sliding up and down

[00:35:05] what we call SKU.

[00:35:07] So generally puts have higher implied volatility idea that the VIX implied fear, but it was wrong? Yeah. You know, that's exactly right. If you go back and look in Twitter and you'll see, hey, there's this sign that, Volfer, you know, Volfer, you know, Volfer, you know, Volfer, you know, and that wasn't the case at all, right? And if you'd listened to that fear and you got kind of like pulling into that, you would

[00:36:20] have missed this really sharp rally that told us that, no, what's actually happened is

[00:36:23] people are selling puts and selling ball into this market weakness, which could really up a little bit the last one or two days, but in general, you know, if you just zoom out a little bit, vol has calmed down significantly, obviously from the 2023s where the VIX was really stable up around the 20s, even really post COVID, right? This is, these are post COVID crash lows and VIX, even a VIX of 13.5 is, as you can see on this chart, you know,

[00:37:40] those are pre COVID crash level. And what I you know, that's what the dynamic is. And in fact, we have another slide here where if you look at the cost of downside protection, it is lower than it's been arguably at least in modern times, right? The skew index that we look at is called the S-DEX. It measures a one standard deviation spider put relative to the

[00:39:03] at the money put. So essentially, what is the relative in really owning this stuff at all. Yeah, so on the next slide, we're talking about the right tail chase. Yeah, and so a lot of people look at the skew index from the SIBO and, you know, there's some good qualities that, but I just wanted to show the S-DEX is the index we just talked about against the skew index.

[00:40:20] The skew index includes call options in this calculations. This is the SKEW from the SIex. That's actually interesting. People have looked at the SKU as a measurement of four, S&P returns and it's not terribly effective. I think if you combine a couple of other indicators, maybe you can find a little bit of edge. But I'm not actually compared the difference between these two, I'd have to look at that. That's a very interesting idea.

[00:41:41] Let me extract.

[00:41:42] I'm gonna be like an options guy now.

[00:41:44] I wanted to talk about these call SKUs.

[00:41:46] So this is the the money implied volatility in terms of a rank? So what you could see is that because earnings has by and large come out for a lot of the biggest names

[00:43:01] with options, a lot of options flow,

[00:43:03] implied volatility has come down overall,

[00:43:06] but SKU has increased. call SKUs. That tells us that there's demand for these calls. That tells us that dealers are likely in a negative game of position, which means that as stocks go up, they have to buy more shares of stock in order to, all the course of a month. So this stuff's moving like crazy. And then last but not least, IWM, 94% dollar cost, you triple Q ETF, the triple long NASDAQ, that's 92% percent of the cost.

[00:45:42] So all of this stuff is very heavily tilted

[00:45:45] towards an aggressive bullish stance. or what I'm thinking about, but this momentum right now, it's such a momentum trade. So when you turn that momentum or you switch that momentum off, you can get a pretty meaningful correction. But again, 3% down to the S and P right now just takes us back to literally where we were last week. So it's not saying a lot except for that this has gotten very rich to the upside and starts to run on exhaust, I guess, at this point.

[00:47:03] And so you need some consolidation to help, you know,

[00:47:05] rebase things.

[00:47:06] So when you talk about negative gamma and dealers

[00:47:07] having to buy on the way up, dealers to have to start selling stock off as the stocks come down. That's what the general idea is. To give you an idea on that topic, I had done this study a couple of weeks ago, just to give an example. We were looking at the delta of a 190 AMD call two weeks to expiration.

[00:48:21] This was into their earnings.

[00:48:22] The IV of the option at the time was 75%.

[00:48:25] It's roughly, this is called a 30 delta. these vol stops, right? Instead of having vol up stock up, we just have market flat, vol comes down, then suddenly those calls stop being so expensive. You don't need as many shares to hedge them anymore and you can start to unwind some of those long stock hedges and that can press the market lower. That makes sense. So, in general, when you have these expiration weeks, when you have these stocks where the

[00:49:41] dealers are buying on the way up, is there a typical point where that peaks?

[00:49:45] I mean, is that peak at expiration?

[00:49:47] Or does it peak earlier in the week? really into Thursday and Friday in particular. So these next two, you have a similar chart, but you looked at SMH and you looked at NVIDIA. Yeah, so I wanted to, here we said, hey, 90th percentile SKU, what does that look like? This is part of our new volatility dashboard and what you see here in green, the green line is one month, so 28 days to expiration specifically.

[00:51:02] SKU for SMH, and what you could see is that

[00:51:05] the 110% out of the money ramp, right? Like a, like a skateboard ramp or skew ramp or whatever it is. Um, whereas if you historically look at the S and P skew or S and M H or somebody's bigger ETF, it generally is completely down trending the whole way down, right? You don't you generally don't have this latting out or

[00:52:20] elevation into the call side of things. You almost always have what looks more like a straight kind just a beat of earnings, they're pricing in, to be honest with you, I don't know what envy you would have to do in order to justify beating this cost you, right? Because what happens is as soon as they report earnings, implied vol goes down. It's just a function of the event passing, right? And so immediately, you have to start swimming up against the

[00:53:42] tide if you're the Nvidia stock because that vol things the options market could teach all of us about. You'll see this all the time. People will be all excited. I own NVIDIA. They'll look after hours. They report these great earnings. They'll be like, all right, I'm really pumped up. And then they look at the stock price. And it's like the thing is just tanking. And so much of this is like these flows that are going on behind the scenes, plus the expectations that are kind of embedded in there, relative to what the

[00:55:01] earnings estimate is for the in the real world. I think in both cases, we're up, we can just measure it out here right now, right? So you had a 40% gain into the earnings in November of 2022, depending on when you want to strike the measurement here, 60% rise the month or two, maybe three months into earnings

[00:56:22] in June of how much they can own. So it almost becomes like with the especially with these bigger ones, Microsoft and Apple, it becomes very difficult to even express like a bullish bet relative to the S&P 500 because the weights are so big now. Yeah. And I think that's where options maybe can help.

[00:57:42] I mean, I don't know if a lot of's just going to take a breather, right? And I think that could be within earnings on 221. That could really be a catalyst just for some change. Yeah, I would never guess Broadcom is bigger than Tesla. Yeah, I was shocked by that, to be honest. You know, I checked this fairly often. So, you know, and a lot of these other names are the names that we all know. But you also look at, you know, you have JP Morgan and UNHCR

[00:59:04] 1%, but then suddenly Exxon Mobil is only 1% of the index

[00:59:07] now, Mastercard Johnson, Johnson, Proctor that we've seen in 2021 and a couple of episodic spikes, I would say in 2022. So there's a little bit more room you could say for call volume to go in terms of records. You know, there's been a couple of times in history, like I can remember early February, there was just this day where call volume printed, you know, like a standard deviation higher than the record and or the days

[01:00:21] around it, I should say, and it was so obvious to blow off top. And we haven't quite hit that,

[01:01:21] You can see this is last lineup, but we're still well off of 2021 and 22 highs even.

[01:01:25] Early in 2022, there was a lot of

[01:01:27] trying to early buy the dips.

[01:01:30] So, you know, look, in 2020,

[01:01:32] we had direct stimmy payments, right,

[01:01:34] to everyone's house and we were all stuck at home

[01:01:36] because of COVID and we're probably not

[01:01:38] in that same environment.

[01:01:39] But I don't think I've seen yet that retail

[01:01:42] gets sucked into this kind of late stage rally, right?

[01:01:45] Like, you know, I'd, you know,

[01:01:47] jack I don't know if your wife is investing 15 to 20, right? Like suddenly it just gaps like magnitudes of order higher. But in the 40, 100, I expect that remember that fixed strike wall, matrix showing us that people are selling puts into these level and that kind of thing. So, so we're watching that again, CPI tomorrow, which is the 13th VIX expiration of the Wednesday. So two days from

[01:03:00] now into Nvidia earnings, I think there's all these catalysts kind of break this market

[01:03:04] momentum and lead to of value in that. And you were talking about some of these more macro things like this. You know, we're in this overbought condition. I think that's pretty clear based on all of this data.

[01:04:21] And so, you know, is that just going to be again, consolidation?

[01:04:23] Then we continue to go to all-time highs like your growth investor buddy, you know, trading or just what is that informing me of the market? I think a lot of people, even if you just trade stock, there's a lot to be gleaned from looking at options implied volatility. So people go, oh, I don't trade options. I don't need to care what like fixed- strike ball is doing. I actually don't think that's true. You can get a lot of great information off of how the options markets pricing things in,

[01:05:40] how traders are leaning, bullish or bearish.

[01:05:43] So we're gonna go through all of these different things

[01:05:45] with case studies and the like.

[01:05:48] And so if you go to volatilitychallenge.com, that's embedded in there. If you see the VIX spiking into certain events, it informs you of how that event is being priced out by traders. You can glean different information. Some of it, even though you're a longer-term alcator, you're looking for moments to buy or sell or moments to make really big, large strategic decisions. There's an immense amount of information

[01:07:02] embedded in those options flows and also in the way that implied volatilities are shifting as well.