Technicals > fundamentals

Callie Cox is US investment analyst at eToro.

Over the past few years, we’ve had to adjust our perspectives on how markets and the economy work. A lot.

Some old assumptions have been tested, like what or who actually drives market moves. Classic analysts would say corporate earnings and economic progress, and they’d be right — at least for the long-term outlook. But on a day-to-day basis, we’re learning more and more that other people’s trades are influencing our own.

This is where options come into play. Options trading has exploded over the past few years thanks to the return of volatility and the availability of all types of contracts — daily, weekly, and monthly. Traders now have tons of options (pun intended) to hedge or speculate to their heart’s desire.

And they’ve taken advantage, sending average daily volume to about 40mn contracts last year — almost triple what it was in 2017. This year it’s jumped even higher, to an average of 45mn contracts a day.

Moreover, much of this increase has been in daily or weekly options. CBOE estimates that same-day options comprised 44 per cent of S&P 500 options volume in January alone.

The boom in short-dated options have warped the signals we get from classic market indicators.

For example, one of the biggest mysteries of this bear market has been the subdued Vix, which has barely reached half of where it’s jumped to in other crises. Part of this is the slow-burn nature of this bear — DataTrek’s Nic Colas likens it to a Hitchcock horror movie environment — but the Vix’s apathy could also be ascribed to the boom in short-term options trading.

Think about it: the Vix is a measure of demand for S&P 500 options expiring 30 days into the future. By nature, it wouldn’t pick up the demand for daily and weekly options, a significant chunk of its total volume. No wonder the Vix was the least sensitive to market swings in a decade last year.

Year-to-date, the Vix has been almost comatose, moving an average of 0.8 points on days when the S&P 500 has gained or lost 1 per cent or more.

It’s not just the Vix, either. Short-term options volume can still add fuel to the fire on some of the stock market’s wildest days, and it can catch you even if you don’t dabble in options.

This is because of the feedback loops between derivatives trading and the underlying securities. Market-makers can hedge their options positions with stock, which means they could be forced to buy or sell a lot of stock on days when options trading flares up.

Take November 10, a day when the S&P 500 soared 5.5 per cent on a cooler-than-expected inflation report. It was the stock market’s 15th best day since 1950, which seemed . . . extreme given year-over-year CPI was still north of 7 per cent?

It turns out there was a lot of position shifting going on underneath the surface. November 10 was the fifth-biggest day for options volume in history, and CBOE data showed that 19 of the 20 most active options that day were set to expire the following day. Short-term options were also sold at the fastest pace in nearly two years.

To be clear, this could’ve been a self-fulfilling prophecy — a market swing that forced people to readjust their positions. But if you put the pieces together, it looks more like an event that initially caught investors off guard. And lately, correlation between options volumes and wild market moves have become tough to ignore.

Why am I going down this rabbit hole of volatility and options market structure? Because it’s important to acknowledge how options and positioning influences perception of risk. And in feedback-riddled markets, perception can become reality.

Analysts and investors watch certain risk metrics — the Vix, put-call ratios, market correlations, yield curves — that have sent some weird messages in this particular bear market. Yet we’ve made assumptions that these measures are appropriate for an environment that’s clearly more short-term focused than ever before.

People obviously shouldn’t throw away their finance textbooks, but we can’t lean on our prior assumptions too much these days. Positioning, flows etc have always been important, but in markets like these technical factors are becoming far more powerful than ever before, and can even swamp fundamentals in the short term.

It will be interesting to see if this is just a phase, or a durable shift in how markets function?