How Modern Markets Work

The vast majority of stock price movements are a result of "options" and "systematic" flows. For those raised on Warren Buffet and the idea that stock prices are a function of "fundamental value", this can be very difficult to stomach. It is simply the case though that in modern markets, less than 10% of trading activity is related to fundamental valuations.

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Let's use the stock crash and "V shaped" recovery in 2020 to illustrate...

After weeks of historic declines, the stock market bottomed on March 23, 2020.

Why was this? Why this date? And why was the market buoyant before March, despite everyone being aware of the Covid virus in China?

To answer these questions, we must understand how the “options” market affects stock prices.

This topic may seem a bit esoteric at first glance, but I promise to teach you guys enough for you to be able to make use of the data that I will provide you with as we move forward.

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The first thing to understand is how much the options market has grown in recent years.

It used to be that options prices would be a ‘derivative’ of stock prices; however, with the growth of the options market, it is now stocks that derive their prices from options activity (the “tail is wagging the dog”).

Importantly, when people buy and sell options, they do not do so directly with each other, but rather with a “market maker”. For example, if you buy a “call” option, it is not another person that sold this option to you, but rather a financial institution.

This institution does NOT want “directional” risk, however. They are not in the business of speculating whether stocks will go up or down: they want to make money (by collecting the cost of the options contracts) regardless of price movements.

To do this, these institutions “hedge” their positions to keep a neutral exposure.

For example, if you buy a call option on Apple, this means that you make money as the price of Apple stock goes up. Because the dealer has sold this option to you, they lose money as the stock goes up.

Because they do not want this risk, when they sell you the option, they will buy the underlying stock. Their whole game is ensuring that the potential losses on the Apple contract they have sold you is perfectly matched by the profits on the Apple stock they buy.

Gamma, Delta, Vega, Vanna, etc. are all fancy Greek letters that are used to describe how these large dealers neutralize their risks (“hedge their exposures”).

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Let’s return to March 23 to evidence the importance of options positioning.

Options have expiration dates, and there are certain times in the calendar where there are particularly important “expirations”- notably March and September.

Turning points in the market often occur immediately following these expirations, as the positioning of the public and the related hedging activities of dealers fundamentally change.

For example, note that the market steadily climbed higher at the beginning of 2020: this was because market participants were hedged- i.e. they bought put options which benefit when the market drops- given concerns over the coronavirus.

When market participants are hedged, it makes it very difficult for the market to drop, and if the market does not drop, then it is “juiced” to the upside by dealers.

This is because options lose value over time. For example, picture that you own Apple stock but are worried about it collapsing because of the coronavirus. You may buy a put option on Apple stock that provides insurance in case your fears become realized.

A dealer is on the opposite side of this trade, selling you the put option. Because they do not want directional risk, the dealer will short Apple stock, so that if it collapses and they lose money on the put they have sold you, they will make an equivalent amount of money on their short position.

Importantly, the more people that buy put options, the more expensive these options become and the less likely that they will have value at their time of expiration.

In short, more “hedging” by the public increases the value of the put options, thus decreasing the risk to dealers.

If the market does not drop, then the put options lose value as they near expiration. Because the put options are losing money, the dealer buy back the shares of Apple they have shorted to keep a neutral position.

This is exactly what happened leading up to the third week of February, 2020 (when these options expired).

However, because the market stayed resilient, many people reduced their hedging activity (i.e., bought less put options) after the expiration in February.

As a result, the following day after expiration, the market collapsed, as there wasn’t the bid by dealers to support markets. This continued until the next monthly expiration in March, where people began to buy hedges again, thus juicing markets to the upside.

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There are many different ways we can analyze the positioning of dealers and the impact on markets. One of the foundational ways of doing so is by analyzing “Gamma”. Without going into detail on what Gamma is, note that positive Gamma environments are less volatile and negative Gamma environments are much more volatile, as the chart below illustrates:

The horizonal (bottom) axis depicts the level of Gamma: as you move further to the left, Gamma gets more and more negative. The vertical axis depicts volatility: note that as Gamma becomes more negative, volatility increases. By contrast, it is almost impossible to have volatility in a positive Gamma environment.

Why is this?

A positive Gamma environment means that when the market goes higher, market-makers sell stock to maintain their “delta neutral” position; conversely, when the market goes down, they buy back stock to maintain neutrality. This provides guardrails to markets.

By contrast, in negative Gamma environments, dealers sell stock when the market goes down and buy it when the market goes up. This thus juices markets to both the upside and downside.

Importantly, some of the largest moves in markets occur when Gamma flips from positive to negative. Note this is exactly what occurred in February of 2020: options expired and dealers went from positive Gamma to negative.

This negative Gamma environment / drop in stocks lasted until the quarterly options expirations in March, as previously noted.

Recall above that stocks sharply rebounded on Monday, March 23. Likewise, note that stocks collapsed at the end of 2018 and sharply rebounded on Monday, December 24th:

Importantly, December 24th was the Monday following options expiration on Friday. It is not a coincidence that these sharp collapses / recoveries occurred immediately following options expirations. It is simply how modern markets function. Price movements are no longer a function of fundamentals, but are rather a function of the “microstructure” of markets.

Furthermore, note that studying options flows / market structure is not only relevant for trying to forecast these “acute” moments: analyzing these flows are also the most effective way to forecast where prices may go over the longer term (2 weeks- 6 month intervals).

As the following chart illustrates, “regimes” have persistence:

It is thus crucially important to not only understand when sharp reversals may occur, but also to understand what general environment (e.g., positive of negative Gamma) we are in, in order to position our portfolios accordingly.

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Conclusion

Candidly, there is much more to be said on these topics. I simply wished to briefly illustrate the importance of understanding these phenomena. For subscribers, I will provide timely updates and analysis on these dynamics. This information can costs upwards of $100,000 (from research desks at banks like Goldman Sachs); however, I will take the data I receive, distill it, and analyze it for subscribers at a fraction of this cost.