We are Living in a Simulation (a Low Vol Simulation)

Bank of America recently estimated that the effect of delta hedging by option market makers has artificially reduced S&P 500 index volatility by 2.7 points over the past month (a 21% fall in volatility). This is the result of market makers generally being long options with high gamma (near-the-money and very close to expiry) which must be hedged in the underlying spot or futures market.

Note – when market makers are long gamma, they hedge by trading counter to the prevailing trend, i.e. sell when prices go up and buy when prices go down. This has the effect of dampening volatility.

Most of that volume is coming from the 0DTE options, i.e., options with less than 1 day to expiry.

Let’s be clear. This is a feature that barely existed before 2022. 0DTE volumes have increased 5x in the last 4 years and are now the biggest tenor bucket by far.

The result is that selloffs in US equities that would otherwise be more dramatic, are being suppressed by the fact that market makers are trading counter to each trend in significant size.

Friday 21 February was a good example of this. Concerns over economic data caused prices to fall during US trading hours, however all the way down market makers were buying S&P 500 and Nasdaq 100 index futures to hedge their books. As such, prices fell in an orderly fashion until they reached a stopping point right around a cluster of long 0DTE puts held by the MMs.

The end-result was not a panic selloff, but a managed decline caused, in part, by the support provided by the options market.

This creates a more relaxed environment, but it’s a dream world, Neo, and it’s not sustainable. In fact, there are warning signs that markets are preparing for a spike in volatility. The amount of VIX calls being purchased continues to hit new records, while the deep OTM put skew on major indices has been stretched to all-time highs.

This indicates heightened fear that a crash is coming and there is good reason to suspect that it might.

The support provided by 0DTE options could not be more temporary, it’s here today, gone tomorrow. If traders decide to stop selling one day and buy instead, the effect will be to accelerate any sell off.

This risk is magnified by the quantity of trading performed by multi-strat hedge funds, who are big sellers of index options (due to the dispersion trade) and who famously cut losing positions quickly and stop trading when conditions change for the worse.

The large quantity of long VIX calls and deep OTM index puts can also accelerate a crash as market makers have to hedge them by selling futures or buying vega.

To summarize, volatility markets often create self-fulfilling prophecies. For the past two years, there has been appetite for short volatility, which in turn has caused volatility to be suppressed. But if that appetite changes, the result will be to expand volatility, and violently jolt us all out of our dream state.

At Advanced Alpha Advisers, we monitor for risks and make sure that we have the necessary protections in place to manage them.