$4.2 trillion options event threatens newly minted bull market

(Bloomberg) – The gravity-defying bull market offers a new conundrum for equity investors as an unusually large stack of options expire on Friday: pursue profits with bullish derivatives or hedge with bearish bets?

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It's always a decision that traders face, but this time the stakes are higher. About $4.2 trillion in contracts linked to stocks and indices are set to expire, according to an estimate by Rocky Fishman, founder of derivatives analysis firm Asym 500. That is 20% more than a year ago.

The event, known as OpEx, requires Wall Street managers to either roll over existing positions or open new ones. This also coincides with the quarterly expiration of index futures and the rebalancing of benchmark indices, including the S&P 500. The process is ominously dubbed “triple witching” and is known to cause spikes in trading volume as well as sudden price fluctuations.

According to Matthew Tym, head of equity derivatives trading at Cantor Fitzgerald LP, traders are likely to add to their call positions, particularly those that are out of the money. However, the impact of the overall event on the broader market is difficult to predict.

“People are underinvested and have to present themselves,” he said. “Tomorrow there is an enormous amount of options. However, I don't have a good sense of the impact this is having on the market.”

With stretched valuations and lingering recession fears, it's safe to assume that protection in the derivatives market is warranted. In the latest Bloomberg survey of sell-side strategists, the average year-end target is for the S&P 500 to fall by more than 7%. At the same time, option costs are hovering at levels near a three-year low.

But the eight-month rise in stocks has defied all critics, propelling the benchmark above the 20% mark in what some quarters see as a harbinger of a new uptrend. Defensively positioned investors have tried to catch up with call options tied to current market leaders such as tech megacaps and small caps.

In fact, the options market, originally thought of as a place for side bets on stocks, has grown so big that it's affecting the underlying stock landscape. According to some derivatives experts, investors' recent rush to call and unwind their previous put positions has added momentum to the broader market's recent rally.

The S&P 500 rose more than 1% on Thursday, extending its June rally to 6%. The benchmark rose for six straight sessions and just posted its longest winning streak since November 2021. Helping the market strengthen were options traders who bought back deep-in-the-money calls before Friday's expiry and then sold new contracts for the next month , a process that required them to buy stocks to hedge, according to Dave Lutz, head of ETFs at JonesTrading.

“There's a lot to buy at the start of the big up months, especially in the last hour of the session,” he said.

The hedging process is complicated, but it works something like this: When a trader sells a call option, they are essentially making a bet that the underlying asset will go down. To offset this unwanted directional risk, the trader typically buys a portion of the asset to maintain a neutral position.

Similar dynamics apply to puts, which were in demand during the banking turmoil and near-miss US debt ceiling. Earlier this year, market makers who sold puts had to sell shares to hedge their risks. With these events now passing without real harm and investors withdrawing their bets, traders have had to reverse their hedging and instead buy stocks to generate tailwinds for the broader market.

Now, Wall Street sentiment is turning again, especially given the optimism surrounding artificial intelligence and companies like Nvidia Corp. that are at the heart of innovation.

“Just a few months ago, I remember the overwhelmingly pessimistic consensus among investors. Bears have a conscience,” said Amy Wu Silverman, head of derivatives strategy at RBC Capital Markets. “When did the inflection begin? Better economic data, stunning gains from NVDA, or maybe just that familiar feeling for those underserved that the train is leaving the station.”

– With the support of Sam Potter.

(Updates with more details on the so-called Triple Witching)

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