Underlying Conditions For Stocks Beginning To Stabilize

Authored by Simon White, Bloomberg macro strategist,

Underlying hedging behavior in the S&P 500 has likely restabilized for now, meaning self-reinforcing, vol-inducing moves are less likely.

Gamma in the S&P, or the second derivative of how an option’s price moves with respect to the price of the underlying asset, turned very negative at the end of September. Goldman Sachs noted their gamma measure had hit a series low. Negative gamma means there is a greater likelihood of higher volatility moves, as option dealers on net chase prices higher or lower when they hedge, rather than lean against price moves. There is also a risk of wider credit spreads over the risk-free rate paid by corporate borrowers.

Two weeks ago there was a large volume of puts outstanding that were becoming more in the money as the market dropped. This meant the market was susceptible to further downside as dealers hedged puts they were short of. The chart below, from Sept. 28th, shows the large volume of puts (blue shaded part of bars) that were below the market and therefore likely needed to be hedged by dealers.

The picture today, though, shows that there are considerably fewer puts outstanding below the market, meaning there is a lower inventory of options that may require dealer-hedging by selling the market as it falls. There are also more calls above the market.

As a result it is likely gamma is now more in balance. Options-analytics company Squeezemetrics’ estimate of S&P gamma is back to positive.

Positive gamma means large, self-reinforcing and vol-inducing moves in the market - with a bias to the downside - are less likely to happen endogenously.

Indeed, positive-gamma conditions – often driven by a bias for investors to sell call options above the market to harvest extra premium for stocks they own – have helped drive equity volatility lower in relation to FX and fixed-income vol, as well as at-the-money equity vol and realized vol.

We’ll see how much this dynamic takes hold again in a week with several exogenous volatility catalysts, principally US PPI on Wednesday, CPI on Thursday, and any escalation of the situation in Israel and Gaza.

And then there's the tightening financial conditions...

As Bloomberg's Wes Goodman added, the tighter financial conditions that will likely lead to another Fed pause are going to curb shares.

The narrative so far is that a possible end to rate hikes is good for equities. But the reason behind it – surging Treasury yields – will turn out to be a lasting headwind.

Echoing other policymakers, Fed Vice Chair Philip Jefferson on Monday said he would “remain cognizant of the tightening in financial conditions through higher bond yields” in assessing policy.

Stocks gained. But this will turn out to be a good-news-is-bad-news twist for equities in the longer run. The surge in yields heightens the danger in the near-term of a financial upheaval along the lines of the regional bank breakdown in March.

Longer term, it threatens to undercut the economy by markedly raising borrowing costs for consumers and companies.