Stock Market Selloffs Will Soon Have More Follow Through

Authored by Simon White, Bloomberg macro strategist,

Greater dealer hedging of put options exposes the stock market to deeper selloffs.

US stocks have held up remarkably well given the building chorus of risks. The selloffs thus far have been, relatively speaking, contained. The largest intraday drop in the S&P 500 since the war started was 3.2%, but every other day has seen a maximum intraday drop of less than 1.7%, with most under 1%.

Gamma has been hovering around zero. When it goes negative, dealers typically shift from absorbers of price swings to exacerbators of them.

Investors generally sell calls a little above the money and buy puts deeper below it, as insurance. As the market moves lower, the delta on the calls goes to zero, and the delta on the puts rises. Dealers are left having to predominately hedge their short put positions, which entails selling.

This dynamic has yet to kick in to a dramatic degree -- not because there are few puts to hedge, but that they are still a further out of the money, so their delta has not grown significantly.

However, a larger selloff would quickly bring more of the puts into focus as their delta rises.

There is a tactical upside case.

Investors look heavily hedged, with high gross exposure and lower net exposure. That helps explain the slow drip lower instead of outright capitulation. It also leaves room for a reflex rally if implied volatility compresses.

The gap between the VIX, implied vol for the SPX and one-month realized vol for the SPX is unusually wide.

As we can see below, using Bloomberg’s OPX function for the S&P 500 on options expiring at the end of this month, there is chunky put gamma (orange bars in chart) waiting in the wings over the next 2-2.5% decline in prices, with the biggest amount seen at the 6475 strike.

(Although dealers are likely long this particular strike if it’s part of JPMorgan Hedged Equity Fund collar strategy - which currently consists of 35,000 contracts on an SPX 5,470 / 6,475 put spread with a short call at the 7,155 strike.)

The gamma backdrop is negative across multiple expiries, with the March triple witching option expiration this Friday the biggest pressure point.

Positioning clusters around 7,000 on the upside and 6,600 on the downside, with 6,800 the key volatility pivot.

Add the daily churn in 0DTE flow, and tactical support and resistance can shift fast, with strikes that are closer to spot levels becoming intraday magnets of resistance and support inside the wider range defined by longer-dated positioning.

Either way, market dynamics are starting to look less favorable, with plenty of fuel to provoke a bigger drop in prices should the market continue to trend lower.

The March monthly expiration stands out as particularly important.

Friday's OPEX represents one of the the largest expirations on record with roughly $1.3 trillion delta notional - about 30% of total market exposure - set to roll off.

With negative gamma dominant, skew elevated, and expiration dyamics ahead, the quiet range-bound market has now disappeared.