Afternoon Notes - 4/19/2022 | Archimedes Methodologies

Good Afternoon:

Bear with me this afternoon; I will try to simplify a few complicated concepts so you can understand where this market finds itself at this moment. The stock market has stalled with most of the bad news baked in. It is trying to pivot from the right shoulder of a Head and Shoulders Reversal pattern on the daily chart and made good progress today. But we are not out of the woods.

The market stopped at the 21-day line and our “Volatility Trigger.” Absent a new catalyst, the options market may influence direction here. I want to take the opportunity to explain the Volatility Trigger, Delta, and Gamma so that you understand how they will control the next move. I will show you the similarities to the 2008 market peak towards the end.

So let’s begin:

The stock market is in a state of equilibrium. The bad news – and there is no lack of it – seems “fully priced” for now, after the recent CPI print gave a glimmer of hope that peak inflation is behind us.
The Fed getting to “neutral” is a yawn now. It would take the Fed jawboning a “restrictive” policy to rattle the market further.
At this point, traders have had the opportunity to price in fiscal/monetary and geopolitical risks and sell accordingly.
But it’s also clear that tail risk remains elevated, which keeps the VIX elevated. After all, we are on the brink of World War III, and I am being serious.
From my “Quant” chair, the issue for markets here is that Dealer shorting will likely increase incrementally into a doom loop if it slides lower. The market is not hedged like it was earlier in the year.
I have focused on the market holding the 4400-4450 area as important in the Morning Notes.
Let me digress. In understanding the stock market, I divide the process into three segments; (i) fundamentals (e.g., P/E ratios, interest rates), (ii) technicals (e.g., trendlines, support/resistance, moving averages), and (iii) quantitative (options market influence).
Let’s focus on (iii) above, the Quant side of the market. In the last five years, the options market has grown so much that it has become the proverbial tail that wags the dog.
Shortly, S&P 500 index options (SPX) will be trading every day, exerting even more influence over equity markets.
Every option bought or sold in the market generally has a Dealer on the other side. They earn the premium you pay for taking the other side of your transaction.
These professionals hedge premium risk by buying or selling the underlying securities. So if you buy a put, the Dealer has to short the underlying securities to keep their portfolio neutral.
Delta measures how much Dealers have to buy or sell to hedge. If a SPY option has a Delta of 50, the Dealer has to buy or sell 50% of the underlying security to hedge. Sounds simple, right? It is, but only for the first few seconds.
Delta changes as price and other factors change, including how close the underlying is to the strike price and expiration.
Volatility also impacts Delta.
After that first hedge, Dealers (with their computers) constantly buy or sell underlying securities to stay even as Delta changes (e.g., 50-55 or 50-45).
The Dealer finds itself (and its computers) tracking how the Delta changes to keep abreast of what has to be bought or sold to stay neutral and bank the premium.
Gamma measures how much the Delta changes after the Dealer’s first hedge and guides them in how much the Dealer needs to buy or sell hour to hour and day to day to stay neutral.
Gamma flows are non-discretionary, as the Dealer has no choice but to buy or sell to stay even. In recent years, Gamma flows have become one of the most critical flows in the marketplace.
There are two other terms you will hear from time to time – Vanna and Charm. Vanna measures how much volatility affects the Delta, and Charm measures how the time to expiration affects the Delta.
Bottom-Line: Dealers use Delta for their first hedge and Gamma to know how much needs to be bought or sold to maintain it. The goal is to stay neutral and keep the premium. That is how Dealers make money – and it is a very profitable business.
SPX options alone account for about 16% of the SPX market cap. There are many billions in gross Gamma outstanding. Say the number is $10 billion. That would mean that the Dealers need to trade approximately $10 billion worth of SPX for a 1% move in the index.
Depending on how Dealers position, Gamma can exacerbate market moves (“short Gamma”) or dampen them (“long Gamma”).
A quick rule of thumb – you are long Gamma when you buy options and short Gamma when you sell.
Wouldn’t it be great to know if the street is long or short, Gamma? How about where the line is between long and short Gamma? What if we could understand how Gamma is changing throughout the day to estimate the flows and how they might impact our trading?
That, precisely, is what I do every day and throughout the day. Every morning (on the Navigator Day Trader subscriber charts), I highlight the Volatility Trigger ( the negative/positive Gamma flip line). I also draw the Absolute Gamma (the strike price with the most concentrated Gamma influence) and Zero Gamma, where the Gamma is neutral and stops influencing price.
And the Gamma hedging flow impact is only going to worsen because of the enormous popularity of short-dated options. Over 50% of total SPX Options Volume is now between 0-five days to expiration, with over 30% at 0 to one day.
And for the index ETF (SPY)—aka “retail” size—it’s even worse: 0-five day to expiration options are over 70% of total volume, and 0-one day is 50%.
If you review the last two days of Morning Notes, 4400 (slightly adjusted to 4396 on the futures) has been the line in the sand in terms of where I saw the largest Gamma concentration, just below the 4444 flip line (Volatility Trigger) between negative and positive gamma flows.

Now, look at today’s chart above. Today, we forecast a 1.117% range from the open. That is roughly 52 points. The Open was 4386.75. Add and subtract 52 points and that is the expected range for today. It appears on the chart from the top of the red shaded area to the bottom of the green shaded area.
Also marked is the Volatility Trigger or “flip line” between negative and positive Gamma (4450 adjusted to 4444 on the futures). The largest strike with the most Gamma right now is 4400 (4394 on the Futures).
Knowing where the Volatility Trigger and highest concentration of Gamma are, we can forecast that the street is short Gamma below 4440 and long above it. But the price will encounter the most Gamma at 4400 in the short-term.
What that portends is what we saw happen today. The market has wider swings (as it did yesterday). It has a negative bias below 4400 and a positive bias above it. But the market will encounter support/resistance at 4400 and 4444 depending on the direction price is coming from.
Since we traded above 4400 most of the day, 4400 acted as support. But the Volatility Trigger was strong resistance because the price came from below it.

Above is yesterday’s chart with a few notes to help you put this in perspective. You will see that with few calls above 4400, and a comparatively large number of puts below, the behavior will change if the market stays under 4450 and 4400, adjusted slightly by subtracting six points for futures.

The Chart above is how the Founders Group saw the market this morning, combining Gamma and the dominant put options. That chart is red because puts dominate calls. It would be green if calls dominated puts or would turn green where call Gamma dominated put Gamma. Note how the Gamma influence drops off as the price rises.
So now, let’s get back to the market, which is trying to put in a swing low at this writing.
Today, the Founders Group took an excellent day trade from the neckline of a small Head and Shoulders Reversal pattern up to the Volatility Trigger right above the Absolute Gamma line for $1,750 per contract.
Knowing that the large Gamma at 4400 provided support right out of the gate, we could target the Volatility Trigger at 4444, and we did.
The market also encountered the 21-day line located near the Volatility Trigger.
All in all, the market was bullish today. It managed to close above the five and 50-day lines with broad participation.
The market needs to stay above the Volatility Trigger and conquer the 21-day line for the index to continue higher.
Also, 10-year Treasury Rates appear to be exhausting at just under 3%, which would give a boost to stocks.

But, lest we get too comfortable, the analogy between the 2008 peak and where we are today is like one of those “separated at birth” memes. The chart above lays the 2022 price over the 2008 price.
Lightning rarely strikes in the same place twice, but I will continue to have the 2008 chart imprinted in my mind.
And that takes me back to the core forecast.
Everything seems priced in at this point. We have a reversal pattern on the daily chart trying to grab hold of its right shoulder on the S&P 500 and NASDAQ 100.
Perhaps we need a new catalyst or the Fed meeting behind us to break out of the expanding triangle on the daily chart, a breakout pattern in and of itself.
I am still leaning towards a rally at least up to the neckline before the Fed meeting, and perhaps higher, then we roll over again, much like 2008.

In summary, I tried to simplify a few complicated concepts so you could understand where this market finds itself. The stock market has stalled with most of the bad news baked in. It is trying to pivot from the right shoulder of a Head and Shoulders Reversal pattern on the daily chart and made good progress today. But we are not out of the woods, and being aware of how the options market might influence price action in the days ahead s essential.

Below the Volatility Trigger, Dealers have to sell index futures if traders start adding to their puts, creating negative feedback or “doom” loops. The situation now is different from February/March, where traders had already established the put positions incrementally between November and February.

Instead, let’s hope the market stays above the Volatility Trigger and creates a positive Gamma spiral from the tip of the left shoulder reversal pattern still forming on the daily chart. Either way, we will know what to do and how to capitalize on the turn.

As always, stay tuned.

A.F. Thornton

P.S. – Whew, that was longer than intended and even wore me out…

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Afternoon Notes – 4/19/2022