A liquidity cascade and negative feedback loop can take the market significantly lower. I will do my best to explain it. It involves the influence of the options market, which has grown so large in the past few years that we have to consider it in our algorithms.
I discuss and identify the Weekly Expected Moves week to week respecting weekly options. And you see how influential they are most of the time. But options have an even more significant impact when considering Gamma and Delta hedging. Dealers on the other side of puts and calls have to hedge. At certain levels of Gamma and Delta, they have to hedge a lot and frequently.
When volatility is this high, it is nearly impossible for dealers to keep up. Accordingly, they step away from the market, and liquidity evaporates, making the problem worse.
We had the positive benefit of Gamma in the bull market phase. We would see tight, persistent rallies. These were positive Gamma squeezes. The more traders bought calls, the more the dealers had to hedge by buying the underlying stock or index or futures. The hedging created a positive feedback loop.
Now we are seeing the opposite. The more investors buy puts; the more dealers have to sell the underlying stock or index or sell futures. This hedging creates a negative Gamma squeeze with tight sell patterns.
ETFs and indexing, in general, are related problems. It does not matter how good your stock is; it suffers when investors dump ETFs and indexes. Options leverage only exaggerates the problem.
Most of the Gamma is sitting at 4000 on the S&P 500 index. As the market approaches that or other significant Gamma levels, dealers may have to unwind their positions as investors cover their puts, and the Gamma squeeze reverses to positive.
I will mention something one of my mentors once told me. The best investments sometimes make you sick to your stomach because the fear is high. We call it the puke point. As Russia makes its full-blown Ukraine invasion and given most of the other Fed risks are known, we may deploy some capital into the capitulation.
Fasten your seatbelts, and let’s see how it goes. It is going to be a long night.
A.F. Thornton