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Minyan Mailbag: A Panic Rally?


...the potential for the market to move is great given any impetus.


Prof. Succo,

Last month, the market dropped during options expiration because of a high number of naked short puts being covered by selling, correct? So, could the same thing happen this month with players being short calls? I know you have written about this often, but could this drive a panic rally today and tomorrow?

Plus, if these "covered call funds" get their options exercised, they will need to rebuy the stock that was called away, driving the market up even more.


Minyan Mike


Let's revisit your description.

The market by itself was under pressure. This is the first thing to understand: option positions by themselves, if out of the money, do not cause buying or selling; it is the movement of the market toward a strike of great open interest where the "gamma" then begins to change to a significant enough degree to force holders of short option positions (and those long them) to begin to re-hedge. Normally the two opposite sides, those long and short, are re-hedging in an offsetting way to mitigate moves in the underlying. The net effect of that re-hedging is to drive the price of the underlying into the strike price.

In order for this to occur, the open interest relative to the liquidity of the underlying must be large. Regardless, nothing matters unless the underlying is relatively close to the strike near expiration so that the gamma is very large.

Last expiration as the market dropped there happened to be large positions expiring in variance swaps, over the counter convexity positions that do not really have a strike. For this rather technical reason the drop in the market was exacerbated.

This illustrates that the derivative market, especially in over the counter positions, is very large indeed and growing. It illustrates that the potential for the market to move is great given any impetus.

No positions in stocks mentioned.

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