Mechanics of a Short Squeeze
Because of the relatively high prices of options sold, we do not have to re-hedge as aggressively, which in turn leads to less follow through on the downside. When option prices are high (demand drives up the price as hedgers become less price sensitive), the gamma (the change in delta) declines.
An example might help. A money manager long a portfolio of stocks becomes concerned that the market is a little ahead of itself. She decides to buy an SPX index option at a time when the market is rallying and option prices are generally cheap. She buys a one month at the money put for around 1% of the index. The gamma (change in delta) of that option at that cheap price is .012: if the market declines 1% the delta of that option will go from .50 to .512. If the market does decline 1%, the market maker who sold that option must sell futures to re-hedge his position. As the trader re-hedges the position by selling futures, he contributes to the continuation of the decline.
Now let's say another money manager becomes fearful of a continued market decline while the market is dropping rapidly. Due to the increased demand for puts in a market decline, the price of all options increases. The money manager being fearful becomes less price sensitive and pays the market price of 2.3% for that same one month put as our first money manager. At this price, the gamma is a much less .006. If the market declines another 1%, the delta will only go from .50 to .506. The market maker who sold these puts has much less re-hedging, and even may not decide to re-hedge at all. With less re-hedging the decline loses its steam.
With the market stabilizing, the money manager is left with an expensive put that is currently worth 2.87%. At this point he begins to re-think his rather hasty previous decision to buy puts. He begins to think how costly it will be to lose 2.86% over just one month. He decides to sell half his position, unfortunately at the same time that a lot of others in his place make the same decision. All of a sudden the market experiences a short squeeze as many participants try to unwind their hedges at the same time, creating a panic demand for futures in the market.
We indicated yesterday in Buzz that this seemed to be happening. Jason's comments of an oversold market are normally synonymous with this situation.
This illustration shows just how much option prices can affect market supply and demand in the short term. It is a purely mechanical process born of psychological swings.
This is only a short term phenomenon and is to be expected when option sentiment gets to short term extremes. If volatility declines over the next few days, as expected, and option prices become cheaper, we will re-establish some of our long gamma and vega that we sold yesterday.
As we said, we believe that the general trend is down now, that is at least until proven different. That does not mean the market will not experience sharp upward corrections like yesterday.
They are to be expected.
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