Stock-Market Routs Keep Coming Around This Time Every Month

(Bloomberg) -- Forget the charts, the valuation analysis and macro inputs conventionally deployed to handicap the stock market. A humbler piece of data has piqued the interest of a couple equity traders of late: The S&P 500 has a habit of tumbling this time of month.

It happened in July, when the month’s biggest downdraft was its 2.7% slide over the three sessions through the 19th. In June, the share benchmark lurched 1.3% on the 18th, its largest fall of the month. May saw a three-day decline ending the 19th knock 1.4% off the index, though a plunge the week before was a bit bigger. And a 1.2% drop over two days ending April 20 was that month’s worst.

It could easily be coincidence, a quirk of happenstance without any basis in probability. Another possibility is that it has something to do with a wonky market event that also occurs right around the middle of every month -- options expiration, which in August comes this Friday.

Why exactly the monthly expiration of contracts to buy and sell shares would cause this is not entirely clear. But at least one Wall Street veteran sees the event as a catalyst for potential turbulence. Charlie McElligott, a cross-asset strategist at Nomura Securities, says dealers who are hedging their options positions by buying or selling underlying stocks have become “long gamma,” meaning they need to push against the prevailing market trend and act as a buffer to the downside. Once options expire, that floor disappears, leaving the market vulnerable to negative shocks.

Right now, the market tranquility partly as a result of “long gamma” is prompting computer-driven funds like those allocating assets based on price swings to pile into equities. By McElligott’s estimate, volatility-control funds may add $50 billion of equities should the S&P 500’s move stay within 0.5% each day through Friday. But that can quickly reverse if equities start to sell off due to a lack of support from options dealers. Futures on the index were down 0.5% as of 8:37 a.m. in New York.

“A -2% day could easily accelerate to something much ‘crashier,’” McElligott wrote in a note last week. He estimated that options dealers could see 30% of their equity exposure coming off upon Friday’s expiry. In a worse scenario, where their positioning turns outright into “short gamma,” he said, dealers would need to sell stocks in case of market retrenchment.

To Alon Rosin, Oppenheimer’s head of institutional equity derivatives, the recent carnage surrounding option expiry was likely coincident. “If anything, what we’ve been seeing and the way what we’ve been playing it is, option expiry typically had a better bid to it off expiration-related flows,” he said. “All the dips have been bought. What we are seeing into August expiry this Friday is a lot of open interest below around 4,440 and 4,450” on the S&P 500. 

The index fell as much as 0.8% as of 9:40 a.m. in New York after ending Monday at a record 4,479.71. It has moved 0.53% a day from peak to trough in August, poised for the calmest month since the end of 2019.

Still, Friday’s event is another wrinkle in the market where options traders have resisted letting their guard down. The Federal Reserve is expected to announce plans on rolling back its monetary stimulus in the coming weeks while the risk of another wave of Covid infections lingers. Add a potential Chinese slowdown and the chaos in Afghanistan, and it’s a recipe for nervousness.

The angst is particularly acute in derivatives tied to the Cboe volatility index, a gauge known as VIX. A measure of implied volatility in VIX options, or VVIX, on Friday reached the highest level relative to the VIX since before the Covid-19 pandemic. In the futures market, six-month contracts on the VIX traded at 7.7 points above the cash index, a premium that before this year hadn’t been seen since 2016, data compiled by Bloomberg show.

To Michael Purves at Tallbacken Capital Advisors, such heightened interest for hedging is a sign that sentiment has yet to turn overly exuberant and there are still skeptics that can be converted into buyers.

“It actually reflects healthy non-complacency in the equity land,” Purves said. “It’s also a reason why it ultimately helps to push the market higher.”

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