Understanding Gamma Flow from Tier1Alpha

T1 Alpha Sit-Rep: Friday,  August 19th

Welcome to Shark Week on the Tier1 channel, where we discuss sharks, and by sharks I mean option dealers and their behavior around expiry:

So far, our call for 4300 to function as a “magnet” has proven roughly correct. We have repeatedly explained why this behavior occurs. Our forecast for tomorrow is more of the same. With no immediate macro catalysts (the economic calendar is literally zero tomorrow in the US), we now wait for option expiry and then the Jackson Hole Fed conference next week offers the most likely fundamental catalyst, alongside potential revisions to Q2 GDP.  As a reminder, we are all oddly in the place of hoping for a recession to stop the Fed from carrying out a full tightening cycle. To think that the US equity market escapes a more significant correction, or that the Fed is going to be persuaded to stop with the S&P500 within 10% of all-time highs, seems… odd. Dealer gamma remains neutral, although skewed upwards by outstanding call option open interest, and the 4300 level remains the “most likely” outcome from a technical standpoint.

Monthly OpEx Week

As we pointed out in yesterday’s note, the option open interest expiring tomorrow is sizeable relative to your typical monthly OI. These conditions have historically represented a disproportionate number of turning points. With interest rates beginning to show some uncertainty around Fed reversal, we will be watching closely for the market to begin taking seriously the Fed’s dissatisfaction with loosening financial conditions.

While overall muted relative to pre-Covid, open interest, particularly on the call side, is beginning to grow. On its own, this represents absolutely nothing. Combined with falling short interest, a hostile Fed, an increasingly clear Chinese recession (certainly in the domestic economy) and a US manufacturing recession (at minimum), it suggests… caution.

Gamma Exposure:

The 4300 strike has become so large it is now distorting the entire shape of the gamma surface.  To fully comprehend the magnitude of this strike, understand that between 4300 and 4200 (a mere 3% on the S&P500), there is a $1.5 TRILLION dollar change in notional gamma.  That’s the equivalent of having to hedge nearly 5% of the entire index value.  It would be an ugly day if something bad happened, but the bet has to be on the house maintaining control.

Gamma + Probable Volatility Bands:

Sideways consolidation has indeed been the correct call for the past week, but we are approaching the point at which the Gamma Bands are beginning to move sideways rather than upwards at a 45-degree angle. When this happened at the end of July, it resolved bullishly, and we have no way of ensuring this will not resolve similarly. But the bias is against it.

We continue to reiterate, “WATCH THIS SPACE!” The R2000 tends to lead cyclical turns and, alongside the Nasdaq, has led the rally off the lows up 24% since June 16th.  Now struggling with the 200d moving average, the same level that rejected it in December and January (yellow line below), this is likely the critical measure for the next move:

S&P 500 Market Breadth:

SPX breadth was broadly neutral yesterday as vol dampening flows continued to buffer any outsized moves. 62% of the index closed in the green for an average of +1% for those advancers. If you’re a passive investor and holding some S&P 500-linked ETFs, you can thank the likes of Nvidia, Cisco, and Broadcom for tilting the index in the right direction.

Although we currently don’t have an exact stat for you on this, we can say after tracking these models for quite some time, it is unusual to see non-top-five companies having the most impact on the direction of spot. Even Nvidia, which holds a 1.3% weighting of SPX, is only the 9th biggest company by market cap.

The summer rally was also enough to get a few SPX components back to their 52-week high, with just under 4% of the index pushing into these levels. Now that SPX is only around 10% under its all-time high, we’d expect to see this number grow exponentially in the near future if this truly is more than just another epic bear market rally.

Vol Control Implied Rebalancing:

Realized vol has paused its rapid decline as most of the larger dates we’ve been tracking have already fallen out of the sample. With the 3-month vol still higher than the 1-month vol, our model is still looking at the 3m trailing window of returns. For the next two weeks, we can expect some mild declines (absent of any new volatility that may occur), but for the most part, the next set of large dates won’t drop from the tape until around the second week of September. A lot can happen between now and then, especially as the gap closes between the 1m and 3m vols, but those mid-June crash dates dropping could trigger some substantial buying flows from the vol control universe.

We expect some muted action from the vol control universe today, with the exception of some lingering repurchases from the $6.1 billion dollar implied move we noted in Wednesday’s report.

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