US$2.7 trillion wall of expiring options a worry for traders reeling from bank crisis

Just as a week of global bank drama winds down, Friday’s (Mar 17) options expiration risks creating fresh turmoil for traders.

An estimated US$2.7 trillion of derivatives contracts tied to stocks and indexes are scheduled to mature, obliging Wall Street managers to either roll over existing positions or start new ones. The process usually involves portfolio adjustments that lead to a spike in trading volume and sudden price swings. 

While the event has its benefits, such as amping up liquidity, that may not be enough to appease investors reeling from shocks ranging from the collapse of three US banks to hawkish comments from Federal Reserve Chair Jerome Powell. 

Demand for bearish options has been on the rise, a stark departure from last year, when a bear-market selloff barely registered in the world of derivatives. Meanwhile, market makers – who are on the other side of transactions and need to buy or sell equities to keep a neutral position – are caught in a state known as “short gamma.” The stance requires them to ride the prevailing trend, buying stocks when they rise and selling when they fall. 

“We’re going to see some hypersensitivity to every headline,” said Alex Kosoglyadov, managing director of equity derivatives at Nomura Securities International, referring to the prospect of market fireworks on Friday. “Any 1 per cent move can quickly turn into a 2 per cent move.” 

Wall Street is on edge after the banking chaos sparked a re-assessment of Fed policy and the economy. The prospect of a recession has forced bond traders to scale back expectations for interest-rate hikes. In the equity market, there has been a swift rotation out of financial shares and into companies with strong balance sheets, such as technology. The S&P 500 climbed 1.8 per cent Thursday, the most in almost two months, after a rescue plan for First Republic Bank. 

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Unlike the second half of 2022, when the S&P 500’s slide failed to spark any big reaction in the Cboe Volatility Index, the so-called fear gauge this time has shown a more pronounced move. While the equity benchmark lost 2 per cent over past two weeks, the VIX jumped more than 4 points, reaching the highest level since October. 

The Cboe Skew Index, a measure of relative costs in S&P 500 options, has climbed in eight of the past nine sessions – a clear sign of investor angst. In contrast, it sank to a 13-year low last November after a bout of equity selling. 

“Ironically, the S&P 500 isn’t selling off that much, but the tail risk has been priced much higher,” Layla Royer, a senior equity derivatives salesperson at Citadel Securities, said in an interview. “It’s an interesting regime change versus what we saw last year.”

Friday’s expiry coincides with the quarterly expiration of index futures in a process ominously known as triple witching. Added to that comes a rebalancing of benchmark indexes including the S&P 500. The combination tends to spark single-day volume that ranks among the highest of the year. 

This time, about 102 million options contracts are set to expire, roughly in line from a year ago, according to data compiled by Chris Murphy, co-head of derivatives strategy at Susquehanna International Group. As fears grow on everything from the economic and monetary cycle to the banking system, a bearish tilt has developed with put open interest up almost 5 per cent while that for calls fell by 6 per cent. 

Contracts linked to S&P 500 account for more than 60 per cent of Friday’s maturing options, according to Tanvir Sandhu, chief global derivatives strategist at Bloomberg Intelligence. He notes the bulk of open interest is concentrated on the 4,000 level. The index has largely stayed within 200 points of the threshold this year, fuelling speculation that the tight trading range was a function of options activity that made it a battle line for investors and market makers. 

The level “has acted as a magnet in recent months,” Sandhu wrote in a note this week. “This quarterly expiry may help unpin the market,” he said, referring to the prospect that the benchmark index trades within a wider band. BLOOMBERG