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Bitcoin Isn’t Any More Dangerous than the Euro

Major representatives of the European Central Bank—including ECB president Christine Lagarde—continue to warn against bitcoin. In a recent article,…

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This article was originally published by Mises Institute

Major representatives of the European Central Bank—including ECB president Christine Lagarde—continue to warn against bitcoin. In a recent article, addressed to the inflation-adverse German audience, the ECB representative Klaus Masuch together with the former ECB chief economist Otmar Issing has stressed five risks of bitcoin: a lack of intrinsic value, risks to financial market stability, the use in financing organized crime, high energy consumption, and the danger that taxpayers are held liable for financial risks. It is good that the ECB wants to protect us against possible risks, but a comparison between bitcoin and the euro in the five points mentioned should be allowed.

First, the authors write that bitcoin has no intrinsic value, i.e., no direct use value as gold does, for example (see also Thiele 2017). This is true, but some value arises from the fact that bitcoin makes electronic transactions possible without a bank account (peer to peer). The euro also has no intrinsic value; at best it has value in the form of the burning value of the notes and the metal value of the coins. Euro credit money has been backed by the investment projects it has financed, but the persistently loose monetary policy of the ECB is increasingly zombifying euro area enterprises. More and more private deposits at the commercial banks are backed by the commercial banks’ deposits at the central bank instead of credit-financed investment.

Bitcoin per Euro

Source: Reuters.

Thus, the trust in the two currencies depends on how credible they are, with this question being strongly linked to the restraints on the supply of the currencies. The number of bitcoins is credibly limited to a maximum of 21 million. Bitcoin miners have to do substantial work to create bitcoin (proof of work). The necessary efforts increase with the number of bitcoins created.

The supply of euros was intended to be limited by the ECB’s objective of price stability as outlined in article 127 of the Treaty on the Functioning of the European Union (TFEU) as well as by the prohibition of government financing by the central bank (article 123 of the TFEU). But these rules seem to be increasingly undermined, as the ECB’s balance sheet continues to grow at a high speed. Moreover, it is less and less clear whether the government bonds and loans on the asset side of the ECB’s balance sheet—which match commercial banks deposits and euro bills issued on the liability side of the ECB’s balance sheet—are at risk of default. Therefore, confidence in the euro is dwindling and confidence in bitcoin is growing, with bitcoin strongly appreciating against the euro (despite strong fluctuations; see chart above).

Second, Masuch and Issing express concern that bitcoin could suddenly lose all its value and thus destabilize the financial system. This risk is low because the supply of bitcoin is limited and a large share of bitcoin is held decentrally. At best, financial instability may emerge if bitcoins are an essential part of a financial product (but see below). Perhaps for this reason, the German legislature has limited investment in bitcoins to special funds and there to a maximum of 20 percent.

On the other hand, the ECB creates risks to financial market stability, because the ultra-loose monetary policy is depressing risk premiums. Speculation and high levels of debt are encouraged, which can lead to new debt and financial crises. In addition, the ECB’s low, zero, and negative interest rate policy is squeezing banks’ interest rate revenues, thereby destabilizing many banks in the euro area. The risks for banks could grow further if the ECB itself issues a digital central bank currency and savers shift their deposits from the commercial banks to the central bank.

Third, the authors object that bitcoin can serve organized crime. Yet, money laundering and terrorist financing existed even before cryptocurrencies, which did not lead to criticism of or even bans on the dollar or the euro. Unlike transactions in fiat money, bitcoin transactions can be viewed on a public ledger (blockchain). Moreover, aren’t there currently concerns that parts of the EU reconstruction fund, which is indirectly backed by the ECB, could end up in the hands of the Italian mafia?

Fourth, there is criticism regarding bitcoin’s impact on the climate, as the energy consumption during production (mining) is high. However, bitcoin production is geographically independent. Bitcoins can be mined where electricity capacity is idle (and therefore cheap). Since electricity is difficult to store, bitcoin is a way to solve the problem of too much electricity (grid fluctuations).

Furthermore, it also takes energy and resources to create and distribute euros—whether in paper or electronic form. Unlike the decentralized bitcoin, the euro is maintained in a huge new fully air-conditioned skyscraper and nineteen national central banks with large numbers of highly paid staff. An extensive network of commercial banks distributes and stores euros in paper and electronic form. From this perspective, bitcoin seems very lean in terms of resource consumption.

Moreover, the ECB’s ultraloose monetary policy is unsustainable in its effect, as persistently low interest rates are boosting debt and consumption (Schnabl and Sepp 2020). The loss of confidence in the euro has triggered a flight into real assets, resulting in construction booms. Between 2003 and 2007, low ECB interest rates contributed to real estate bubbles in Spain and other southern euro area countries, which left many construction ruins in their wake. Since then, low interest rates have boosted construction activities in most euro area countries. From the perspective of Hayek’s overinvestment theory, the ECB’s persistently loose monetary policy is causing an unprecedented misallocation (and thereby waste) of resources (Schnabl 2019). As bitcoin is scarce, it helps to avoid such overinvestment booms.

Finally, concerns are expressed that a financial crisis triggered by a sharp drop in the value of bitcoin could force policymakers to offset losses in order to prevent a systemic crisis in the financial system. The warning against a suspension of the liability principle is justified. Everyone should invest and speculate at their own risk.

In line with the liability principle, the bitcoin network creates default risks on an individual level due to its decentralized nature. From this point of view, there is no systemic crisis. In contrast, in the financial system of the euro area, the liability principle was suspended with the bailout of banks and highly indebted euro states in the course of the European financial and debt crisis  back in 2008–12. Since Mario Draghi’s “whatever it takes,” the ECB has been keeping a growing number of highly indebted euro states fiscally stable with the help of extensive government bond purchases. Individual risks are thus socialized, thereby paralyzing growth.

The upshot is that the persistently loose monetary policy of the ECB and other central banks has led to a loss of confidence in the euro. This loss is not only reflected in rising bitcoin prices as well as in hiking stock prices, real estate prices, gold prices, etc. The ECB’s ongoing low, zero, and negative interest rate policy is leading to an immense misallocation and waste of resources, which is likely to dwarf the energy consumed by bitcoin mining by far. If bitcoin—via currency competition with the euro—helps to discipline the ECB’s monetary policy, then it makes an important contribution to both financial market stability and sustainability in the European Union.

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Author: Gunther Schnabl

Economics

Portfolio Tweaks for 2022

Are you ready for risk-off? … two trades from Eric Fry looking poised to generate strong returns … two hedge trades to balance your portfolio

In 2022,…

Are you ready for risk-off? … two trades from Eric Fry looking poised to generate strong returns … two hedge trades to balance your portfolio

In 2022, which of the following will have better returns?

Volkswagen or Tesla?

Gold or Bitcoin?

Intel or NVIDIA?

Got your picks?

Our macro specialist, Eric Fry, is going with…drumroll…Volkswagen, gold, and Intel.

A few of you might suddenly be choking on your dinner. So, let’s jump straight to Eric for more color:

I expect the “character” of the financial markets to shift noticeably from a “risk-on” bias to “risk off.”

In other words, I expect investors to behave more cautiously and timidly than they did in 2021.

Generally speaking, therefore, I’m expecting relatively cautious investments to outperform their relatively risky counterparts.

“Caution” certainly feels appropriate after the market’s selloff in recent weeks, including today’s massive turnaround that saw the Nasdaq go from 2% gains to a loss (as I write, near the end of the day).

Yesterday, the Nasdaq slipped into an official correction. Meanwhile, the S&P and Dow are down roughly 6% and 5% from recent highs.

So, what 2022 trends will present investors that wonderful combination of returns and caution?

In Eric’s latest issue of Investment Report, he detailed several. Today, let’s peek into the issue to find out what opportunities Eric sees outperforming in 2022.

***A fantastic setup in commodities

For newer Digest readers, Eric is our global macro specialist and the editor behind Investment Report. As a macro investor, he evaluates markets and asset classes from a big-picture perspective to identify attractive opportunities.

Once a macro trend is in his crosshairs, he digs down to find the right, specific investment to play the opportunity.

It’s been a powerful strategy. In his decades in the business, Eric has dug up more 1,000%+ gaining investments than anyone we know of in the newsletter industry.

Returning to cautious approaches to 2022, Eric points toward commodities.

Now, regular Digest readers are familiar with Eric’s bullishness on the copper trade. In fact, yesterday’s Digest touched on this.

We won’t rehash those details again, but here’s Eric’s quick take:

Bottom line: Robust future demand growth for copper is fairly certain, but the mining industry’s capacity to satisfy that growth is not.

That’s the sort of equation that should put upward pressure on the copper price for many years to come.

But copper isn’t the only commodity Eric likes in 2022.

The second is something our world wants to do without, but addictions are hard to break. And this one is likely to generate great returns before it kicks the bucket.

From Eric:

No matter how “doomed” crude oil may be over the long term, it could deliver some spectacular short-term gains.

The bullish backdrop for crude has become too compelling to ignore.

***In the past, Eric has highlighted the fallacy of “more electric vehicles mean oil is dead”

In short, though EVs will capture a growing share of the global auto market in coming years, the total auto market will continue to grow larger. That means the number of gas-powered automobiles on the road will continue to increase as well.

When you combine that reality with demand from other industries, the International Energy Agency (IEA) expects worldwide demand will be at least 25% higher in 2050 than it is today.

Recently, oil demand has rebounded sharply, supporting higher prices. In fact, this week, oil hit a seven-year high (in part due to an attack by Yemeni Houthi rebels on the three United Arab Emirates fuel tankers).

But investors pointing toward this seven-year-high saying that prices are peaking are missing an important part of the equation – basic supply and demand.

As to demand, this is from yesterday in The Wall Street Journal:

Global oil demand will exceed pre-pandemic levels this year thanks to growing Covid-19 immunization rates and as recent virus waves haven’t proved severe enough to warrant a return to strict lockdown measures, the International Energy Agency said Wednesday.

And for supply, here’s Eric:

Most folks assume that OPEC and others could easily ramp production to satisfy any significant surge in demand. But that assumption rests on a frail statistical foundation.

The U.S. has supplied almost all of the world’s crude production growth during the last decade, not OPEC. Pulling that rabbit out of the hat a second time will not be easy, as U.S. shale production topped out two years ago.

Eric points out that oil and gas companies have been slashing the exploration budgets for years. Global investments in oil and gas exploration and production are down by about 65% since 2014.

It’s not hard to connect the dots:

Net-net: Bountiful new supplies of crude oil seem highly unlikely.

A tightening oil market, coupled with a rising inflationary trend, provides ample reason to expect oil stocks to deliver market-beating results in 2022.

***Two “hedge” plays to balance your broader portfolio

Copper and oil are likely to bring firepower to your returns this year – think “offense.”

Let’s now look at two ways to play defense: gold and a bet against bonds.

Starting with gold, there’s no denying that this trade has been incredibly disappointing, most notably because it’s done nothing while inflation has surged.

From Eric:

As the chart below shows, the gold price trend tends to track the inflation trend… but not this time around.

Despite the skyrocketing inflation reading on the right side of the chart, the gold price has been falling!

Chart showing gold's price dropping while inflation has been surging

Even so, the yellow metal deserves the benefit of the doubt, both as an inflation hedge and as a hedge against stock market volatility… at least for now.

I still believe gold-related plays deserve a few investment dollars in a balanced portfolio.

Plus, gold might get a boost from an unexpected source…grumpy Bitcoin investors.

Through nearly all of 2021, Bitcoin acted like an inflation hedge. As yields surged, so too did Bitcoin’s price. When they fell, Bitcoin dropped.

As we noted earlier this week here in the Digest, this relationship appears to have come to a fiery crash in 2022.

What we’re seeing now is Bitcoin being treated as a risk asset. As yields surge, investors have been dumping Bitcoin.

But they’re not dumping gold.

Below, we look at gold versus Bitcoin since December 1. Bitcoin has lost 27% while gold is up 4%.

Chart showing gold's price rising while bitcoin's price has fallen sharplySource: StockCharts.com

Remember, both of these assets derive their value from one source – emotion.

If we are truly seeing a broad shift toward “risk off” sentiment, all signs point toward gold being considered a stabler storehouse of value than cryptos.

And this could attract some “me too” Bitcoin investors who have been burned and are now looking for something more solid.

(To avoid confusion, we’re bullish on Bitcoin and elite altcoins. The analysis above refers to the mindsets behind investing in the two asset classes.)

***For the second hedge play, consider a bet against bonds

Interest rates have been sliding for four decades. But Eric suggests we could finally see a reversal this year.

From his issue:

As most folks are aware, the CPI inflation rate is running red-hot at a 40-year high of 7%. That means the buyer of a 30-year Treasury bond yielding 2.0% is receiving a robust after-inflation return of minus 5% per year.

That math is not the kind that builds wealth.

Sooner or later, bond buyers might demand more than 2% interest to tie up their money for 30 years… especially because the federal deficit is still running at a $215 billion monthly clip, or $2.6 trillion per year…

Without the price-insensitive Federal Reserve sopping a big chunk of that titanic Treasury bond supply, who will? And at what price?

Someone will buy our bonds, of course. But they might demand a much higher rate of interest to do so.

Eric is quick to point out that a sustained rising rate environment is not a certainty.

In fact, just about everyone is anticipating rates will be much higher a year from today. And longtime investors will likely tell you that when everyone believes the same narrative about the market, surprises often result.

That said, higher rates are enough of a possibility for Eric to feel confident about taking on this trade as a hedge.

If you’re an Investment Report subscriber, be sure to check out your latest issue. Eric details the specific investments he’s recommending for each of these trends plus a few others. To learn more about joining Eric in Investment Reportclick here.

***Wrapping up, who knows what 2022 will bring, but it’s unlikely to offer the huge, broad returns as 2021

Is your portfolio ready for that?

If not, look at the trends we’ve touched on today. They’re likely to provide both returns and an added degree of portfolio hedging.

I’ll give Eric the final word:

Markets are forever and always cyclical. Sometimes cycles take their sweet time to shift direction, but they always do… eventually.

Once upon a time, hedging was a worthwhile activity…

That was before the Fates shifted and began smiling on unhedged strategies.

I believe the Fates may be shifting once again. We’ll see.

Have a good evening,

Jeff Remsburg

The post Portfolio Tweaks for 2022 appeared first on InvestorPlace.












Author: Jeff Remsburg

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Economics

JPMorgan Spots A Crack In The Market One Day Ahead Of $3 Trillion OpEx

JPMorgan Spots A Crack In The Market One Day Ahead Of $3 Trillion OpEx

Earlier today we quoted a JPMorgan trader who was wondering if after…

JPMorgan Spots A Crack In The Market One Day Ahead Of $3 Trillion OpEx

Earlier today we quoted a JPMorgan trader who was wondering if after yesterday’s mid-day swoon, the result of systematic, vol-targeting and CTA strategies unleashing a barrage of sell orders, if today’s action would be similar, to wit: “Let’s see if we can hold pre-market gains throughout the session as yesterday afternoon felt like systematic selling. If 1.90% was a buy-level in bonds, then we may have a relief rally being initiated led by Tech.”

A few hours later we found out the answer, and it was a resounding no, because just around the time European market closed, the selling resumed, and boy was it glorious:

So what happened? Well, clearly there were more sellers than buyers (yes, contrary to the ridiculous response that sellers and buyers are always the same, sellers can certainly be more than buyers, and it is the change in price that reflects relative selling or buying pressure and preference).

But there was something more, because as as JPMorgan’s QDS strategist Peng Cheng observed, after weeks of relentless buying the dip by retail traders, on Thursday retail investors net sold $53mm, with $400mm coming in the last 2 hours. This, as JPM puts it, “is notable as it is the first time retail investors have net sold since December 6th. Since December 6th, the retail investor had been net buying, on average, more than $800mm per day.”

But whereas JPM notes that the above is “great color” it does not get to the why of the sell-off.

And while the answer includes some combination of technicals, deal gamma, and systematic activity, JPM’s Andrew Tyler writes that the “overarching story is how the Fed is changing investor behavior.” As he notes, the combination of ending QE, beginning QT, and rate hike liftoff has left Equity investors with significant uncertainty, one which is manifesting itself in a “sell all rallies” mentality with regards to the Tech sector.

What is curious, is that according to JPMorgan’s Positioning Intelligence team, the selling is led by non-Hedge Funds (one wonders just how much of the recent markets tumble is due to deleveraging by risk-parity whales such as Bridgewater). Here is an excerpt from their weekly wrap:

Tech – Still selling expensive stocks, but buying others: In the US, Expensive Software (JP1BXSFT) continues to underperform and HF flows have remained negative MTD. Additionally, expensive stocks in general (JP1QVLS) saw very strong selling over the past 5 days (>2z) with particularly strong selling on Thurs; it’s worth noting that periods of large selling in the past year have actually been followed by underperformance among these stocks. Despite the selling of expensive stocks and underperformance, Info Tech was actually the most net bought sector in N. Am. (just under +2z) and gross was added (>1z) for the week. Semis were the main driver, although most of TMT saw net buy skews for the week in aggregate.

As the bank concludes, among the reasons for the market scare is that with the Fed meeting next week, what should be a non-event now has investors questioning (i) will the Fed end QE next week; (ii) is next week a live meeting or does liftoff begin in March; and, (iii)is the first rate hike 25bps, 50bps, or more. Incidentally, JPM’s answer to all is no (and 25bps).

But before we get there, and get a powerful relief rally as Powell reaffirms that for all of Biden’s hollow rhetoric, the Fed will not cause a market crash just to tame inflation (the same inflation the Fed though was transitory as recently as October) and save Biden’s approval rating…

… there is another issue to consider: tomorrow’s option expiration of $3.1 trillion in notional, including some $1.3 trillion in single-stocks.

As Goldman’s Rocky Fishman writes in his latest Vol Vitals note, “the January expiration is always a focus for single stock option markets, because January options are listed years in advance and can build up high open interest“, a topic we discussed extensively earlier this week in “All You Need To Know About Friday’s “Deep” Option Expiration.

Going back to tomorrow’s critical market event, in its post-mortem from Thursday, SpotGamma writes that as expected, “a negative gamma position in all the indices made for volatile trade, today. The high gamma $4,600.00 SPX strike held as resistance; real-money sellers, alongside the hedging of negative delta options trades, bid volatility, and pressured indices.”

In other words, stock liquidation played into the large negative gamma position which accelerated selling into the close, SpotGamma writes, adding that so long as the SPX trades below its Volatility Trigger – around 4,630 –  SpotGamma sees heightened volatility, and adds that trades with respect to Friday’s monthly OPEX will only compound the instability.

In short, tomorrow could unleash sheer chaos in early trading, but once trillions in notional expire, taking away with them a substantial chunk of the negative gamma that dealers are currently trapped under, it is quite likely that following an initial burst lower, the market will finally bottom out for the near-term.

Before we dig a little deeper into what to expect tomorrow, here is some context for today’s waterfall rout, courtesy of SpotGamma:

Stocks continued to sell, Thursday, pressured by increased jobless claims, the prospects of more aggressive tightening of monetary policy, and poor responses to earnings.

Growth and rate-sensitive names like Amazon and Peloton (which happened to halt production due to slowing demand), as well as Netflix (which fell after-hours on slower subscriber growth), are just some of the names leading to the downside. There were rumors of forced liquidations, which seemed to sync with with the afternoons indiscriminate selling.

Graphic: Nasdaq, which is officially in a correction, approaches key technical support.

And despite a reduction in gamma levels ahead of today’s regular trade (9:30 AM – 4:00 PM ET),  SpotGamma observes that the move lower in markets, overall, comes with an increased concentration of put-heavy gamma tied to Friday’s monthly options expiration.

To preface, delta denotes an options exposure to the underlying direction. Gamma, on the other hand, is the potential delta-hedging of options positions. 

  • When a position’s delta rises (falls) with stock or index price rises (falls), the underlying is in a positive-gamma environment.
  • When a position’s delta falls (rises) with stock or index price rises (falls), the underlying is in a negative-gamma environment.

In the latter case, as the risk of out-of-the-money customer protection developing intrinsic value increases (given an increase in implied volatility or move lower in price), dealers are long more delta, and therefore the addition of hedges (short stock/futures) introduces negative flows (i.e., the addition of short delta hedges to long delta positions) that pressures markets.

This negative gamma regime, which we experienced today, is affecting both single-stocks and the index products. Below, the selling of calls and buying of puts in Tesla, for instance, is a negative delta trade dealers hedge by selling stock, thus exacerbating weakness.

To note, the reduction in the positive delta in names like Tesla, which, heading into this week, had nearly 107% of its deltas set to expire (as a percentage of average daily volume), is one dynamic further pressuring markets.

This activity is feeding into products like the Nasdaq which is seeing a lot of put buying. A shift higher in the VIX term structure (below) denotes demand for index protection, especially in shorter-dated options that are more sensitive to changes in direction and implied volatility.

Graphic: VIX term structure shifts up. This introduces negative vanna flows

If volatility continues to rise, positive exposure to delta rises. This solicits even more selling.

Graphic: The “Biggest tail risk to SPX isn’t any macro data/virus/war but its own options market.”

Why does this matter and why is all of the above potentially bullish? Because many stocks are to have their largest “put-heavy” gamma positions expire soon. We are taking trillions in put notional. These positions are, at present, compounding weakness as dealers sell aggressively against very short-dated, increasingly sensitive negative gamma positions.

The removal of this exposure post-OPEX and the approaching FOMC event will leave dealers with less positive delta exposure to sell against. That’s why, SpotGamma sees the market soon entering into a window of strength, to which we will only add that once $3+ trillion in options expire Friday and much of the dealer negative gamma overhang disappears, the selling which we predicted would dominate this week ahead of Friday’s Op-Ex, will have exhausted itself and the bandwagon of shorts that piggybacked on the rout in stocks is about to be painfully squeezed higher.

Still, while the next move is higher, as long as bears successfully maintain S&P prices below the $4,630.00 SPX Volatility Trigger, there is increased potential for instability as dealer hedging flows continue to take from market liquidity (sell weakness and buy strength), further exacerbating underlying movement.

Tyler Durden
Thu, 01/20/2022 – 21:30






Author: Tyler Durden

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Economics

JPM Spots A Crack In The Market One Day Ahead Of $3 Trillion OpEx

JPM Spots A Crack In The Market One Day Ahead Of $3 Trillion OpEx

Earlier today we quoted a JPMorgan trader who was wondering if after yesterday’s…

JPM Spots A Crack In The Market One Day Ahead Of $3 Trillion OpEx

Earlier today we quoted a JPMorgan trader who was wondering if after yesterday’s mid-day swoon, the result of systematic, vol-targeting and CTA strategies unleashing a barrage of sell orders, if today’s action would be similar, to wit: “Let’s see if we can hold pre-market gains throughout the session as yesterday afternoon felt like systematic selling. If 1.90% was a buy-level in bonds, then we may have a relief rally being initiated led by Tech.” A few hours later we found out the answer, and it was a resounding no, because just around the time European market closed, the selling resumed, and boy was it glorious:

So what happened? Well, clearly there were more sellers than buyers (yes, contrary to the ridiculous response that sellers and buyers are always the same, sellers can certainly be more than buyers, and it is the price that reflects relative selling or buying pressure).

But there was something more, because as as JPMorgan’s quant and derivative strategist Peng Cheng observed, after weeks of relentless buying the dip by retail traders, on Thursday retail investors net sold $53mm, with $400mm coming in the last 2 hours. This, as JPM puts it, “is notable as it is the first time retail investors have net sold since December 6th. Since December 6th, the retail investor had been net buying, on average, more than $800mm per day.”

And while according to JPM the above is “great color” it does not get to the why of the sell-off.

So while the answer includes some combination of technicals, deal gamma, and systematic activity, JPM’s Andrew Tyler writes that the “overarching story is how the Fed is changing investor behavior.” As he notes, the combination of ending QE, beginning QT, and rate hike liftoff has left Equity investors with significant uncertainty, one which is manifesting itself in a “sell all rallies” mentality with regards to the Tech sector.

What is curious, is that according to JPMorgan’s Positioning Intelligence team, the selling is led by non-Hedge Funds (one wonders just how much of the recent markets tumble is due to deleveraging by risk-parity whales such as Bridgewater). Here is an excerpt from their weekly wrap:

Tech – Still selling expensive stocks, but buying others: In the US, Expensive Software (JP1BXSFT) continues to underperform and HF flows have remained negative MTD. Additionally, expensive stocks in general (JP1QVLS) saw very strong selling over the past 5 days (>2z) with particularly strong selling on Thurs; it’s worth noting that periods of large selling in the past year have actually been followed by underperformance among these stocks. Despite the selling of expensive stocks and underperformance, Info Tech was actually the most net bought sector in N. Am. (just under +2z) and gross was added (>1z) for the week. Semis were the main driver, although most of TMT saw net buy skews for the week in aggregate.

As the bank concludes, among the reasons for the market scare is that with the Fed meeting next week, what should be a non-event now has investors questioning (i) will the Fed end QE next week; (ii) is next week a live meeting or does liftoff begin in March; and, (iii)is the first rate hike 25bps, 50bps, or more. Incidentally, JPM’s answer to all is no (and 25bps).

But before we get there, and get a powerful relief rally as Powell reaffirms that for all of Biden’s hollow rhetoric, the Fed will not – in fact – cause a market crash just tame inflation and save Biden’s approval rating…

… there is another issue to consider: tomorrow’s option expiration of $3.1 trillion in notional, including some $1.3 trillion in single-stocks.

As Goldman’s Rocky Fishman writes in his latest Vol Vitals note, “the January expiration is always a focus for single stock option markets, because January options are listed years in advance and can build up high open interest”, a topic we discussed extensively earlier this week in “All You Need To Know About Friday’s “Deep” Option Expiration.

Going back to tomorrow’s critical market event, in its post-mortem, SpotGamma writes that as expected, “a negative gamma position in all the indices made for volatile trade, today. The high gamma $4,600.00 SPX strike held as resistance; real-money sellers, alongside the hedging of negative delta options trades, bid volatility, and pressured indices.”

In other words, stock liquidation played into the large negative gamma position which accelerated selling into the close, SpotGamma writes, adding that so long as the SPX trades below its Volatility Trigger – around 4,630 –  SpotGamma sees heightened volatility, and adds that trades with respect to Friday’s monthly OPEX will only compound the instability.

In short, tomorrow could sheer chaos, but once trillions in notional expire, taking away with them a substantial chunk of the negative gamma that dealers are currently trapped under, it is quite likely that following an initial burst lower, the market will finally bottom out for the near-term.

Before we dig a little deeper into what to expect tomorrow, here is some context for today’s waterfall rout, courtesy of SpotGamma:

Stocks continued to sell, Thursday, pressured by increased jobless claims, the prospects of more aggressive tightening of monetary policy, and poor responses to earnings.

Growth and rate-sensitive names like Amazon and Peloton (which happened to halt production due to slowing demand), as well as Netflix (which fell after-hours on slower subscriber growth), are just some of the names leading to the downside. There were rumors of forced liquidations, which seemed to sync with with the afternoons indiscriminate selling.

Graphic: Nasdaq, which is officially in a correction, approaches key technical support.

And despite a reduction in gamma levels ahead of today’s regular trade (9:30 AM – 4:00 PM ET),  SpotGamma observes that the move lower in markets, overall, comes with an increased concentration of put-heavy gamma tied to Friday’s monthly options expiration.

To preface, delta denotes an options exposure to the underlying direction. Gamma, on the other hand, is the potential delta-hedging of options positions. 

  • When a position’s delta rises (falls) with stock or index price rises (falls), the underlying is in a positive-gamma environment.
  • When a position’s delta falls (rises) with stock or index price rises (falls), the underlying is in a negative-gamma environment.

In the latter case, as the risk of out-of-the-money customer protection developing intrinsic value increases (given an increase in implied volatility or move lower in price), dealers are long more delta, and therefore the addition of hedges (short stock/futures) introduces negative flows (i.e., the addition of short delta hedges to long delta positions) that pressures markets.

This negative gamma regime, which we experienced today, is affecting both single-stocks and the index products. Below, the selling of calls and buying of puts in Tesla, for instance, is a negative delta trade dealers hedge by selling stock, thus exacerbating weakness.

To note, the reduction in the positive delta in names like Tesla, which, heading into this week, had nearly 107% of its deltas set to expire (as a percentage of average daily volume), is one dynamic further pressuring markets.

This activity is feeding into products like the Nasdaq which is seeing a lot of put buying. A shift higher in the VIX term structure (below) denotes demand for index protection, especially in shorter-dated options that are more sensitive to changes in direction and implied volatility.

If volatility continues to rise, positive exposure to delta rises. This solicits even more selling.

Why does this matter and why is all of the above potentially bullish? Because many stocks are to have their largest “put-heavy” gamma positions soon expire. We are taking trillions in put notional.

These positions are, at present, compounding weakness as dealers sell aggressively against very short-dated, increasingly sensitive negative gamma positions.

The removal of this exposure post-OPEX and the approaching FOMC event will leave dealers with less positive delta exposure to sell against. That’s why, SpotGamma sees the market soon entering into a window of strength, to which we will only add that once $3+ trillion in options expire Friday and much of the dealer negative gamma overhang disappears, the selling which we predicted would dominate this week ahead of Friday’s Op-Ex, will have exhausted itself and the bandwagon of shorts that piggybacked on the rout in stocks is about to be painfully squeezed higher.

Still, while the next move is higher, as long as bears successfully maintain S&P prices below the $4,630.00 SPX Volatility Trigger, there is increased potential for instability as dealer hedging flows continue to take from market liquidity (sell weakness and buy strength), further exacerbating underlying movement.

Tyler Durden
Thu, 01/20/2022 – 21:30






Author: Tyler Durden

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