Quick: how did equity traders feel about inflation after Tuesday’s consumer price index hit? Depends on when you asked.
Everyone was bullish right after it came out. S&P 500 futures soared 1% as traders decided disaster had been avoided. Three and a half hours later, that optimism had evaporated: the index was down 1%. By the close stocks were back where they started, marking the third time they’d swung so widely this month alone.
While getting a grip on the macro message of markets is particularly hard at a time the Federal Reserve is fighting a pitched battle against price pressures, other factors native to the stock market itself may be playing a role in the unhinged moves. First among them, many analysts say, is the sudden mania for extremely fast-twitch options that traders have started to exploit with vigor as part of speculative operations when news is breaking.
These contracts, with shelf lives shorter than 24 hours, comprise a category known as zero-day-to-expire options that have exploded since mid-2022, at times causing derivatives to amplify moves in underlying assets. That’s made the task of figuring out the market’s collective thinking on the economy an especially futile exercise of late.
“These big swings like yesterday were a great example,” Jim Bianco, founder of Bianco Research, said in an interview on Bloomberg TV. “We have to be ready for this idea that, ‘hey, look, the market’s up 1%. What does it mean? Wait an hour, it’s now down on the day. Wait an hour, it’s back up on the day.’ That’s where I think that the 0DTE options are really starting to play. It’s the market that’s confusing a lot of people.”
Granted, the wild swings reflected conflicting narratives at a time when the path of Fed policy and economic growth remains very hard to track. While Tuesday’s inflation data reinforced the bear case that interest rates will stay higher than longer, it also fed an argument that the economy will avoid a recession.
Yet the proliferation of 0DTE options is likely complicating matters, turning small moves into big ones and inducing violent reversals that make mincemeat of narratives. Over the prior 10 sessions, S&P 500 futures have endured 14 intraday swings of at least 1%. On a closing basis, they have posted seven separate sessions where they erased a gain or loss of at least 0.9% since January — the most turbulent start to a year since 2016.
The whiplash created a headache for anyone who’s seeking to get a clean read on the economy via markets. Just ask Dennis DeBusschere, founder of 22V Research. Heading into Tuesday’s inflation reading, the firm’s client survey showed people expected a strong print would spark a risk-off move.
When stocks started to pull back following the initial spike, DeBusschere flagged some of the hawkish elements of the release, such as services price pressures. Then as the S&P 500 bounced back and turned green around 10 a.m., he issued a mea culpa.
“Thinking that today’s CPI should be a negative looks pretty wrong. Shame on us,” DeBusschere said at that time.
Single-day options are also part of hedging strategies that may be exacerbating moves when news breaks. Generally speaking, on Tuesday traders had bought contracts for to guard against a shock CPI. The cost of hedging against losses had risen in the options market, a sign that traders were bracing for a hot print.
When the worst didn’t happen, these hedges were unwound, helping propel a recovery in futures. It’s partly why the Cboe Volatility Index, or VIX, dropped 7% in a seemingly outsize reaction in a market when Sthe &P 500 ended the session basically flat, according to Danny Kirsch, head of options at Piper Sandler & Co.
Taken up first by retail traders during the 2021 meme mania, 0DTE options have gained popularity among big money managers. During the second half of 2022, such options made up more than 40% of the S&P 500’s total trading volume, data compiled by Goldman Sachs Group Inc. show. That’s almost double from six months ago.
In a study by JPMorgan Chase & Co. in November, strategists including Peng Cheng found that the market impact from those trades can vary from a drag of as much as 0.6% to a boost of up to 1.1%.
The group at the center of it all is options dealers, who take the other side of trades and must buy and sell stocks to keep a market-neutral stance. As options traders rush to buy calls to catch up with a market rally, those purchases theoretically force dealers to snap up stocks. The same happens in reverse.
As the market is stuck in a war between bulls eying a “no landing” and bears warning over “higher for longer” rates, that’s emboldening the use of 0DTE options to make quick profits. Over the past month, nearly one of two every options traded on the S&P 500 was 0DTE, according to Nomura Securities International’s cross-asset strategist Charlie McElligott.
That’s adding another lay of noise to a market that has been defying efforts to predict or explain it.
“US equities are such an untradable mess right now,” McElligott said.
--With assistance from Jonathan Ferro, Lisa Abramowicz and Tom Keene.
This article was provided by Bloomberg News.