Near-Term Volatility: Will Option Dealers Sell? Implications Of Debt Ceiling On Dealer Positive Vanna

Yesterday was a relatively flat day, as the markets cruise to the upside in monthly options expiration (opex) week. I have been saying that markets support a slow move up through June opex, which is seemingly what we are getting. However, there is a lot of positive vanna underneath.

In normal conditions, positive vanna underneath is bullish, because premium reduction through time and implied volatility (IV) dropping is a bullish force. However, if something causes an IV expansion, it is a strongly bearish force.

Is there something to cause an IV expansion on the horizon? Indeed – the debt ceiling crisis.

Personally, I'm not afraid of political resolution. That will come, and it seems the market is waiting for that. What I'm concerned about are the liquidity consequences of a Treasury General Account (TGA) replenishment.

TGA replenishment is a net drain on liquidity. Households and institutions buy US Treasuries (USTs) instead of money market funds, who put USTs into reverse repurchase program (RRP). This is net neutral. Foreign investment is neutral in the short term. Then, when the TGA is spent, it is a gain to liquidity.

Let’s put that in the context of the Volatility Index VIX. The VIX is an implicit measure of liquidity. Less liquidity means higher VIX. There seems to be a factual reason for net liquidity to drop from this strong UST issuance, so higher VIX is a strong possibility.

With a lot of vanna below the market, an equity drop can start once issuance begins. This drop would be near the beginning of June.

From an options dealer positioning standpoint, this drop should bottom near 3850 on the S&P 500 Index SPY but could have some extra momentum to the downside. The drop coincides with a credit crunch, extra puts, and rapid economic contraction with hints only beginning to show themselves.

From a fundamental standpoint, SPX could float slightly higher in fits and starts as it has been with a debt ceiling resolution as a sign of a top. The beginning of June – only two weeks away – is when to go long gamma bearish. We have a week or so to collect our equity option premium and belongings and be ready for the next trade.

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