How To Trade The S&P 500 Index And The Market By Using Options Data

The end of last week was probably one of the most volatile endings to the week that we have seen in a while. The S&P 500 Index peaked at 4538 to end at 4478.That for the biggest equity market in the world is a substantial intraday move. 

There were several reasons that drove that price action. Let’s start from Thursday. After market closing Apple and Amazon came out with earnings. Both of these stocks are particularly important because of their weighting in the S&P 500 Index. Amazon.com, Inc. AMZN weighs 3.06%, while Apple Inc. AAPL 7.51%. 

For that reason, market participants were monitoring these results very closely. While Amazon came in strong, Apple gave mixed signals, with services improving, while iPhone sales were down. 

From a macro perspective we had the release of the numbers from the job market on Friday. The numbers came with mixed feelings, while Non Farm Payrolls rose to +187,000 in July; Unemployment Rate came at 3.5%, and average hourly earnings rose by 4.4% Y/Y while estimates were at +4.2%.  

The Importance Of Leverage In Trading The US Stock Market

The other factor is one less understood. Post 2008, the way market participants take positions in the market has changed. We started seeing an increase of products that come with leverage. The use of Options surged dramatically, not only for institutional players but also for retail. This chart can give you an idea of how many retail traders are now participating in the options market.

Source: Twitter @MenthorQpro

The option market uses leverage. For an investor this means that returns can be higher than just going long the underlying. Also if used correctly, this product can also help risk manage better. But since there is leverage, if used incorrectly it can create bigger losses. 

The increase of leverage by investors has an effect on market price action. When an investor buys an option, on the other side of the trade you have a Market Maker. This market participant is very important because it provides liquidity for investors, while making sure that there are no major disruptions. 

We will not go into too much detail about how a market maker works, but it is important to understand his participation, because as the market maker provides liquidity, he is also hedging. A market maker does not take a directional position. His role is purely to “make” markets. 

In trading terms, his position and his trading book should always be flat. He stays flat by buying and selling the underlying. In the case of the SPX, while market participants buy or sell options, the market maker buys or sells an equivalent of underlying to stay hedged. This process is called delta hedging.

This delta hedging activity can add or remove liquidity and create volatility like we saw last Friday. This is why, as a trader, you really want to understand how option gamma affects markets. Especially in the short term, the market is affected mostly by technical movements rather than fundamentals. 

The Impact Of Options Key Price Levels On The S&P 500 Index

Let’s use Friday price action to understand how option activity in the market was a major force of that price movement. 

In this chart we have highlighted three key levels. As we go through those three different levels we will explain why each one of them was hit. 

Source: Twitter @MenthorQpro

• Put Support: we opened on Friday with spot price near the put support level. At this level, there is a lot of participation in put options. Major participants are hedged here as they are buying protection from the possibility of the market falling below this point. When the market breaks below this level, it is usually a very bad sign and the price can move fast.
• High Vol Level: during the day we moved all the way to the High Vol Level. This is a very important level that divides a market between negative and positive gamma. When a market is in positive gamma, volatility is low. When we go into negative gamma (environment we were in on Friday), volatility becomes accentuated. We moved all the way to this level, but remained in negative gamma.
• GEX Level 1: at the end of the session the price moved towards the Put Support again, it broke that support and finished at the GEX Level 1. This is the price level with the highest gamma. As we were saying before, breaking below is critical. Next week we will want to see whether that Put Support moves lower. When the market becomes bearish, the Put Support level moves lower because the market is rolling its hedges downwards.

What To Expect For This Week?

We are definitely in a critical part of this market. There is a lot of leverage, interest rates have been going up and the Fed direction on monetary policy is still not clear. When it comes to earnings one has to understand that at these valuation either multiples come down or you really need earnings to explode. 

All of these factors are keeping the market on edge, and even the traders in Wall Street are unclear about the path of the market.

The path for this week looks still bearish. In the shaded area next to spot price you can see the 1D Expected Move. That is an indicator based on forward looking implied volatility. For now the Put Support has not moved but volatility is expected as we will be losing a lot of gamma. You can see how gamma is turning negative in the yellow bars at the bottom of the chart below.

Source: Menthor Q Models

These are volatile times, tighten up your risk management and focus on positioning as you enter the markets.

About the Publisher: Menthor Q is a leading TradeTech company that specializes in developing advanced quantitative models for active investors. The team is made of industry experts, and is dedicated to making the financial markets more accessible and understandable to active investors. Menthorq's models leverage the power of Big Data and AI to offer actionable and operational model to retail investors. https://www.menthorq.co/

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