(Bloomberg) — The selloff that took the S&P 500 Index into a correction last week was notable for its relative calm. Now, as investors scour metrics of market sentiment and key price levels for hints of either a recovery or a further slide, they also need to watch a more nebulous aspect: market liquidity.
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Stock-market crises from the 1987 crash to Covid share a common theme: dried up liquidity intensified market moves. Now, with the rapid growth of derivatives, there’s a focus on how option positions affect underlying spot markets, especially given the tendency for derivatives blow-ups to linger in memory.
Volatility hasn’t spiked — the Cboe Volatility Index climbed steadily to near 30 before retreating even as shares kept dropping. And while intraday swings attracted day traders, S&P 500 put skews flattened and the VIX call-to-put ratio dropped, signs that some of the equities slide came from investors taking money off the table by selling both stocks and related option hedges.
While dealer hedging to adjust positions due to negative gamma from short option bets may have added some momentum at times, there hasn’t been an upswell of commentary about options having an outsized effect on the market. That’s largely down to liquidity, which has been mostly stable, according to one measure of market depth from the Chicago Fed and CME Group Inc.
“Liquidity is clearly key for underlying spot markets to absorb the flow generated from the option Greeks,” said Benedicte Lowe, equity derivatives strategist, and Georges Debbas, head of equity derivatives strategy Europe at BNP Paribas SA. “The main risk is when dealers turn heavily short gamma and liquidity is withdrawn and then you can see spot overshoot significantly.”
The declines in the S&P 500 have largely happened during regular trading hours, when liquidity is higher. And moves haven’t been due to a shock data point or announcement, but rather a steady drumbeat of tariff proclamations and trade bluster, much of which is walked back within hours.
While investors are rightly focused on levels of positioning in the S&P 500 — where more than $2 trillion options trade each day in non-delta adjusted notional — there’s $500 billion in front-month futures as well as a deep cash and exchange-traded fund market to absorb hedging flows in normal market conditions.
“The market isn’t solely dictated by dealer positioning — these dynamics are just one piece of a larger puzzle,” said Joe Tigay, portfolio manager of the Rational Equity Armor Fund and the Catalyst Hedged Equity Fund. “On some days, they’re barely noticeable; on others, they can turn a standard pullback into a full-blown cascade.”
The recent sharp moves — whether sparked by DeepSeek AI news or wild dollar/yen swings — started when liquidity was lower. In risk-off scenarios, when market makers pull bids and offers, the impact can increase dramatically on smaller orders that will cause price distortion at least intraday.
The biggest impacts from options are likely to be seen in single stocks rather than the broader indexes, where smaller overall trading volumes can result in one-sided options trading to move shares as dealers cover positions.
The GameStop Corp. saga in 2021 is perhaps one of the most high profile incidents where option positioning appeared to spur a short squeeze in the underlying stock.
And market makers in the Nordics have at times found themselves stuck in big, illiquid client trades where options flow is reported to drive the underlying stock price at times.
One of the most hyped events on the derivatives calendar has become the quarterly option expiry, known as “triple witching.” While trillions of dollars of notional exposure expires on those days, there is rarely an outsized impact, outside of brief flurries of volatility around pricing periods, such as during the 10-minute exchange delivery settlement price window on the Euro Stoxx 50 index.
But even then, although consensus often builds among independent data providers, prime brokers and bank strategists for the likely positioning of dealers, differences of opinion still emerge.
This is not to say it’s impossible for options to affect the broader market — “the tail wagging the dog.” Zero-day contracts reached a record 56% of S&P 500 option volume in February, and even more on some days in March. That’s large enough for buy-side investors to take note amid other market signals.
“This activity is now sizable enough to materially affect the movement of major equity indexes such as the S&P 500 or the Nasdaq,” said Stefano Amato, senior fund manager at M&G investments, Multi-Asset Group. “We consider these dynamics as a sentiment gauge, which together with increased flows into passive products, can cause short-term overreaction.”
–With assistance from Sagarika Jaisinghani.
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